University of Malawi

Chancellor College
Department of Economics







MASTER OF ARTS IN ECONOMICS
(PARALLEL PROGRAMME)





ECO 690: INTERNATIONAL
ECONOMICS

ZOMBA, MALAWI
November 2009

Prepared by

Exley B.D. Silumbu








CORE COURSES

Microeconomics
Macroeconomics
Quantitative Methods
Policy Analysis



ELECTIVE COURSES

Agricultural Economics
Industrial Economics
Managerial Economics
Corporate Finance &
Investment
Public Finance
Environmental Economics
International Economics
Monetary Economics
Health Economics








UNIVERSITY OF MALAWI
2
CHANCELLOR COLLEGE
ECONOMICS DEPARTMENT

MASTER OF ARTS IN ECONOMICS PROGRAMME

ECO 690: International Economics
Course Outline

Objectives

This course aims: (a) To acquaint the student with contemporary blend of fundamental
principles of foreign trade under varying market structures; (b) To make the student
appreciate the wide range and impact of policy instruments applied in strategic trade and
financial policy choices; and, (c) To direct and motivate the student to constraints and
opportunities to the conduct of business within the context of increasing international
initiatives in the areas of regionalism, multilateralism and globalization facing Sub-
Saharan Africa.

Main Course Texts
Argy. International Macroeconomics
Krugman, P. R. and M. Obstfelt International Economics, Harper Collins.
Pugel, T. International Economics, Mac Graw-Hill.
Vousden, N The Economics of Trade Protectionism. Cambridge University Press.
Feenstra, R. C. Advanced International Trade, Princeton University Press.
Agenor and Monttiel. Development Macroeconomics.
Obstfeld, Foundations of International Economics. MIT Press.

Topics

1 Trade Theory and Policy under Perfect Competitive Markets
Classical and Factor Proportions Comparative Advantage
Main Results and Theorems
The Specific Factor(s) Model
Growth and Trade Orientation
Trade Policy: Tariffs and Non-Tariff Barriers
Empirical Evidence and Measurement of Policy Effects

2 Intra-Industry Trade under Imperfect Competition
Pre-cursors: Product Cycles, Technological Gaps, Etc.
Non-Factor Proportions Theories
Trade Policy under Imperfect Markets
Empirical Measurement



3 Trade Policies under Sub-Optimal Conditions
3
Private versus Social Costs and Benefits
Domestic Product and Factor Market Distortions
Uncertainty and International Commodity Market Distortions
Choice of Trade Regimes
Trade and the Environment

4 International Trade Cooperation and Liberalization
Endogenous Trade Policy
Unilateral Trade Liberalization
The Theory of Trade Preferences
Regional Integration Arrangements
The Generalized System of Preferences
Multilateralism and Globalization: Options for the Least Developed Countries

5 International Factor Mobility and Trade in Services
Capital Mobility: Foreign Direct Investment and Transnational Corporations
Labour Migration
Trade in Services
Intellectual Property Rights

6 Exchange Rate Theories and Practice
Interest Rate Parity
Exchange Rate and Prices
Exchange Rate Determination

7 Approaches to Open-Economy Macroeconomic Adjustment: Theory and Policy
The Mundel-Flemming Model
The Income-Absorption Approach
The Monetary Approach to Balance of Payments
Structuralist Models

8 International Monetary Arrangements and Institutions
Evolution of the International Monetary System
Choice of an Exchange Rate Regime
Financial Markets Integration: Stability and Crises
Optimum Currency Areas and International Monetary Cooperation and Unions






4
CHAPTER 2
CLASSICAL THEORY OF COMPARATIVE ADVANTAGE
2.1 Key Assumptions of Classical Trade Theory
2.2 The Law of Classical Comparative Advantage
2.3 Money Wage Costs, Productivity and Comparative Advantage
2.4 Labour Standards and Trade Policy
2.5 Concluding Observations
The dominant theory of international trade which is based on the perfect competitive
market structure is the theory of comparative advantage. It is traditionally presented in
two parts; first, is the classical theory associated with David Ricardo (1817), which was
based on one factor of production, labour, and constant costs; and second, is the
multifactor-based factor endowment or factor proportions theory. This Chapter and
Chapter 3 present the intellectual genesis and logical foundations of the comparative
advantage theory since the classical phase. This Chapter is devoted to the demonstration
of the classical comparative advantage theory and the gains from engaging in trade based
on that theory. As pointed out in Chapter 1, classical thought, and in particular its foreign
trade theory, was an attempt to reject the mercantilist practice of government control and
protection or support of domestic industries and trading monopolies. Instead of this
protectionist regime, classical economists championed the superiority of free enterprise
system based on the competitive market structure as the most efficient way of allocating
scarce resources in order to maximize income and the welfare of nations. In turn, as
shown below, the Ricardian classical theory of comparative advantage emerged as a
major correction to Adam Smiths concept of absolute advantage.
Interest in the classical trade theory rests on a number of reasons. First, it is a stand alone
scientific work which is amenable to extensions in various directions. Second, it has
been supported by overwhelming empirical evidence even up to the first decade of the
new millennium. As we discuss in Chapter 5, this is in sharp contrast to the H-O theory.
Lastly, there are still substantial contemporary remnants of the theory in terms of the
relationship between low wages and labour standards and international competitiveness,
and also in the contemporary debates and policy circles regarding export products from
developing countries (DCs) and the least developed countries (LDCs) and whether or not
trade in such products should be regulated. These are development issues that are
discussed variously in later sections.
2.1 Key Assumptions of Classical Trade Theory
In addition to the assumptions of free trade or absence of government interventions in
economic transactions, zero transport costs and perfect competition, classical theory was
premised also on the key assumptions of the labour theory of value (LTV), constant costs
and imperfect international factor mobility. We next elaborate on the last three
5
assumptions. By the LTV, labour played the double role of, one, as the only producer of
new value and, therefore, as a measure or indicator of productivity; and, two, as a
measure of the real costs and values of products. In order make comparisons, it has to be
assumed that labour units are homogeneous domestically and internationally. For
example, suppose that the number of labour units (say, labourdays) required to produce a
metre of cloth or textiles (T) is l
t
; that is
[2.1a] l
t
= labourdays/metre of textiles
Then we can say that the cost of producing one metre of textiles is l
t
labourdays. If we
have another product, say maize (Z) we can also write:
[2.1b] l
z
= labourdays/bag of maize
Labour costs are related to labour productivity, which in turn is defined as total units of
output produced, say Q units, divided by the total number of units of labour, L, which
produced that output. That is, Average Physical Product of Labour (APL) = Q/L =
units of output per labour unit. Because of the assumption of constant (labour) cost in the
relevant range of production, the reciprocal of a labour technical coefficient is the APL.
Using equation [2.1b] for instance
[2.2] APL
z
= 1/l
z
= Bags of maize produced in one labourday
The assumption of imperfect international factor mobility was made by classical
economists, especially Ricardo, in an attempt to account for cost and productivity
differences across countries. By making a distinction between intra-country trade and
international trade, Ricardo reasoned that in pursuit of a higher rate of profit, free capital
mobility within a country would cause capital to move from regions with higher labour
cost (low productivity) to low-cost regions, thereby leading to equalization of labour
costs and commodity prices. If this capital were to occur internationally, it would also
flow from high-cost countries to low-cost countries, thereby leading to cheaper goods,
which would be exported in reverse to the capital-originating countries. This, to Ricardo,
would undoubtedly be advantageous to the capitalist, as it would raise the rate of profit,
but also to consumers in both the capital-sending and capital-receiving countries. Having
built this complementarity scenario between capital mobility and flow of goods, Ricardo,
nonetheless rejected its feasibility because of impediments to international capital
mobility, which he explained in the following terms:
Experience, however, shows that the fancied or real insecurity of capital, when not under the immediate
control of its owner, together with natural disinclination which every man has to quit the country of his
birth and connections, and instruct himself, with all his habits fixed, to a strange government and new laws,
check the emigration of capital. These feelings, which I should be sorry to see weakened, induce most men
of property to be satisfied with a low rate of profits in their own country, rather than seek a more
advantageous employment for their wealth in foreign nations (Ricardo, p.83).
Whether or not this assumption was valid in Ricardos time, classical economists made
one of the most enduring assumptions in international trade theory; that which allows for
perfect domestic mobility of factors and goods but imperfect factor mobility in order to
allow for perfect mobility of goods internationally. In arriving at the assumption of no
6
international factor flows but trade in goods, Ricardo also seems to have assumed that
these were substitutes. This view, formalized by Mundell (1957), has been extended and
generalized to specifying conditions under which factor mobility and trade flows could be
substitutable or complementary (Wong, 1986). This issue is taken up in Chapter 5.
The assumption of constant costs means that every extra unit of a good is produced at the
same unit cost, so that marginal cost is constant and is equal to average cost in the
relevant range of the production process. This assumption is stated more formally in
subsequent sections.
With these key assumptions, we are now ready to distinguish between the concepts of
Absolute Advantage and Comparative Advantage. Suppose we have two countries, Home
(h) and Foreign (f), and two products, textiles and maize, and that the respective labour
requirements are as shown in Table 2.1 (the APLs are in parentheses). It is important to
assume that labour units are equivalent across countries, so that commodity exchanges
occur for equivalent products.

Table 2.1: Labour requirements in labour days (APL in brackets)
Country Textiles Maize
Home l
th
(APL
th
) l
zh
(APL
zh
)
Foreign l
tf
(APL
tf
) l
zf
(APL
zf
)

2.1.1 Absolute Advantage
Adam Smith laid down a supply-side microeconomic foundation for trade theory in his
dictum:
It is the maxim of every prudent master of a family, never to attempt to make at home what it will
cost him more to make than to buy. What is prudence in the conduct of every private family,
can scarce be folly in that of a great kingdom. If a foreign country can supply us with a
commodity cheaper than we ourselves can make it, better buy it of them with some part of the
produce of our own industry, employed in a way in which we have some advantage. (Adam
Smith, 1776, pp. 478-479)
According to this Smithian concept of absolute advantage, suppose we observe in
autarky that:
[2.3] l
th
< l
tf
and l
zh
> l
zf
or:
[2.4] APL
th
> APL
tf
and APL
zh
< APL
zf

7
In terms of labour costs, we would record that textiles are less costly produced and
therefore cheaper in Home than abroad and, vice versa, that maize is less costly and
cheaper in Foreign than in Home. The home country would be said to have an absolute
cost advantage over the foreign country in the production of textiles, while the foreign
country has an absolute cost advantage in production of maize over the home country. In
terms of labour productivities, this would mean that Home is absolutely more productive
or efficient in textile production than Foreign, while Foreign is absolutely more efficient
in maize production than Home. Under these pre-trade or autarky supply conditions,
therefore, the direction of bilateral trade would involve Home exporting textiles to
foreign, and, vice versa, Foreign would export maize to and import textiles from Home.
How do countries gain from trade based on absolute advantage? Let us assume that the
labourdays required to produce a metre of textiles or a bag of maize for Home and
Foreign are as given in Table 2.2.

Table 2.2: Classical Absolute Advantage
(labour days)
Country Textiles Maize
Home 2.0 5.0
Foreign 6.0 1.5
We see that Home has absolute cost advantage in textiles, l
th
= 2 < 6 = l
tf
, while Foreign
has an absolute cost advantage in maize, l
zf
= 1.5 < 5 = l
zh
. If Home shifted the 5 days
from maize to the production of textiles, it would realize 2.5 metres (= 5 days per bag/2
days per metre), instead of 1 metre. This means that in autarky one bag of maize will be
going for 2.5 metres of textiles in Home, which in days equivalence is: 1 bag = 2.5 metres
= 5 days. For Foreign, by shifting the 6 days from textiles into maize sector, it could
produce 4 bags of maize with them. Foreigns autarky exchange ratio would be 4 bags of
maize per metre of textiles, which in labour equivalence is: 1 metre = 4 bags = 6 days. In
terms of productivities, verify that Home is more productive or efficient in the production
of textiles than Foreign because with one labourday Home produces 0.5 of a metre while
Foreign can only produce 0.17 of a metre. The reverse is true in the case of maize, as it
can be easily demonstrated that the foreign country is more productive in maize than the
home country; that is 0.4 of a bag is greater than 0.2 of a bag in Foreign and Home,
respectively.
Suppose there is an opportunity for these countries to freely exchange 1 metre of textiles
for 1 bag of maize. By opening to free trade the days equivalence for the home country
translates to: 1 bag = 1metre = 2 days. The advantage in the home country with free trade
is that a bag of maize which in autarky costs 5 days to produce, only costs 2 days to
purchase from the foreign country, so that the saving of 3 days can be used to produce 1.5
metres (at the domestic production rate of 2 days per metre) for domestic consumption.
8
With trade, Foreigns labour equivalence ratio would be: 1 metre = 1 bag = 1.5 days,
which yields a labour saving of 4.5 days that (at the production rate of 1.5 days per bag)
can be used to produce extra 3 bags of maize for local use. Certainly this is a mutually
beneficial or gainful trade, which Adam Smith used to advocate trade liberalization
during his time, and the doctrine of absolute advantage reigned for almost forty years.
2.2 The Law of Classical Comparative Advantage
Although Ricardo was not an academic scholar as Smith had been, he nonetheless made
lasting inroads to the theory of international trade. While adopting the LTV, he observed
that even if a country, say Home, had absolute advantage in the production of both goods,
say, l
th
< l
zf
and l
zh
< l
zf
, the basis for trade may still exist if comparative costs or
productivities were used instead of absolute costs or productivities. Ricardo used an
example whereby England required 100 men to produce cloth and 120 men to produce
wine per year, while Portugal required 90 men and 80 men in cloth and wine,
respectively. It is evident that Portugal has absolute advantage in both goods. Ricardo,
however, argued that gainful trade, even to Portugal, could still take place between the
two countries due to specialization, which he articulated along the following reasoning:
If Portugal had no commercial connection with other countries, instead of employing a great part
of her capital and industry in the production of wines, with which she purchases for her own use
the cloth and hardware of other countries, she would be obliged to devote a part of that capital to
the manufacture of those commodities, which she would thus obtain probably inferior in quality
as well as quantity
The quantity of wine which she shall give in exchange for cloth from England is not determined
by the respective quantities of labour devoted to the production of each, as it would if both
commodities were manufactured in England, or both in Portugal
This exchange might take place notwithstanding that the commodity imported by Portugal could
be produced there with less labour than in England. Though she could make the cloth with 90
men, she would import it from a country where it required the labour of 100 men to produce it,
because it would be advantageous to her to employ her capital in the production of wine, for
which she would obtain more cloth from England, than she could produce by diverting a portion
of her capital from the cultivation of vines to the manufacture of cloth. (Ricardo, p. 82)
We then proceed to formally present this Ricardian proposition of comparative
advantage. A comparative cost of a country is expressed as a ratio of the unit cost of
producing one product with respect to the unit cost of another product. If we use the
textile unit labour as the numerator, then the comparative cost for each of the two
countries would be calculated using the following ratios:
[2.5] Home country :
zh
th
l
l
; Foreign country :
zf
tf
l
l

These ratios may be interpreted as the cost of textiles relative to maize, or simply as the
relative cost of textiles. With the assumption of competitive factor and product markets,
9
the autarky equilibrium relative product prices in each country will closely reflect relative
costs. For Home:
zh
th
h
h
z
t
l
l
p
P
P
a =
|
|

\
|
] 6 . 2 [
And for Foreign:
zf
tf
f
f
z
t
l
l
p
P
P
b =
|
|

\
|
] 6 . 2 [
These equilibrium ratios would be the ruling autarky domestic trading relative prices or
autarky terms of trade when textiles and maize are exchanged or traded for one another in
the domestic market of each country before opening up to foreign trade. According to the
Ricardian system, the basis for mutually gainful trade exists if the autarky comparative
costs and therefore autarky terms of exchange differ across potentially trading countries.
Suppose in autarky we observe the following inequality in comparative costs or exchange
ratios.
f z
f t
f h
zh
th
l
l
p p
l
l
= < = ] 7 . 2 [
This would mean that textiles are produced relatively less costly in the Home compared
to (than in) the Foreign, and therefore textiles would be relatively cheaper at Home than
in Foreign. Conversely, using the inverse of the ratios in equality [2.7], maize is produced
with a lower relative cost in Foreign than in Home and therefore maize would be
relatively cheaper in Foreign than at Home. Consequently, we would state that Home has
a comparative advantage in textile production (or that Home has a comparative
disadvantage in maize production) compared to Foreign. Conversely, Foreign possesses a
comparative advantage (disadvantage) in the production of maize (textiles) compared to
Home. This comparative (labour) cost gap or differential would cause a two-way
(bilateral) trade to take place whose direction would involve Home exporting textiles to
Foreign while importing maize from Foreign, and vice versa.
Let us use Ricardos example by interpreting the number of men as labour units to
produce a unit of a given product, e.g., a metre of cloth or a litre of wine. Using ratios in
terms of cloth to wine (l
c
/l
v
) for each country, the calculated comparative labour costs are
as follows: For England: 100/120 = 0.833; and for Portugal: 90/80 = 1.125. We see
indeed that despite Portugals absolute advantage in both products, she produces cloth
relatively more costly than England and, conversely, England is a relatively higher cost
producer of wine. This means that England would be a relatively lower cost supplier of
cloth than Portugal, which in turn is a relatively lower cost producer of wine as the
reciprocal comparative cost ratios (l
v
/l
c
) are: 1.2 for England and 0.89 for Portugal.
10
We have compared costs by calculating a ratio for each country for the two products. Let
us instead calculate ratios across countries for each product as follows: l
th
/l
tf
and l
zh
/l
zf
.
Using labour costs for England as numerators, we get for cloth, 100/90 = 1.11, and for
wine, 120/80 = 1.5. Surprisingly, we see again that England produces cloth with
relatively fewer labour units than in wine. Does this mean that if the inequality stated in
[2.7] holds, then the inequality, l
th
/l
tf
< l
zh
/l
zf
, will also be valid to determine comparative
advantage?
With these observations, we can make the following statements:
A country has comparative advantage in a product (products) which it can
produce at a relatively lower cost than other courtiers in the rest of the world
(ROW).
A country will export to the ROW a product (products) in which it has
comparative advantage and import from the ROW a product (products) in which it
has comparative disadvantage.
2.2.1 Ricardian Gains from Trade
So far we have been concerned with the basis for international trade. The next question
is: Why do countries engage in trade? The rationale for countries to engage in free trade
rather than remain in isolation is that there are concrete net gains that can be derived from
such trade. We demonstrate more rigorously two such gains than we did in the context of
absolute advantage. These gains are due to:
The improvement in the terms of trade, from autarky to international terms of
trade, as a country opens up to free trade as shown in this section.
The expansion of consumption possibilities beyond the autarky production
possibilities as shown in the next section
Improvement in the Terms of Trade
In order to demonstrate the terms of trade gains, let us show initially what would happen
if each country traded at the other countrys autarky relative price. Note first that we can
express the Homes autarky relative price of textiles as:
h h
l
l
p
zh
th
h
|

\
|
=
|
|

\
|
= =
textiles of metre
maize of bags
maize of /bag labourdays
textiles of /metre labourdays
] 8 . 2 [
This means that the relative price of textiles is the number of bags of maize that a metre
would fetch in the Home market in autarky. With this definition, the pre-trade
comparative cost advantage gap, p
h
< p
f
, of inequality [2.7] can then be restated as:
f h
p f h p a |

\
|
< |

\
|

textiles of metre
maize of bags
textiles of metre
maize of bags
] 9 . 2 [
11
From Homes point of view, the gain from trading at Foreigns autarky relative price of
textiles is that a metre of textiles would fetch more bags of maize than at Homes relative
price. Vice versa, Foreigns improvement in terms trade by trading at Homes relative
price is given by the inverse, 1/p
h
> 1/p
f
; or:
etc
p
p for p f h p b
f
f f h
,
1
;
maize of bag
textiles of metres
maize of bag
textiles of metres
] 9 . 2 [ =
|
|

\
|
>
|
|

\
|
=
That is, a bag of maize from the foreign country would purchase more meters of textiles
when traded at Homes relative price than at its autarky relative price. With negligible
transport costs, government taxes and other trade hindrances, then with free international
commodity arbitrage, some common world or international terms of trade, (P
t
/P
z
)
w
,
would settle somewhere between the two autarky exchange ratios as follows:
f w
w
z
t
h
p p
P
P
p <
|
|

\
|
< ] 10 . 2 [
A countrys international terms of trade are defined as the ratio of the price of its export
product to the price of its import product, or P
x
/P
m
. For the Home country, which is
exporting textiles in exchange for imports of maize, its foreign terms of trade
improvement can be stated as follows:
h w
p h w p a = |

\
|
> |

\
|
=
textiles of metre
maize of bags
textiles of metre
maize of bags
] 11 . 2 [
This implies that a metre of textiles fetches more bags at the world terms of trade than at
Homes autarky relative price. Homes TOT improvement is by (p
w
p
h
)/p
h
> 0. With
similar reasoning, Foreign as maize exporter and textile importer would gain as follows:
' '
maize of bags
textiles of metres
maize of bag
textiles of metres
] 11 . 2 [
f w
p h w p b =
|
|

\
|
>
|
|

\
|
=
where . ) / ( / 1
'
w t z w w
P P p p =
This result is demonstrated in Figure 2.1a in which the relative cost ratios are translated
into relative price lines. Homes autarky price line is flatter than Foreigns because of the
12

Figure 2.1a: Classical TOT Improvement
comparative advantage gap. Below price line p
h
, a metre of textiles would be purchasing
less bags of maize than at the competitive equilibrium price in the home country; that is,
a metre of textiles would be selling at a loss and therefore firms in the home country
would not be willing to offer textiles in exchange for maize. In order to exploit gains
from exchange Home would supply textiles for steeper price lines than p
h
. For example,
T
0
of textiles would fetch more bags maize at point B on p
f
of Z
1
than Z
0
at point A on p
h
.
Similarly Foreign would not supply any maize for textiles to the left of p
f
, but stands to
gain for flatter price lines as Z
1
would exchange for T
1
at point C than at point B for only
T
0
. The autarky price ratios demarcate the region of mutually advantageous trade and for
any world price line such as p
w
, both countries gain in TOT improvement.
This theoretical analysis of the gains in TOT can be further concretized using Ricardos
example of Portugal and England as shown in Figure 2.1b. The pre-trade relative prices
are plotted as ray (P
c
/P
v
)
E
= (l
c
/l
v
)
E
= 0.83 for England and (P
c
/P
v
)
P
= (l
c
/l
v
)
P
= 1.125 litres
of wine per metre of cloth. The autarky exchange ratios set the minimum acceptable
rates of exchange for each country. At point A for instance, England cannot accept to
trade 1 metre of cloth for less than 0.83 of a litre of wine, while at point D Portugal will
not accept to offer 1 litre of wine in exchange for less than 0.89 of a metre of cloth (or at
point B to offer 1.125 litres for less than 1 metre of cloth). Each country however stands
to gain most at each others autarky TOT. For example, 1 litre of wine which exchanges
for 0.89 of a metre in Portugal (at point D) would be worth 1.2 metres at Englands
autarky TOT (at point E), which is an improvement by 20%. For England, a metre,
13

Figure 2.1b: Ricardos Terms of Trade Gain
which trades for 0.83 of a litre at home, can fetch 1.125 litres of Portuguese wine,
yielding a TOT gain of 36%. This then means that each country would indeed gain if the
world TOT were established somewhere in between their autarky exchange ratios, and a
candidate is a 1 to 1 rate which passes through point F.
Consumption Gains and Complete Specialization
In order to illustrate the result that opening up to trade creates expanded consumption
possibilities beyond the autarky consumption set, we first develop the analytical tool of
the production possibilities (feasibility) frontier (PPF). A PPF traces combinations of
maximum levels of output of a given number of products when fixed amounts of
resources are fully and most efficiently employed. In order to get the full-employment
equations, assume that Foreign and Home have each a maximum number of labour units,
L
F
and L
H
, respectively, which are allocated to the two sectors as follows:
zh th H
zf tf F
L L L b
L L L a
+ =
+ =
] 12 . 2 [
] 12 . 2 [

If all Home labourdays were exclusively fully employed in textile production, the
maximum metres produced would be T
H
= L
H
/l
th
, or, alternatively if all labour were
exhausted to maize production, the maximum number of bags produced would be Z
H
=
L
H
/l
zh
. Note, for example, that labour employment is expressed as L
H
= l
zh
Z
H
.
Capitalizing on this idea, full employment to the two sectors to produce any mix of the
two products for each of the two countries would be:
H h zh h th
F f zf f tf
L Z l T l b
L Z l T l a
= +
= +
] 13 . 2 [
] 13 . 2 [

14
For purposes of furthering our understanding, let us introduce a numerical example of
this employment system by adopting these figures: L
F
= 18 million labour hours, L
H
= 40
million hours, and the labour requirements as: l
tf
= 6, l
zf
= 3, l
th
= 8, and l
zh
= 10. The
full-employment equations in [2.13] are calibrated as:
40 10 8 ] 14 . 2 [
18 3 6 ] 14 . 2 [
= +
= +
h h
f f
Z T b
Z T a

It can be seen that the foreign country has absolute advantage in the production of both
products and yet it has comparative advantage only in maize while the home country has
comparative advantage in textiles. We use the information on employment in [2.14] to
derive first the Homes PPF as summarized diagrammatically in Figure 2.2. The Home
equation 2.12b is depicted by line L
H
L
H
in Panel (A). Panels (B) and (C) plot the
production functions for maize and textiles, respectively. In general, a production
function depicts the technological relationship between inputs and output, and in our case,
with only labour and the assumption of constant costs, the production functions for maize
and textiles are linear, which for Home are as follows:
L L L APL
l
L
T PF b
L L L APL
l
L
Z PF a
th
th
TH
zh
zh
ZH
125 . 0
8
1
: ] 15 . 2 [
1 . 0
10
1
: ] 15 . 2 [
= = = =
= = = =


15

Figure 2.2: Classical Production Possibilities
Since in Home labour is more productive in textiles than in maize, APL
th
> APL
zh
, the
PF
TH
is drawn with a steeper slope (closer to the textile axis) than the PF
ZH
is to the maize
axis. To derive the PPF for Home, note that if all the labour were exclusively employed
in the maize sector, production would be at point A on the PF
ZH
, which translates to
intercept Z
H
on the maize axis in Panel (D). In textiles, this would be point B on the
textile PF or T
H
on the textile axis. If labour were employed in the production of both
products as in equation 2.13b, full employment would be at point C
0
which when traced
through the respective home production functions, translates into point C
3
in Pane (D).
With constant costs, we derive a straight-line curve traced by points Z
H
C
3
T
H
as Homes
PPF. Foreigns PPF can be similarly derived. Note that Foreigns labour, with a labour
requirement of 3, is more productive in maize than Homes labour; thus, APL
zh
= 1/3 =
0.33 > 0.1 = APL
zh
. The resulting steeper PF
ZF
than PF
ZH
means that, given the same
labour supply, Foreign will produce a higher maize output, at Z
F
, than Homes Z
H
. If
given the same labour force one country is more productive than others, the difference
16
would be accounted for by a technological gap between them, and most modern trade
theorists argue that this is what classical theorists assumed to be the major basis for
comparative advantage.
In order to facilitate subsequent analyses, the PPFs for the two countries have been
redrawn in Figure 2.3, with Z
F
T
F
and Z
H
T
H
for Foreign and Home, respectively. The
equations of these autarky lines with maize as the subject are:
f f f
zf
tf
zf
f
f
T T T
l
l
l
L
Z a 2 6
3
6
3
18
] 16 . 2 [ = = =
h h
zh
th
zh
h
h
T T
l
l
l
L
Z b 8 . 0 4
10
8
10
40
] 16 . 2 [ = = =
The slopes of these lines represent the given autarky comparative costs:
2 8 . 0 ] 17 . 2 [ = =

= =

zf
tf
f
f
zh
th
h
h
l
l
T
Z
and
l
l
T
Z

The lines have been drawn in order to respect the comparative advantage inequality l
th
/l
zh

< l
tf
/l
zf,
so that the Foreigns PPF is steeper than the Homes.
Economic Meaning of the Slope of a PPF The slope of a PPF measures the rate at
which products are traded off in the production process as resources are shifted between

Figure 2.3: Classical Complete Specialization
production lines and is known as the marginal rate of product transformation. This
measures the opportunity cost (OC) of one product in terms of the other product. In our
case the slope measures the OC of textiles; that is, the number of bags of maize that
17
should be sacrificed as resources are withdrawn from the production of maize in order to
increase production of textiles by one metre. The constant slope of our PPF embodies the
assumption of constant costs or constant OC between the two products. In this sense a
country has a comparative advantage in the product that it can produce at a lower OC
than another country. The concept of opportunity cost is more relevant in the case of
many factors of production as demonstrated more rigorously in the next Chapter than in
the case of the classical labour theory of value. In the limited sense used here it can be
verified that Homes PPF is flatter than Foreigns, thereby indicating that it has a
comparative advantage in textiles throughout the range of the PPF and vice versa for the
Foreign country.
Production and Consumption Changes In order to show the consumption gains from
trade, let us first record the autarky equilibrium positions as follows: Foreign produces
and consumes at point U, with
f o
Z and
f o
T of maize and textiles, respectively, which is
autarky set U(T
of
, Z
of
). The respective autarky production and consumption set for Home
is V(T
oh
, Z
oh
). As TOT improves with the opening up to free trade,

producers in each
country increasingly find it profitable to expand production of the product in which they
have comparative advantage. At Home, for example, labour will be withdrawn from
maize production to increase successive units of textiles at constant cost (in a constant
number of bags of maize lost) in order to take advantage of profits offered by
improvement in terms of trade until no maize is produced and all labour if fully
committed to textile production at point T
H
. The opposite will be happening in the
Foreign with no production of textiles as labour will be fully employed in maize
production at Z
H
. This extreme classical production effect of trade under constant cost
assumption is known as complete specialization as each country completely specializes in
the production of the good in which it has comparative advantage.
Although Ricardo used the concept of comparative advantage as the basis for
advantageous trade, he nonetheless reached the same conclusion that countries will
exclusively specialize in the product of their comparative advantage, a result which
Adam smith had also envisaged, though based on absolute advantage. The possibility of
this phenomenon was clearly described by Ricardo as follows:
Two men can both make shoes and hats, and one is superior to the other in both employments;
but in making hats he can exceed his competitor by one-fifth or 20%, and in making shoes he can
excel him by one-third or 33%; - will it not be for the interest of both that the superior man should
employ himself exclusively in making shoes, and the inferior man in making hats? [Our
emphasis or italics]. (Ricardo, p. 83).
In order to locate the free-trade consumption bundles we should realize that once trade
opens up the world prices will be ruling in both countries markets and exchange between
them will be taking place at those world TOT. Since we know that the world TOT will
be juxtaposed between the pre-trade TOT which have now become obsolete, p
h
< p
w
<
p
f
, the world price line is flatter than the Foreigns autarky PPF but steeper than Homes
autarky PPF (Figure 2.3). The world price line emanates form each countrys point of
complete specialization in production. In the numerical example, it has been assumed
that p
w
= 1.125 bags of maize per metre, so that: 0.8 < 1.125 < 2.
18
In order to pin down the consumption effects of this Ricardian model, let us assume that
each country consumes the same level before and after trade of the product in which it
has comparative advantage, say Z
of
= 1.5 million bags and T
oh
= 1 mil meters,
respectively for Foreign and Home. This means that the free-trade consumption bundles
are: V'(T
1f
, Z
of
) and U'(T
oh
, Z
1h
), for Foreign and Home respectively. It should be noted
that these free-trade consumption sets are beyond the pre-trade PPF for each country
when they were then infeasible. But with trade, the consumption possibilities have
expanded beyond the autarky possibilities. This means that the post-trade consumption
sets are superior to the autarky consumption sets.
Table 2.3: Production and Consumption Trade Effects
Product Production Consumption
Country Autarky After
trade
Change Autarky After
trade
Change
Home Textiles T
oh
T
H
T
H
-T
oh
> 0 T
oh
T
oh
T
oh
-T
oh
= 0
Maize Z
oh
0 0 Z
oh
< 0 Z
oh
Z
oh
Z
1h
Z
oh
> 0
Foreign Textiles T
oh
0 0 T
of
< 0 T
oh
T
oh
T
1f
T
of
> 0
Maize Z
of
Z
F
Z
F
- Z
of
> 0 Z
of
Z
of
Z
of
- Z
of
= 0
The feasibility of the free-trade consumption set is made possible by trade which takes
place through excess demand and supplies that are reported in Table 2.3 as read with
Figure 2.3 in terms of production and consumption effects. These can be read as follows:
Home country increases textiles production to T
H
, but still consumes T
oh
to give
domestic excess supply of T
oh
T
H
as its exports to Foreign. Home country reduces
maize production to zero so that there is excess demand for maize of OZ
1h
=
T
oh
V
1
, which is satisfied by imports from Foreign.
Foreign country increases maize production to Z
F
, yielding excess supply of
maize of Z
of
Z
F
, which constitute Homes maize imports of T
oh
V
1
. Foreign
country produces zero textiles, so that its excess demand for textiles of OT
1f
=
Z
of
U
1
is satisfied by imports from Home of T
oh
T
H
.
These exchanges yield the right-angle trade triangles Z
of
Z
H
U
1
and T
of
V
1
T
H
which
share the p
w
as the hypotenuse.
Opening up to trade has increased consumption possibilities as with the same
fixed labour resources which prevailed in autarky, each countrys free trade
consumption bundle is beyond the autarky PFF and which is superior to the
autarky bundle. This means that for each country, real income has risen with free
trade, as at world terms of trade a larger bundle is affordable over the autarky
bundle which was then unattainable.
19
Overall, free international trade has led to a better allocation of a given set of
resources, thereby achieving the highest possible efficiency due to specialization
at the world free-trade relative price which is superior to the autarky relative
prices.
2.2.2 Maximization of World Output
The result stated in the last bullet refers to the maximization of output or real income at
the world level, which is demonstrated here using the world PPF as done in Figure 2.4.
We first review the principles used to construct such a transformation frontier, which is
drawn with two PPFs labeled as RBS and RAS. The distance on the vertical axis OR is
the total that could be realized if both countries completely specialized in maize
production, so that OR = Z
F
+ Z
H
. Similarly, the distance for textiles on the horizontal
axis is OS = T
F
+ T
H
. The inward-kinked line RBS consists of two triangles. The top
triangle Z
o
RB is Foreigns feasible space OZ
F
T
F
of Figure 2.3 while the bottom triangle
T
o
RA is the Homes feasible space OZ
H
T
H
of Figure 2.3. For the outward-kinked line,
the top triangle Z
F
RA is Homes feasible space, while the bottom one T
H
AS is Foreigns
space. It can be visibly observed that the outward-bending PPF labeled RAS is superior
to the inward-bending frontier RBS as the latter is enveloped by the former. For instance,
the production point A consists of greater levels of production of both goods and
therefore reflects better resource utilization than the production mix at point B. Point A
can be shown to be a joint position of complete specialization at the world TOT as
follows.
20

Figure 2.4: Constant cost World Possibilities Frontier
We know by assumption that
zh
th
zf
tf
l
l
l
l
> , so that if we had a relative price of textiles greater
than
zf
tf
l
l
(that is, steeper than both frontiers), then both countries would specialize in
textile production. However, as the price ratio gets flatter and coincides with the slope of
Foreigns frontier, the Foreign would trade-off production of the two goods, and when
the price ratio becomes less than its Frontier, then Foreign would not compete in textiles
while Home would not compete in maize and each country would completely specialize
according to comparative advantage. The world price ratio is represented by line Y
w
Y
w

and is tangent to the world PPF at point A, known as the Ricardian point, meaning that
world income is maximized there in the classical comparative advantage tradition.
Classical Equilibrium Price
We can extend this analysis to gauge where the world TOT would settle using the supply
and demand framework. The trickiest part is to develop the supply schedule. Instead of
21
using the absolute supply curves separately for the two goods as we did in Chapter 1, we
construct the relative textile supply curve (RS) as the ratio T/Z. The constant-cost
assumption and complete specialization mean that any departure from autarky TOT, a
country switches into complete specialization. To turn around the above analysis, recall
that if the world price ratio is below Homes autarky textile relative cost, both countries
wont supply textiles, T
h
= T
f
= 0, and world textile supply would be zero, T
wo
= T
h
+T
f
=
0. However, both countries would be able to supply maize, with Foreign at its complete
specialization level, Z
F
, and Home at some level Z
h
, so that total maize supply would be
Z
wo
= Z
h
+ Z
F
> 0. This means that the RS will be T
wo
/Z
wo
= 0. In Figure 2.5, this result
is on the vertical distance from the origin to Homes autarky relative cost.
For any world TOT between the two autarky relative costs, each country completely
specializes so that T
w
/Z
w
= T
H
/Z
F
and the RS curve is the vertical distance between points
H and F. At the Foreigns autarky relative cost, Home is completely specialized with T
H

and Foreign can supply any T
f
textiles, and world textile supply will be T
w1
= T
H
+ T
f
>
T
H
. However, Home produces zero maize, while Foreign produces some Z
f
which is
below Z
F
; that is, Z
f
= Z
w1
< Z
H
. Since world textile supply is greater than T
H
while
maize supply is below Z
F
, then T
w1
/Z
w1
> T
H
/Z
F
, which yields the infinitely elastic RS
curve beyond point F.
The relative demand (RD) of the model is depicted as a continuously downward-sloped
curve in Figure 2.5. It is drawn on the basis of a normal or standard demand curve for
each product, so that in each country, as the relative price of textiles falls, more textiles
will be bought and less maize will be consumed, thereby causing the relative quantity of
textiles to rise both domestically and worldwide.

Figure 2.5: Classical Relative Demand and Supply

General equilibrium relative world price will be the one that equates RS to RD, and in the
figure this is at point W, which is juxtaposed between the two autarky relative costs. We

22
would expect this to be the theoretical classical expectation that opening to mutually
gainful free trade will lead to TOT gain, from H and F for Home and Foreign,
respectively. But suppose equilibrium is on the RS of one of trading partner, such as at
W
1
or W
2
for Home or Foreign, respectively. At W
2
, that would indicate strong world
preference for maize, in which case Foreign will completely specialize in Maize while
Home would be producing both goods on its frontier and be indifferent to foreign trade.
2.2.3 The Ricardian Theorem and Many Goods
The Ricardian comparative advantage theory that a country specializes in the product(s)
in which it has a lower relative labour cost or higher relative productivity can be
intuitively demonstrated as is done next for two goods and two countries, and then with
two goods and many countries. Starting with the former scenario, we know, by
assumption in inequality 2.7, that Foreign has comparative disadvantage in textile
production, so that if we cross multiply the comparative cost gap or inequality we get:
.
th zf zh tf
l l l l > From the employment equation system 2.13, we can form the following
matrix system:
0 ; ; ] 18 . 2 [ > = =
(

=
(

=
(

th zf zh tf
zh th
zf tf
zh th
zf tf
h
f
zh th
zf tf
l l l l
l l
l l
D A
l l
l l
A
L
L
Z
T
l l
l l

Matrix A is the coefficients matrix whose elements are the labour requirements and the
|A| is the determinant (D) of matrix A, which in this simple 2 by 2 square matrix, is
calculated as the difference between the cross-products of the diagonal elements of the
coefficients matrix in the order shown. The determinant of our system is positive due to
the assumed comparative labour costs. Since D is non-zero, then a unique solution for
the unknowns T and Z is guaranteed. To solve for T, replace the column vector of the
textile labour costs in A matrix by the column vector of the labour quantities, compute
the associated determinant, and then divide the result by the determinant of the
coefficients matrix. This procedure, known as Cramers Rule, leads to the solutions for T
and Z as follows:
D L l L l D
L l
L l
Z b
D L l L l D
l L
l L
T a
h th h tf
h th
f tf
h zf f zh
zh h
zf f
/ ) ( / ] 19 . 2 [
/ ) ( / ] 19 . 2 [
= =
= =

Divide both the top and bottom parts of the right hand side of T by l
th
L
f
and those of Z by
l
zf
L
h
, so that:
23
h zf h
f
zf
th
zf
tf
f th f
h
th
zf
th
zh
L l
D
L
L
l
l
l
l
Z b
L l
D
L
L
l
l
l
l
T a
/ ] 20 . 2 [
/ ] 20 . 2 [
|
|

\
|
=
|
|

\
|
=

Take derivatives of T and Z with respect to the first item inside their respective
parentheses to obtain:
0
) / (
] 21 . 2 [
0
) / (
] 21 . 2 [
> =

> =

D
L l
l l
Z
b
D
L l
l l
T
a
h zf
zf tf
f th
th zh

Note that for each product, the denominator in the deferential term on the left-hand side
(LHS) is its relative labour cost for the respective country. For textiles, it can be verified
that the higher is the ratio l
zh
/l
th
, the less competitive Home becomes in maize production
and therefore the more it should specialize in textile supply. The opposite will be the
case for Foreign, as it will specialize in maize the higher is the ratio l
tf
/l
zf
.
Two Goods and Many Countries The classical case of 2 2 commodities and countries
can be easily extended to multidimensional case of many commodities and countries. We
only demonstrate the case of two goods and many countries, where the commodities are j
= 1, 2, and for reference purposes these are textiles and maize, respectively, and countries
are c = 1, 2, , m. Then at some world TOT, p
w
, the comparative cost advantages, l
1c
/l
2c
,
will be ordered as follows:
m
m
m
m
c
c
w
c
c
l
l
l
l
l
l
p
l
l
l
l
l
l
l
l
2
1
1 2
1 1
1 2
1 1
2
1
23
13
22
12
21
11
... ... ] 22 . 2 [ < < < < < < < <

+
+

This means that trade will take place between two blocs of countries, with those to the
left of the world price ratio completely specializing in product 1, textiles, and those to the
right in product 2, maize. The weak inequality is inserted in order to take into account
the possibility of the world TOT coinciding with a countrys autarky relative cost. Figure
2.6 depicts a PPF for a limited number of countries and the PPF is based on the same
principles that were applied to construct the two-country case of Figure 2.4. With the
world price line p
w
, it turns out that world output is maximized at the frontier of country
3, where p
w
= (l
13
/l
23
) and that country will be indifferent to engage in international trade.


24

Figure 2.6: Two-Goods Many-Countries Specialization

2.3 Money Wage Costs, Productivity and Comparative Advantage
Classical comparative advantage has been demonstrated in terms of real comparative
labour costs and inverse labour productivities without regard to monetary wages. Under
competitive markets, commodity prices will closely reflect the unit costs of production,
which is the nominal wage or money wage rate, W, multiplied by the labour requirement
as follows:
[2.23] P
jc
= W
c
l
jc

The product Wl is the monetary labour cost required to produce one unit of product j or
in short the unit labour cost of product j. The nominal wage rate is expressed as money
units per unit of labour; for example, it is equal to units of our currency per hour of
labour worked, MK/hr. Then the product on the right side of equation [2.23] defines the
price as: P
jc
= (MK/hr) (hour per unit of product j) = (MK/unit of product j). Given the
inverse relationship between l and APL, we get these expressions:
jc jc
jc
c
jc c c jc jc jc
jc
c
jc
jc
ACL P
APL
W
l W W VAPL APL P
P
W
APL
l
= = = = = = .
1
] 24 . 2 [
The term W/P
j
is the real wage or wage unit and is measured in units of product j per
labour hour as:
unit
MK
hr
MK
P
W
w
j
j
/ = = = units of j per hour. The term VAPL is the value
of the APL. The last relationships to the right define the unit labour cost in terms of the
25
ratio of W/APL, which is also the average cost due to labour (ACL). Under competitive
markets, the price of each product is equalized and in the labour market, the nominal
wage rate is equalized across industries in the whole economy, so that each employer
faces the same money wage for equivalent labour. The only control variable to the firm
is the APL, and when P
j
.APL
j
> W, then a labour unit, one hour of labour, is contributing
more to revenue than to total costs and that would induce firms to hire more labour.
Conversely, for P
j
.APL
j
< W, means that profitability is undermined and firms will
reduce employment. Therefore, in equilibrium all prices will be proportionately tied to
wages so that across countries we can make comparisons of relative productivities with
respect to relative nominal wage rates. Now, suppose we see the following inequality
between our two countries and two products:
zf
zh
f
h
tf
th
APL
APL
W
W
APL
APL
> > 25 . 2 [
It should be immediately realized that, unlike in earlier analyses, now we have taken
ratios of APLs for each product but for different countries. This inequality states that
Home has a cost advantage in textiles as the comparative wage is less than the relative
productivity in textiles, and it can be verified that Foreign has cost advantage in maize.
In the case of two countries and n number of products, we can rank these products as
follows:
2
1
2 ) 1 (
1 ) 1 (
2 ) 1 (
1 ) 1 (
2
1
2
1
22
21
12
11
... ... ] 26 . 2 [
n
n
n
n
j
j
j
j
APL
APL
APL
APL
APL
APL
W
W
APL
APL
APL
APL
APL
APL
> > > > > >

+
+

And in terms of relative real labour costs, we get the inverse ordering:
2
1
2 ) 1 (
1 ) 1 (
2 ) 1 (
1 ) 1 (
2
1
2
1
22
21
12
11
... ... ] 27 . 2 [
n
l
l
l
l
l
W
W
l
l
l
l
l
l
n
n
n
j
j
j
j
< < < < < <

+
+

26

Figure 2.7: Wages, Productivity and Comparative Advantage
This ranking is depicted in Figure 2.7 for five products with the productivity ratios
recorded on the vertical axis and the relative costs on the horizontal axis. In this scheme
of things, efficiency means either a higher relative productivity or a lower relative cost in
the same product than the wage ratio between countries. As an example, we have made
the actual wage ratio between products 3 and 4 at point E. This would signal country 1 or
Home to specialize in electronics, textiles and bicycles, while Foreign specializes in sugar
and maize.
2.3.1 How China has Juggled Low Wages with Productivity
Chinas niche in aggressively penetrating world export markers since mid-1980s has been
partially, but very importantly, based on domestic low wage rates and a large pool of
labourforce capable of adapting to productivity competitiveness. Even firms from the
first-generation NICs of East Asia of Taiwan, South Korea, Hong Kong and Singapore,
which in the late1960s and 1970s were Japans suppliers of cheap components have
joined the major global firms over a cross-section of industries from the HICs to use
China as their platform to enhance their global competitiveness. Due to this low-wage
advantage, some elements in the HICs had pointed to alleged flouting of labour standard
and pressed for Chinas admission into the framework of the WTO in order to subject it
to more transparent labour employment practices. However, Chinas accession to the
27
world trade body (in December 2001) has generated even more tremors, especially with
the dismantling, in January 2005, of the Multi-Fiber Agreement (MFA), a regime that had
since the 1960s regulated the world market for textiles and garments through quotas.

Table 2.4: Chinas World Comparative Labour Costs (1998)
Ratio of hourly labour costs Ratio of unit labour costs
Country National Textiles
Col (2)
Clothing
Col (3)
National
Col (4)
United States 47.8 20.9 23.1 1.3
Japan 29.9 1.2
Singapore 23.4 1.3
Taiwan (1997) 20.6 9.4 2.3
Korea, Rep. of 12.9 5.9 6.3 0.8
Chile 12.5 0.8
Mexico 7.8 4.0 3.4 0.7
Turkey 7.5 0.9
Malaysia 5.2 1.1
Philippines (1997) 4.1 0.7
Egypt 2.8 1.5
Kenya 2.6 2.0
Indonesia (1996) 2.2 9.1 12.1 0.9
Zimbabwe 2.2 1.2
Hong Kong 9.1 12.1
China: Productivity Indicators in Textile and Clothing Industries (1999)
Textile Industry Clothing Industry
All firms SOEs FFEs All firms SOEs FFEs
Number of firms 10,981 3,011 3,033 6,611 792 2,864
Share of VA to sales (%) 24.7 26.9 24.4 24.8 28.4 24.9
VA per worker (yuan per
year)
21,900 15,300 38,500 24,500 16,800 25,800
Profits share in sales (%) 0.94 -0.09 1.46 3.36 0.96 2.96
Sources: UNCTAD, Trade and Development Report, 2002, Box 5.2, p. 152 and Tables 5.4 and 5.5. Notes:
Wages and unit labour costs include social charges and in the calculation of unit labour costs, average wages
were divided by manufacturing value added (VA). Ratios are average wages and unit labour costs of each
country to Chinese levels. Hourly labour costs in China for 1998 were US$0.62 and US$0.43 in textiles and
clothing industries, respectively. SOEs and FFEs are state Owned Enterprises and Foreign Funded
Enterprises, respectively. Exchange rate in 1998 was 8.28 Yuan per US$ (IMF, International Financial
Statistics: Yearbook, 2002, p.355)
But how cheaper and productive has been the Chinese labour? Comparative wage rate
can be measured as a ratio between the average wage in China relative to foreign average
wage rates, such as, w
f
/w
c
, so that the higher this ratio the relatively cheaper Chinese
labour would be. Using this ratio Table 2.4 gives comparative wage costs between China
and selected DICs, NICs and other DCs at the close of the 1990s. As ranked under
column (1), the national ratio ranged from the highest wage gap of about 50 times with
the USA to the lowest with India of only 1.5. The gaps with the Asian NICs were also
high from 23 times with Singapore to 13 times with South Korea. These were, however,
lower in the textile and clothing industries with the highest being 12 with Hong Kong and
the lowest of 4 times with South Korea.
28
A better measure of comparative wage gap has to take into account Chinas relative
productivity and, using manufacturing value added (MVA), the following index can be
useful:

f
c
c
f
c c
f f
MVA
MVA
W
W
MVA W
MVA W
=
/
/
] 28 . 2 [
The interpretation if this index is that lower Chinas MVA
c
relative to a foreign MVA
f

has the effect of reducing the comparative wage gap, and therefore making Chinas
effective comparative cost to be smaller. As can be seen from column (4) of Table 2.4,
indeed Chinas unit labour costs were relatively higher than those of major competing
DCs such as South Korea, Chile, Mexico, Turkey, Philippines and Indonesia.
China has steered its economy to the top elite of the global economy. In terms of
manufacturing performance the share of its MVA to total world MVA has moved it from
a rank position of below the top ten in 1980 to number 8 in 1990 with 2.7% share and to
number 4 in 2000 with 7% which was surpassed only by the USA, Japan and Germany,
respectively, with 24.1%, 14% and 8.5% shares. Among the DCs, China ranked number 2
with 10% in 1980, number 1 in 1990 with 15.7%, and maintained the position in 2000
with a share of 29.4%. (UNIDO, Industrial Development Report, 2004, pp.183). In terms
of export integration, China has effectively competed even in products embodying high
skill-requiring technologies. As shown in Table 2.5, Chinas position globally rose by at
least six notches across all exports of manufactures during the 1990s and shot to the top
among DCs with gains in high-technology export products.



Table 2.5: Chinas Export Integration into World Markets

Product Group

Top 25 World Exporters


Leading Developing Countries


1990 2000 1990 2000

Resource based
20 11 4 1

Low technology
8 1 3 1

Medium technology
16 11 3 3

High technology
21 9 7 4

All manufactures
4 1

Source: UNIDO, Industrial and Development Report, 2004, pp. 183, 191-193

In order to solve the productivity problem, Chinas openness has blended national state
owned enterprises (SOEs), local private firms, with foreign firms through foreign direct
29
investment (FDI). As can be seen in Table 2.4 (bottom section), the productivity of SOEs
(in VA per worker) in the clothing and textile sectors was substantially lower than in
foreign-connected units. The inferior performance of the SOEs is due to institutional
obligations and practices they inherited from the communist era with the tendency to
over-employment and gradual technological upgrading.
Chinas spectacular export performance in manufacturing caused widespread concern
during the early part of the year 2005 from a cross section of countries ranging from the
richest to the poorest of them, from importers as well as export competitors, and the low-
cost labour has been the alleged cause this competitive advantage. Mexico is a typical
case of a competitor whose plight the International Herald Tribune said Mexico, long
the king of low-cost plants and exporter to the United States of everything from Ford
Trucks to Tommy Hilfiger shirts to IBM computers, is being rapidly supplanted by
Chinas hundreds of millions of low-wage workers.In all, 500 of Mexicos 3,700 so-
called macquiladora (tax-free export-oriented) plants have shut down since 2001, at a
cost of 218,000 jobs, the Mexican government saysNow China, whose American-
bound exports grew 20% last year (in 2002) while Mexicos remained flat, is expected to
surpass this country as No. 2 exporter (after Canada) to the United States ( Mexico
manufacturers lose business to China. IHT, September 3
rd
, 2003, p.11; Quoted in
UNIDO, 2004, p. 142). Also hardly affected were LDCs from SSA that benefit from the
USAs African Growth and Opportunity Act (AGOA) passed in 2000 by which
qualifying countries can export a range of products to the US market duty free. Hardest
affected has been the garments industry after the removal of the MFA. In Malawi, one
of the ten poorest countries in the world, the largest garment exporter lost 33% of its
exports to the USA at a cost of 28% of its 3,000 workforce in mid-2005 and this was
attributed to the cheaper Chinese exports to the US market. (Chirimba Garments lays
off 850, The Malawi Nation, 13 July, 2005, Business page 5)
While low wage costs have been cited as key to Chinas competitive advantage,
productivity differences especially with most SSA countries seems to be a better
explanation for the loss of the duty-free preferential advantage of AGOA. Evidence
suggests that the worker productivity in Lesotho, a shining performer under AGOA in
garments, was between 30% and 70 % lower than in China. Given that wages are not
very different from Chinese, it would be difficult for such countries to sustain
competitiveness especially once AGOA expires. The explanation for this lower
productivity in the apparel manufacturing in Lesotho, which is representative for most
poor SSA countries
lies in the wage system (time rather than piece work), low levels of formal skills, the lack of training (apart
from basic on-the-job instruction) and poor employer-worker relationships. Asian firms do not invest
much in employee training, preferring to use Chinese supervisors and technicians. The government has
done nothing to encourage skill formation by firms (say, through fiscal incentives), nor has it set up any
training facilities for the industry. Its main efforts have been directed to getting AGOA extended rather
than to using the remaining grace period to raise capabilities to competitive levels. There is thus a real
risk that the industry will evaporate once AGOA ends, unless the government launches targeted capability-
building measures and provides the basic public goods that the industry needs (UNIDO, 2004, p. 13)

30
2.3.2 The Exchange Rate, Labour Costs and Trade
Since the adoption of the flexible exchange rate system in the early 1970s by the
Developed Industrialized Countries (DICs), traders and governments have become very
sensitive to exchange rate movements, especially how they affect international
competitiveness. We use a simplified example to illustrate the sensitivity of trade to
various exchange rates using our example of employment equations of [2.14]. Assume
that the hourly wage rates between the two countries are US$6 and MK210 in the foreign
and home country, respectively. At an exchange rate of MK140 per dollar the absolute
costs of one metre will be: 6 hours times $6 per hour or $36 in Foreign and in the Home
we get 8 hours times MK210 per hour or MK1, 680 per metre, which at the exchange
rate gives $12 per metre. The results for both products and countries at various
exchange rates are given in Table 2.6.

Table 2. 6: Exchange Rate (ER) and Trade
ER
MK40 = 1$ MK100 = 1$ MK140 = 1$ MK200 = 1$
Country Textiles Maize Textiles Maize Textiles Maize Textiles Maize
Home $42 $52 $16.8 $21 $12 $15 $8.4 $10.5
Foreign $36 $18 $36 $18 $36 $18 $36 $18
The home currency at the exchange rate of MK100 is consistent with complete
specialization example we have used between the two countries, as textiles will be
cheaper in Home than in foreign countries while maize will be cheaper in the latter
countries than in the home country. An exchange such as MK40 makes home country to
be a net importer of both products and under flexible exchange rate system, excess
demand for both products will lead to depreciation of the local currency. At MK40, the
currency would be said to be overvalued; meaning that it is priced below its equilibrium
level that is consistent with comparative advantage. However, some exchange rates such
as MK140 and MK200 per dollar reverse the trade imbalance in favour of the home
country in both products as the home currency would be said to be undervalued; that is, it
is unnecessarily too cheap vis - a - vis other currencies. An overvalued currency
penalizes its countrys exports in favour of imports while an undervalued currency
promotes its countrys exports at the expense of its imports from other countries. This is
exactly the allegation leveled at Chinas exchange rate management by its major trading
partners, especially the DICs. The contention has been that Chinas export performance
and accumulation of huge trade surpluses and foreign reserves have been, inter alia, due
to deliberate undervaluation of the Yuan. The pressure on China to revalue its currency
was intensified during the year 2005 under various diplomatic flurries subsequent to the
phasing out of the MFA. Although the US Treasury had estimated that the yuan was 40%
undervalued after ten years of fixed parity with the US dollar, China revalued it by only
2% on 21 July 2005 and promised to move to a tunnel exchange rate management system
against a basket of currencies. In the 1970s through the 1980s, most currencies of LDCs
31
were at their overvalued levels in order to encourage import substitution industrialization
(ISI) strategy and to satisfy the import-dependent consumption habits of the emerging
powerful middle class, a policy stance which turned out to be a major cause for the
dismal export performance of these countries. As a result, these countries have variously
adopted more cautious exchange rate management systems.
2.3.3 Empirical Tests of the Classical Trade Theory
How well does the classical comparative advantage theory fit the real world-trading
situation? Recall that the Ricardian theory, in its productivity version, predicts that a
country will export commodities in which it has the highest relative labour productivity
(i.e., average product of labour).
The earliest work in this regard was by MacDougal (1951, 1952), who set out to
empirically test whether the classical comparative advantage theory of trade was
supported by data on the bilateral trade between the United Kingdom (k) and the United
States of America (s). As a measure of comparative productivity advantage, MacDougal
used the ratio of the average product of labour in the USA (APL
s
) to the UKs average
product of labour (APL
k
) using the 1937 data for each of the 25 products in his sample.
To measure the export pattern, he used the ratio of USAs exports (X
s
) to UKs exports
(X
k
) of each product. He found that there was a positive linear pattern shown by a scatter
diagram for a cross-section of commodities between the relative average products
(APL
s
/APL
k
) and relative export performance indexes (X
s
/X
k
). This meant that the
products in which the USA exhibited a higher labour productivity, the export shares were
also higher than the UKs. This tended to support the classical prediction of trade pattern
from comparative advantage based on comparative labour productivities. Subsequent
studies conducted by Stern (1962) for 1950 data and Balassa (1963) for 1951 data yielded
the same findings as MacDougals. Bhagwatis (1964) findings, however, contradicted
the above results. Using linear regression technique, he found that there was no
statistically significantly linear relationship between relative export price (P
s
/P
k
) and
relative labour productivities (APL
s
/APL
k
) or between average labour costs (ALC
s
/ALC
k
)
and (P
s
/P
k
) in the bilateral trade between the US and the UK. However, the intuitive
appeal of Balassas and Sterns findings seems to have overshadowed Bhagwatis study.
Sterns study unlocked MacDougals observation on the inconsistence in his data which
indicated, contrary to expectation, that in third country markets the share of UKs exports
were higher that USAs relative productivity advantage. Using 1950 data set, Stern
found that even in third country markets the USAs productivity advantage was
consistent with its market dominance. This seemed to corroborate MacDougals own
speculation made earlier on that UKs market advantages in third country markets may
have been due to imperial trade preferences, which started weakening after the post-
Second World War period.
Other studies confirming the Ricardian prediction are by Golub (1995) and Golub and
Hsien (2002). Golub sought to establish the relationship between relative unit labour
costs and relative export performance between the USA relative to those of the UK,
Japan, Germany, Canada and Australia. A relative unit labour cost is defined with
32
respect to the UK, for example, as the ratio: .
/
/
k k
s s
APL W
APL W
Computing similar ratios with
respect to the other countries and using 33 industries, Golub (1995) found a negative
correlation between relative unit labour costs and export ratios, thereby indicating that the
higher the relative unit labour costs of the USA the lower its export performance relative
to other countries. This result was vindicated by the Golub-Hsien (2002) study for
products of 39 sectors between the USA and nine countries those included in Golubs
(1995) study plus France, Italy, Mexico and S. Korea, covering the period 1972-1991.
In spite of this powerful predictive regularity of the Ricardian theory, it still fails to stand
up to some real life situations. First, other factors of production and resources are not
accounted for to explain trade patterns. Second, complete specialization is an extreme or
rare phenomenon among trading nations. In actual economies non-traded goods exist
even under relatively free trading regimes. Complete specialization may exist in the case
of 100% export oriented processing zones (EPZs) and only for specialized products and
not the whole industry. The third observation is the reliance on fixed coefficients in the
production process when there is great potential for more flexible and variability in the
combination of inputs. These three aspects recognition of other factors of production,
incomplete specialization and flexible factor intensities are tackled in the next Chapters.















33



CHAPTER 3
THE FACTOR PROPORTIONS THEORY OF COMPARATIVE ADVANTAGE
The factor endowment theory was proposed by Eli Heckscher (1918) and elaborated by
Ohlin (1933) with a view to providing an explanation for the commodity composition of
international trade. While in the Ricardian theory, which had been unrivaled for 100
years, the basis for comparative advantage is the difference in autarky relative labour
costs or labour productivities, the factor endowment or Heckscher-Ohlin (HO) approach
goes further to propose that such pre-trade relative cost differences are in turn due to
differences in relative resource endowments; that is, differences in proportions in which
factors of production are available in different countries.
According to the HO theory, a country has comparative advantage in the product which
utilizes most intensively; that is, which is heavily biased in the use of the factor which is
in relative abundance in that country compared to other countries. Therefore, the
direction of trade will be that a country exports products which are intensive in the
relatively abundant factor(s) and import products which are intensive in the relatively
scare factor(s). This statement, also referred to as the HO Theorem, has spawned some
key corollaries, including the Stolper-Samuelson Theorem (1947) on the distribution of
income and the Factor Price Equalization Theorem (Samuelson 1948, 1949), both of
which are presented in the next Chapter. With the rigorous application of neoclassical
marginalist analysis (especially by Samuelson in the 1940s), the factor proportions model
became to be known (and is still known) also as the (traditional) orthodox theory of trade
or the HOS model.
We review next the assumptions of the model and then present the logical flow of the
proof of the theorem.
3.1 Assumptions of the HO Model
The HOS model is based on a set of restrictive assumptions, leaving other possible
features which alternative economies may assume as the basis for alternative theories of
trade. In this regard, the material covered in this Chapter serves as a reference guide for
judging the points of departure from the HO theory of such alternative theories of trade
which are covered in later Chapters. The HO models assumptions fall into three broad
classes: those related to market and general economic environment; and demand-side
assumptions about consumption of welfare patterns; and the supply-side assumptions;
which are about technology and factor or production conditions.

This is a two-factor, two-product and two-country (2 by 2 by 2) trade model. These
factors are capital and labour which are fully employed to produce textiles and maize in
Home and Foreign countries. These countries possess the following characteristics.
34

1. Perfect competition prevails in both factor and commodity markets and the firms
objective is to maximize profits.
2. There are indrances and frictions to the the achievement of this objective and
trade when it opens between the two countries such that there are no transport
costs; perfect information prevaials and absence of government interference or
enhancement through any policy or institutional instruments in the market place.
3. Commodities are perfectly mobile within each country and between then when
trade opens. However, while factors of production are perfectly mobile between
the two industries in each country, they are completely immobile internationally
even when trade in commodities opens.
4. Prefernces and tastes are similar between the countries so that their community
indifference map and social welfare functions are similar. This means that
consumers in these countries can consume the two products in the same proprtion
when confronted by the same relative price for the products.
5. Countries are exposed to the same state of technology which is different in the
production of each commodity. That is, while each commodity is produced by a
different production function, countries will use the same production function for
each product. Further, firms in each country will use the same factor intensity or
technique when contfronted by the same relative factor price.
6. There are diminishing returns to each factor of production and both production
function exhibit constant retaurns to scale. This set of production conditions
guarantees strictly convex isoquants and concave production possibilities frontiers
in producing both products.
7. There is no factor intensity reversal in the production of the two commodities as
factor prices change. This requires that at each factor price commodities can be
uniquely and unambiquously ranked, classified or identified by their respective
factor intensities. Assumptions 5 and 7 are further explained next.

3.1.1 Technology and Absence of Factor Intensity Reversal

With this background we are now at an advantageous stage to demonstrate two pivotal
HOS assumptions regarding technology and relative factor costs; namely, the
assumptions of identical technologies and absence of factor intensity reversal.

Identical Technologies

In terms of technology, the HOS model assumes that countries have access to identical
production functions but which are different for each commodity and that the factors of
production are identically productive across countries. If technology is uniform
internationally, then the isoquants for each commodity, as those shown in Figure 3.5, will
be the same across countries. This means also that the same quantities of the factors
employed in the production of a particular commodity would yield the same level of
output in each country. Further, if countries had equal quantities of capital and labour, or
if the endowment ratio were equal, they would employ the factors with the same
technique. Even more so, each country would apply the same technique in the production
35
of a given good if relative input prices were equal. For example, at the relative wage
given in Figure 1.6, firms in each potential trading partner would produce Q
o
at point X
using factor intensity OX. The result would be that the ratios of the marginal products,
MPL/MPK, would be equalized across countries.

Absence of Factor Intensity Reversal

This assumption requires that goods be uniquely and unambiguously ordered or identified
according to factor intensities at all possible relative factor prices. That is, if a good is
capital intensive while another one is less capital intensive (is labour intensive) at a
relative wage such as w
o
/r
o
, these goods should be similarly classified or ranked in terms
of their factor intensities should the relative wage change to (w
1
/r
1
). Let the relative wage
rise as: w
1
/r
1
> w
o
/r
o
); and, further, let maize production be more capital intensive than
textiles as: K
z
/L
z
> K
t
/L
t
. The assumption of "no factor intensity reversal" is
demonstrated with the aid of Figure 3.7. Panel (A) shows firm optimization in the
capital-labour plane with maize isoquant Z
o
Z
o
and textile isoquant T
o
T
o
. The initial
techniques with initial relative wage,
o

w
o
/r
o,
are, respectively, at points A and B for
maize and textiles. Maize is more capital intensive than textiles as the technique
represented by ray OA = (K
zo
/L
zo
) is greater than (K
to
/L
to
), which is ray OB. That is:

[3.25] For:
o

w
o
/r
o
(K
zo
/L
zo
) = OA > OB = (K
to
/L
to
)

At the higher relative wage,
1

w
1
/r
1
, which has a steeper slope than that for w
o
/r
o
,
labour becomes relatively more expensive, so that in the process of economizing its use,
less of it will be employed and more capital will be used. The new optimization positions
are C on Z
o
Z
o
and D on T
o
T
o
. We can record two observations. First, as a result of a rise
in the relative wage, both products have become more capital intensive; thus for maize:

[3.26a] K
z1
/L
z1
= OC > OA = K
zo
/L
zo


and for textiles:

[3.26b] K
t1
/L
t1
= OD > OB = K
to
/L
to


Second, in accord with the assumption of no factor intensity reversal, still maize
production remains more capital intensive than textiles at the higher relative wage. That
is:

[3.27] For: w
1
/r
1
K
z1
/L
z1
= OC > OD = K
t1
/L
t1


Panel (B) records the same result of non-reversibility of factor intensities using a unique
mapping between the various relative wage rates to factor intensities.

Recall that the factor equilibrium condition which is representsd by a positive
proportionate relationship between relative wage and factor intensities as (w/r) =
(MPL/MPK) = (K/L), > 0. This relationship is represented by lines TT and ZZ for
36
textiles and maize, respectively, in Panel B of Figure 3.7. The relative wage is measured
along the vertical axis and factor intensity on the horizontal axis. These functions show
that as the relative wage rises (falls), production becomes more capital (labour) intensive
for each good. At the initial lower relative wage
o
w
o
/r
o
, maize at A
1
is more capital
intensive than textiles at B
1
; or
zo
K
zo
/L
zo
> K
to
/L
to

to
. At the higher relative wage

w
1
/r
1
, it can be observed that, although production has become more capital intensive
in general, still maize production is more capital intensive than textile production,
z1

K
z1
/L
z1
> K
t1
/L
t1

t1
, thereby sustaining the assumption of absence of factor intensity
reversal. The possibility of the occurrence of factor intensity reversal is considered in
Chapter 5.
3.2 The Logical Basis and Flow of the HO Theorem
3.2.1 Factor Endowments
With these assumptions, countries are will be dissimilar only in relative factor abundance.
There are two definitions of relative factor abundance, namely, the physical and the
relative price definitions. We use next the former dfiniiton, by which factor endowment
is measured by the autarky proportions in which aggregate fixed resource endowments
are available. As demonstrated henceforth, this dissimilarity is the source of comparative
advantage. Suppose in terms of absolute physical units the pre-trade aggregate capital
stocks and labourforces for two countries can be somehow computed as follows: K
H
and
L
H
units for Home country and K
F
and L
F
units for Foreign country. In terms of
proportions, these countries respective endowments can be presented as: K
H
/L
H
and
K
F
/L
F
. Suppose further we observe this inequality in autarky in these countries
endowment proportions:
H
H
F
F
L
K

L
K
] 62 . 3 [ >
Then we would conclude that Foreign is more relatively endowed with capital than Home
and therefore Foreign is a capital rich (but a labour scarce) economy. Conversely, Home
is a relatively labour endowed but a capital scarce economy. As long as pre-trade
differences in factor endowments exist as in inequality [3.62], then the basis for
comparative advantage and therefore trade has been established. The model then makes a
series of logical deductions:
From relative factor endowments to autarky relative factor prices/costs.
Product factor intensities to autarky relative product prices through relative factor
costs.
Relative autarky product prices to comparative advantage.
3.2.2 Factor Abundance and Autarky Relative Factor Costs
37
When all adjustments have been made through perfect competition in factor markets,
each economy will be at its autarky full employment position and equilibrium relative
factor prices will be established by equating them to the ratios of marginal productivities.
We need to invoke the variable proportions theory here. We also assume that maize is
more capital intensive than textile producton (which is labour intensive). Since
technologies and production functions are the same, efficiency in resource use will
dictate that firms in the Foreign country adopt higher capital-intensive techniques in both
products than Home. Since Foreign has relative abundance of capital than Home, the
scarce labour in the Foreign would tend to be relatively more productive than at Home
where it is in comparative abundance. In other words, the relative scarce capital in the
Home will be more productive combining with the abundant labour than in the Foreign
where it is abundant. We expect this ratio to hold in autarky:
.
MPK
MPL

MPK
MPL
] 63 . 3 [
h f
|

\
|
> |

\
|

In this case, the cost minimization rule will hold such that the relative wage will be
higher in Foreign than in Home. Thus
h f f
r
w

MPK
MPL

MPK
MPL
r
w
] 64 . 3 [ |

\
|
= |

\
|
> |

\
|
= |

\
|

This result is illustrated using isoquant analysis in the Edgeworth-Bowley Box diagram
of Figure 3.16. Take first the Box for Home country. The capital-labour plane for
textiles has its origin at the bottom left point O
th
, with capital allocations to textiles
measured vertically along the left axis labour horizontally to the right. Textile isoquants
indicate rise in output such as from T
oh
to T
4h
, and vice versa for reductions. Maize
origin is from point O
zh
, top right, with labour in maize measured horizontally to the left
and capital in maize read to the right downward. Maize production increases from
isoquant such as Z
h
Z
h
to Z
oh
Z
oh
. Joint optimization positions in factor allocations are
shown by infinite isoquant tangencies such as at points H
o
and H
1
. Such optimal
positions are traced by the efficiency locus O
th
H
o
/H
1
O
zh
. The Box for Foreign can be
similarly described although the efficiency locus is missing. The lengths and widths of
the Boxes indicate relative factor endowments, with Foreign as a capital abundant
country according to endowment inequality [3.62].
The autarky factor optimization positions are at H
o
for Home and F
o
for Foreign at which
equilibrium relative wage lines are tangent to the isoquants for textiles and maize. It can
be verified that the relative wage line for Foreign,
f
, is steeper than that for Home,
h
,
as per inequality [3.62]. At the respective optimal points, full factor employments are:
Home:
[3.65a] L
H
= L
ot
+ L
oz
= L
ot
+ (L
H
L
ot
)
[3.65b] K
H
= K
ot
+ K
oz
= K
ot
+ (K
H
K
ot
)
38

Foreign:
[3.65c] L
F
= L
ot
+ L
oz
= L
ot
+ (L
F
- L
ot
)
[3.65d] K
F
= K
ot
+ K
oz
= K
ot
+ K
F
- L
ot
)
Factor Intensities. The assumption that maize production is more capital intensive than
textile production can be verified in the Box diagrams, whereby for Home, technique H
Z

= O
zh
H
o
for maize is steeper than for textiles, H
T
= O
th
H
o
; and for Foreign, F
Z
= O
zf
F
o
>
O
tf
F
o
= F
T
.
3.2.3 Autarky Relative Factor Prices and Opportunity Costs
Let us now make a direct link between autarky relative factor costs and opportunity costs
in each country. Taking the Home country first, we recall that this is labour abundant
with a lower relative wage (labour is relatively cheap) as per inequality [3.62]. Since
textiles are labour intensive they will be produced at a relatively lower cost in Home than
in Foreign which is labour scarce with a higher relative wage. But maize, which is
capital intensive, will be produced expensively in Home which is capital scarce. In the
Foreign, maize will be produced there relatively cheaper since it is intensive in capital
which than in Home.
In terms of opportuinity costs this result means that the marginal cost of textiles relative
to that for maize will be lower in Home than in Foreign economy; that is, textiles will be
produced with lower opportunity cost (OC) at home than abroad. Thus:
TH
ZH
TH
ZF
TF
TF
OC
MC
MC
MC
MC
OC = > = ] 66 . 3 [
3.2.4 Opportunity Costs, Relative Product Prices and Comparative Advantage
Under the perfect competitive market mechanism commodity prices are equated to
marginal costs and relative prices to opportunity costs. This is established when each
country is maximizing its national welfare subject to its PPF and the solution is obtained
at the optimum product mix. This solution is set out in Figure 3.17, which portrays the
autarky general equilibria of the two countries. In terms of the shape of the PPFs, we
observe the following features: since Home is labour endowed and textiles are labour
intensive while Foreign is capital endowed and maize is capital intensive, the increasing
opportunity cost PPFs reveal that the relative maximum outputs, or intercepts, are such
that F
Z
/F
T
> H
Z
/H
T
, meaning that Foreign will be producing relatively more maize with
respect to textiles than Home, and vice versa. The respective autarky general equilibrium
optimization positions are as follows: Home is producing and consuming at point H
o
of
T
oh
textiles and Z
oh
of maize while Foreign is in autarky equilibrium at point F
o
.
Inequality [3.66a] is depicted by the higher slope of PPF at point F0 than at point H0.
Each country is maximizing welfare with highest possible welfare indifference curve of
39
U
o
U
o
. In both situations the general equilibrium optimization condition for optimum
product mix is satisfied as the three curves are simultaneously tangent to each other.
Techically this requires that the slope of the PPF (the rate of produc transformation,
RPT), the slope of the indifference curve (rate commodity substitution in consumption or
exchange, RSC0 and the slope of the price line (product relative price) be equal.
The comparative advantage gap will be determined by MC pricing by which the autarky
relative prices p
h
= (P
t
/P
z
)
h
, and p
f
= (P
t
/P
z
)
f
, will be equal to the respective OCs.
Accordingly, it can be observed that the autarky price line for Foreign is steeper than for
Home, p
f
> p
h
. We then deduce that textiles will be relatively cheaper at Home than in
Foreign or that textiles will be relatively more expensive in Foreign than at Home (maize
will be relatively cheaper in Foreign than at Home). Thus
H ZT H ZT TH f TF F ZT F ZT
RSC RPT OC p OC RPT RSC ) ( ) ( p ) ( ) ( ] 67 . 3 [
f
= = = > = = =
The logical flow of the HO model of comparative advantage we have just mapped out
leads us to state that:
Foreign, which is capital abundant, has comparative advantage in maize, which is
capital intensive. Foreign has comparative disadvantage in textile supply which is
intensive in labour which is scarce in that country.
Home has comparative advantage in textile production which is intensive in
labour, the abundant in that country.
Foreign will export its capital-intensive maize to Home and import the labour
intensive textiles in which labour-rich Home has comparative advantage.
Although factors of production are immobile internationally, each country will be
indirectly exporting the services of its abundant factors embodied in its exports of
goods, and will be indirectly importing the services of scarce factors embodied in
its imports of goods.
3.2.5 The Fundamental HO Theorem
The purpose here is to demonstrate algebraically the HO theorem whose logical flow has
just been illustrated. We use a general formulation and then be more specific in
conclusion. We start with the full-employment equations:
L T l Z l b
K T k Z k a
t z
t z
= +
= +
] 68 . 3 [
] 68 . 3 [

This, in matrix form, is represented as:
(

=
(

L
K
T
Z
l l
k k
t z
t z
] 69 . 3 [
40
By our working assumption of factor intensities, we know that:
z t t z
t
t
z
z
l k l k
l
k
l
k
> > ] 70 . 3 [
We want to get a relationship between commodity ratio Z/T and endowment ratio K/L,
and since the latter is known, by the endowment assumption [3.62], we can for now solve
for the commodity ratio using the steps that follow. The determinant of the coefficients
matrix is: D = k
z
l
t
k
t
l
z
> 0, by the factor intensities assumption. The solutions for Z and
T are:
D K l L k D
L l
K k
T
D L k K l D
l L
k K
Z a
z z
z
z
t t
t
t
/ ) ( / ] 71 . 3 [
/ ) ( / ] 71 . 3 [
= =
= =

Taking the commodity ratio and dividing the result by L, we obtain:
) / (
) / (
] 72 . 3 [
L K l k
k L K l
K l L k
L k K l
T
Z
z z
t t
z z
t t

=
Differentiating the ratio Z/T with respect to K/L, and simplifying by using factor
intensities, the desired result becomes:
t z
z z
t t z z
z z
t z z t
l l
L K l k
l k l k
L K l k
k l k l
L K d
T Z d
2 2
)] / ( [
/ /
)] / ( [ ) / (
) / (
] 73 . 3 [

=
The denominator is unequivocally positive and non-zero while the numerator is the
expression for the determinant and factor intensities. It is positive, k
z
/l
z
> k
t
/l
t
, if Z/T and
K/L are positively correlated, which would mean that a country which is relatively
endowed with capital will be biased toward production of Z which is capital intensive.
Production will be pro-T, the labour intensive product, for a labour-endowed country,
since the numerator will be negative, indicating a negative association between Z/T and
K/L. Since factor endowments for Foreign and Home and factor intensities are such that:
t
t
z
z
H F
l
k
l
k
and
L
K
L
K
> |

\
|
> |

\
|
] 74 . 3 [
then, for any ratio Z/T on their respective PPFs, the following bias will hold: RPT
f
>
RPR
h
, and p
f
> p
h
. Because of the assumption of no factor intensity reversal:
h f H F
r
w
r
w
L
K
L
K
|

\
|
> |

\
|
|

\
|
> |

\
|
] 75 . 3 [
41
Therefore, the basis for trade under the HO theory relies on dissimilar factor endowment
proportions. Similarity of endowments would reflect that:
h f
h f H F
p p
r
w
r
w
L
K
L
K
= |

\
|
= |

\
|
|

\
|
= |

\
|
] 76 . 3 [
In this case, there would be no HO comparative advantage even if factor intensities
(technologies) were still different between products and this would collapse to the
Ricardian comparative advantage.





















42
CHAPTER 4

CONSEQUENCES OF OPENING TO COMPETITIVE FREE TRADE

This Chapter examines some of the pertinent adjustments and results that are likely to
occur as a country opens up to free trade. These effects, which build on the classical
analysis of Chapter 2, are impacts on variables such as: terms of trade, consumption,
production, income and welfare. Applying both general and partial equilibrium
approaches, particular emphasis is placed on identification of the gains and losses from
moving to a competitive trade open-economy regime and their distributional patterns
within and among the participating countries. Having done this analysis, the Chapter
then tackles the question of determination of equilibrium world TOT. In the course of
these presentations, additional analytical concepts and tools are defined, developed and
applied.
4.1. Welfare Gains in General Equilibrium Analysis
A change in the aggregate welfare position of a country is a fundamental measure of the
net gain or loss due to a change in a trade regime. Traditionally, the net welfare gain
from opening up to trade is traced from two sources; namely, the consumption gain (or
pure exchange gain) and efficiency gain due to specialization at world TOT. The trigger
to these twin gains is the TOT gain as a country moves from trading at autarky TOT to
trading at world TOT. This TOT effect was rigorously explained in the context of the
demonstration of gains from classical comparative advantage in Chapter 2, to which
reference is made.
Given the comparative advantages of our two countries, opening up to trade will, with the
facilitation of perfect commodity arbitrage, lead to establishment of some common world
TOT that will settle somewhere between the two countries autarky exchange ratios, such
that: .
f w h
p p p < < The immediate TOT gain is that a unit of the product in which a
country has comparative advantage or its export product, will fetch more units of the
commodity in which the country has comparative disadvantage at the world TOT than at
the pre-trade relative price. For Home, a metre of textiles will be worth more bags of
maize at p
w
than at p
h
, while Foreigns bag of maize will purchase more metres of textiles
at p
w
than at its p
f
. We next explain and demonstrate two very important static gains
known as consumption gain and efficiency gain in increasing opportunity supply
situations.
Consumption Gain. The gain from trading at the world terms of trade just described is a
gain from pure exchange or the consumption gain, which arises even before domestic
production responses have fully adjusted to the shift from autarky to improved world
terms of trade. This means that the consumption gain accrues from trading the autarky
bundle at the world terms of trade instead of at the autarky terms of trade. Using the
Home country diagram of Figure 4.1, this is shown by a world price line ,
1 w w
p p which
crosses the autarky point H
o,
but is tangent to welfare curve U
2
U
2
at the welfare
43
maximizing point C
2
. The gain from this pure exchange is associated with an
improvement in Homes welfare from welfare level U
o
U
o
to a higher one U
2
U
2
.
Efficiency Gain. The other gain from opening up to free trade is due to specialization
according to comparative advantage, which is associated with an increase in efficiency as
a better resource allocation is achieved at the world terms of trade than in autarky. For
each country, the terms of trade improvement raises relative profitability or changes the
incentive structure in favour of the product in which each country has a comparative
advantage. This leads to withdrawal of some resources from the product the country has
comparative disadvantage and augmented in increased production of the good in which
that country has comparative advantage. Consequently, output of the comparative-
advantaged product will expand while that of the comparative-disadvantaged product will
contract in absolute terms. For the Home country, this product restructuring is shown by
movement on her PFF from H
o
to H
1
at which the world price line p
w
is tangent to the
PFF. Textile production expands from T
oh
to T
1h
while maize output contracts from Z
oh

to Z
1h
. The efficiency or specialization gain associated with this structural adjustment,
leads to a further rise in welfare from point C
2
to C
4
. It can therefore be observed that the
resultant total welfare increase from engaging in free trade is the sum of the consumption
gain (exchange gain) and efficiency gain (from specialization). This is an extremely
important result which deserves special emphasis and is therefore highlighted as follows:
4.1 Net National Welfare Gain = Welfare increase due to Consumption Gain + Welfare
increase due to Efficiency Gain
The observation that the trading welfare positions, C4 and C6, for Home and Foreign,
respectively, are beyond the PFF implies that trade offers enlarged consumption
possibilities compared to no trade at all. Free trade is better than no trade at all. This
maximization of welfare at free-trade world level should be underscored in a fundamental
manner. Recall that a country-wide PPF was constructed by way of what we termed
Efficient Output Choice by firms and in the two-firm example, more output was
produced when the marginal rates of product transformation (RPTs) of the firms were
equalized and then there were no further gains between them to exploit. Further, through
Efficient Product Mix, each country in autarky reached Pareto optimality by
maximizing welfare subject to its PFF and the autarky equilibrium price ratio, and, again,
no further gains remained to be further exploited. But with the existence of comparative
advantage and at the world scale, further gains for exploitation have been made possible,
and once welfare has been maximized at the world price ratio, no further advantages
remain unexploited between the trading partners. This means that at the same trading
TOT, the two countries have equal opportunity cost of textiles (or have equalized RPT)
that are equal to their equalized marginal rates of commodity substitution in
consumption. Further welfare analysis and its distribution are re-visited using partial
equilibrium framework in Section 4.3.

44


4.2 Aggregate Income Changes

Opening up to free trade, or any trade regime change in general, has powerful effects on a
countrys aggregate income and its distribution to the participating socio-economic
agents and groups. This section explores the effect on real aggregate income as countries
open up to free trade, while postponing the question of income distribution to Section 4.4.

An important gain from free trade that we have just discussed is the position of the
trading consumption bundle which lies above the PFF. The consequent improvement in
welfare, due to improvement in the terms of trade, is associated with real income gain.
Let us demonstrate this income gain using the Home country whose equilibrium autarky
and trading positions are extracted from Figure 4.1 and a section of which (without
indifference curves) is shown in Figure 4.3. Suppose P
a
is an index number for Homes
autarky general price level, so that the total nominal income or GDP is equated to total
nominal revenue or expenditure as follows:

o t o z
n
a a a
T P Z P Y Y P + = ] 2 . 4 [

To express this in real terms using bags of maize, divide through by maize price to get:

A Z p Z T p Z T
P
P
Z
P
Y P
Y
o h o o h o o
z
t
o
z
a a
o
+ = + = + = = ] 3 . 4 [

Note that the slope of the Home autarky terms of trade is given by A Z Y Z p
o o o h
/ = ,
which implies that A Z P Y Z
o h o o
. = . With substitutions in Equation [4.3], we get the
vertical distance (in bags of maize) as:

o o o o
Y Z Z Y + = ] 4 . 4 [

Similarly, the free trade real income can be expressed as

1 1 1 1 1 1
] 5 . 4 [ Y Z Z B Z p Z Y
w
+ = + =

Since Y
1
> Y
0
in real (maize) terms, free trade has led to a rise in real income by dY =
(Y
1
- Y
0
) > 0. But since maize production has contracted due to trade, by how much
should textile production expand in order to offset the decline in maize output? Let us
generate a weighted income growth equation as follows: subtract the autarky income
Equation [4.3], from the free-trade Equation [4.5] and derive proportionate changes to
obtain:
45
0 ] 6 . 4 [ >
|
|

\
|
+
|
|

\
|
=
o o
o
o o
o h
h o
o h
o
Z
dZ
Y
Z
T
dT
Y
T p
p
dp
Y
T p
Y
dY
a
or
( ) ( ) ( ) ( )Z n T p n Z n T p n Y b
h h

] 6 . 4 [ > + > + =

The term
o o h
Y T p n / = is the share of autarky expenditure in autarky GDP and a hat over
a variable signifies proportionate change in that variable from its autarky level. In order
to add some meaning to Equation [4.6b], we need to distinguish between the barter TOT
from the income TOT. The barter or commodity TOT are defined as the relative price of
exports in terms of imported goods as:
m x b
P P TT = . The income TOT are defined as the
product of the barter TOT and the export volume as:

b
m
x
y
TT X
P
P
X TT . ] 7 . 4 [ = =

In the case of equation [4.6a], the expression for income TOT is mimicked by the product
term p
h
T
o
. Then the term )

( T p + is the sum of a change from autarky to the trading

barter TOT and growth in production of the exportable good. Therefore, real income will
rise as the growth in income TOT exceeds the contraction in the import-competing sector,
here the maize sector for the home economy.

4.4 Factor Income Changes and Distribution

It has been established that opening to free trade leads to an increase in aggregate real
income, provided that growth in the expanding export-specializing sectors exceeds the
rate of contraction in the import-competing sectors. It is in this sectotral performance
bias that a shift in a trade regime can have powerful effects on income distribution within
and across countries. Although David Ricardo concurred with Adam Smith on the
efficiency and welfare maximizing of free enterprise system in general and free trade in
particular, he differed with Smith on the proper objective of political economy. In a letter
to Thomas Malthus of October 9, 1820, Ricardo stated Political Economy you think is
an enquiry into the nature and causes of wealth I think it should be called an enquiry
into the laws which determine the division of the produce of industry among the classes
who concur in its formation. No law can be laid down respecting quantity, but a tolerably
correct one can be laid down respecting proportions. Every day I am more satisfied that
the former enquiry is vain and delusive, and the latter only the true objects of the
science. (Quoted in John Maynard Keynes, The General Theory of Employment, Interest
and Money, A Harbinger Book, 1964, p. 4 ftn. 1).

Economists distinguish two types of income distribution; namely, functional distribution
and personal distribution. The former type, which Ricardo referred to, focuses on
incomes earned by factors of production, including labour compensation in form of
wages and salaries, property income such as rent and royalties, and productive asset
income of profit, interest and dividends. Income distribution is measured by income
46
shares. Personal or size income distribution is based on the assumption that all income
earned from various sources eventually accrues to individuals or households.

The traditional neoclassical trade policy analysis has focused on trade effects of
functional or factoral income distribution, and following this approach we shall
reexamine the key predictions of the Factor Price Equalization Theorem, the Stolper
Samuelson Theorem, and the Fixed Factor Proposition. Before tackling the distributional
effects of a HOS-type of trade, it is important to digress a little in order to review the
derivation of factor markets and how they function especially under competitive
conditions.


4.4.2 Factor Price Equalization Theorem

The Factor Price Equalization (FPE) Theorem states that opening to free trade based on
factor endowment leads to equalization of factor prices for each factor both in relative
terms and in absolute terms across the trading countries. In order to trace factoral price
effects of trade regime change, we start in reverse by tracing the domestic factor market
changes with the introduction of the world TOT in the goods market in each domestic
economy. Thus, as trade begins, the TOT improvement and specialization lead to
increased production of the respective products in which countries have comparative
advantage and to contraction of output in the comparative disadvantaged products. This
analysis uses the mapping from TOT improvement to domestic relative factor prices and
then to factor intensities: TOT (Intersectoral Production) (Derived Input
Demands) (w/r) (K/L) (MPL/MPK).

Using Figure 4.11, we start with the Home case first. With improved TOT in favour of
textiles and when all domestic adjustments have been made, textile production rises from
isoquant T
oh
to a higher one T
o1
, while the contraction in maize production is shown by
movement from curve Z
oh
to a lower one Z
1h
. However, in the short-run, TOT
improvement triggers resource reallocations involving withdrawal of some labour and
capital from the contracting maize sector to be redeployed in the expanding textile sector.
In the process, there are joint technological and economic adjustments taking place.
Technologically, capital and labour are released from the maize sector with a higher K/L
ratio of O
zh
H
o
than the ratio in which they are required in the textile sector of O
th
H
o
.
Economically, at the autarky relative wage, V
h
= (w/r)
h
, firms in the short run require
more labour relative to capital (or less capital relative to labour) in the expanding labour-
intensive textile sector than is being released from the K-intensive maize sector. This
relative rise in the derived demand for labour leads to rising relative wage. Profit
maximizing (or cost minimizing) firms will start to economize on the use of labour in
favour of capital, thereby causing the factor intensities in both sectors to be more capital
intensive than in autarky.

In the long run, when all adjustments have run their course and consistent with the world
TOT, p
w
, it can be verified from Figure 4.11 for Home that:
47
Labour withdrawn from maize of L
1z
-L
oz
is increased employment in the textile
sector by L
1t
-L
ot
. Similarly, capital reduced in maize of K
1z
-K
oz
is increase in
textiles of K
1t
-K
ot
.
From autarky equilibrium H
o
to trading position H
1
, factor intensities in both
maize and textile production have become more capital intensive: For textiles:
O
th
H
1
> O
th
H
o
, and for maize: O
zh
H
1
> O
zh
H
o
. However, maize production still
remains more capital intensive than textile production (in accord with the
assumption of no factor intensity reversal).
From the law of variable proportions and firm optimization, the rise in the K/L
ratio with trade means that the relative marginal productivity, MPL/MPK, has
risen and, therefore, the relative wage must have commensurately risen too; that
is, V
w
= (w/r)
w
> V
h
.

In the Foreign, the reverse adjustments have taken place from F
o
to F
1
, to the extent that
capital has become relatively more productive than labour as the production processes
there have become less capital intensive with the consequent fall in the relative wage: V
w

= (w/r)
w
< V
f
.

Relative Factor Price Equalization. This part of the theorem is illustrated by the fact
that in both countries employers are facing the same relative wage, V
w
. This is because
both countries are facing the same world TOT, have access to the same technology, factor
intensities have converged, and, since factors of production are equally productive, the
ratios of marginal products and, therefore, the relative wage have been equalized.

A more complete picture of the relative factor equalization effect is provided in Figure
4.12, which depicts the logical flow of the HOS framework that was sketched in Chapter
3 and was based on assumptions of endowments and factor intensities. The assumption
of incomplete specialization is crucial here. Foreign country is capital endowed while
Home country is labour endowed. Maize is capital intensive while textiles are labour
intensive at each relative wage without factor intensity reversal. This relationship is
shown in Panel A of the Figure by lines TT and ZZ, which define the positive
relationship or mapping between the relative wage and the factor intensity such that at
each relative wage, maize is more capital intensive than textiles. The lines TT and ZZ do
not cross in the relevant range due to absence of factor intensity reversal. The factor
endowments make relative wage at Home to be lower than in Foreign, V
f
> V
h
, and factor
intensities are more capital intensive in Foreign than at Home, (K/L)
tf
> (K/L)
th
, and
(K/L)
zf
> (K/L)
zh
. The PP line in Panel B maps relative factor prices onto relative
product prices. Under our assumptions, Home, which is labour endowed has comparative
advantage in labour intensive textiles while Foreign, which is capital rich has
comparative advantage in capital intensive maize: p
h
< p
f
. We can trace back the effects
of opening up to trade with p
w
as the world TOT. This leads to equalization of the
relative wage at V
w
, which then determines the convergence of factor intensities; in
maize as (K/L)
zw
and in textiles as (K/L)
tw
.

Equalization of Absolute Factor Prices. This can be traced from the technological
adjustments sketched above. By assumptions of identical technologies and quality of
48
productive factors, there will be convergence of the marginal products of each input
between the two countries. In addition, without any trade hindrances and government
interventions, Home and Foreign have become a unified and integrated economic space
in which commodity prices are equal and are, in turn, equal to marginal costs for each
product. Although artificially segmented by factor markets (due to immobility of factors
between the two countries), firms in each sector are using the same profit maximization
rule and are at the PFF where the opportunity cost of each product is equalized and the
MC of each product is also equalized. Recall, from Chapter 3, the cost-minimization
FOC of w = MPL and r = MPK, where = LMC. Then using the MC-pricing rule
that in the long run P = MC, we can state this FOC for labour as w = MC.MPL = P.MPL
= VPML, which in real terms is MPL = w/P. Expressing this condition at the world
TOT, we obtain the following labour and capital productivities measured in bags of
maize:

zw
w
tw w zw
w
zw
w
tw w tw
zw
tw
zw
P
r
MPK p MPK b
P
w
MPL p MPL
P
P
MPL a
= =
= = = =
] 54 . 4 [
] 54 . 4 [

Since there is convergence in the MPs of each factor, this means that when factors of
production are paid according to their marginal products, their real return will be equal
between the trading countries for each factor at the world TOT.

4.4.4 The Stolper- Samuelson Theorem

The Stolper-Samuelson Theorem (SST) takes the income effects of a trade regime change
socially deeper than the factor price equalization theorem by providing a prediction of
who the gainers and losers would be. At the general level, the SST states that: A rise in
the price of a product will raise in absolute terms the real return(s) to the factor(s)
intensively used in that product and will reduce absolutely the real return(s) to factor(s)
less intensive in that product. A fall in the price of a good will reward its less intensively
used factor(s) and penalize its more intensively used factor(s). The SST is described
intuitively first and then more rigorously proved diagrammatically and algebraically in
that order.

Specifically with respect to trade, the SST is based on almost all the assumptions that we
listed for the HO model in Chapter 3, together with the assumption of incomplete
specialization. A shift to free trade which is based on comparative advantage (defined in
terms of factor abundance) raises the price of the product intensively produced by the
abundant factor and leads to a decline in the price of the product intensively used by the
scarce factor. In accord with the SST, the real income of the abundant factor will rise
while the reward to the scarce input will fall. In our example, the gainers in Home are
workers and the losers are capitalists. In the Foreign, capitalists gain while workers lose.
We can see this effect if we compare the autarky and world real factor returns and
incomes. The world real returns are given in the factor price equalization equations
[4.54]. In the Home, the autarky real factor prices in maize terms are:
49
zh
h
th h zh h
zh
h
th h zh
P
r
MPK p MPK and
P
w
MPL p MPL = = = = = ] 55 . 4 [
Since we want to explain income changes, let us first record the autarky income level and
its functional distribution. Figure 4.13 depicts the Home labour market which is in
autarky full-employment equilibrium at H
0
, with real wage rate at
h
= MPL
zh
. The
aggregate autarky real income and its distribution to labour and capital, respectively is
Y
oh
= L
H
.MPL
zh
+ K
H
.MPK
zh
= OAH
o
L
H
+ ACH
o
= OCH
o
L
H
. The rise in the price of
textiles increases the derived demand for labour, while the fall in the price of maize
reduces the derived demand for capital. This has the effect of shifting the autarky labour
demand curve upwards so that it is consistent with world TOT. Consequently, the real
wage rises to
w
. Comparing with the MPs in Equation [4.54], we can therefore
unambiguously observe that both in maize and textile units, the real wage in Home,
which is labour rich, has risen with trade, since in maize terms:
zh
h
zw
w
th h tw w zh zw
P
w
P
w
and MPL p MPL p MPL MPL a > > > , , ] 56 . 4 [
In the latter case, the gain in the real wage is due to the rise in both the TOT and the
MPL. The real return to capital has fallen in both product measures: that is, MPK
zw
<
MPK
zh
. This is because the decline in nominal return (in absolute terms) is greater than
the TOT gain; thus:

h h w h h w
p p p r r r
r
dr
b / ) ( / ) ( ] 56 . 4 [ > =
In order to verify the changes in distributional shares, we record (also using Figure 4.13)
aggregate income at free-trade factor rewards as: Y
hw
= L
H
.MPL
zw
+ K
H
.MPK
zw
=
OBWL
H
+ BDW = ODWL
H
. In order to account the distributional changes, first, recall
that in Section 4.2, it was proved that aggregate real income has risen with trade from Y
o

to Y
1
; here, Y
wh
> Y
oh
. Second, that each factor quantity is the same in autarky and under
free trade. Third, since MPK has decreased while that of labour has increased, and then
with trade, Home capitals total real income has declined, while labours real income has
risen. Finally, with CRTS, the distributional share has increased in favour of the
abundant factor, labour and decreased for the scarce factor, capital. That is:

ok
zh H
wh
zw H
oh
zh H
wh
zw H
Y
MPK K
Y
MPK K
and
Y
MPL L
Y
MPL L . . . .
< >

You can easily carry out a similar analysis but in reverse for the capital-rich foreign
country, where the real return to capital has increased while the real wage has fallen.
Consequently, the total real income share of capitalists has increased at the expense of the
income share to labour.

Illustration of the SST in the Factor Price Frontier
This intuitive demonstration of the SST can be demonstrated using unit-price-unit-cost
functions, also known as the zero profit condition. This is the case whereby total revenue
50
earned by firms equals total payments to factors of production. For each product we
have:

[4.57a] TR
z
= TC
z
= rK
z
+ wL
z

[4.57b] TR
t
= TC
t
= rK
t
+ wL
t


By dividing through total outputs Z and T into their respective equations, we derive unit
price or unit (average) cost equations:

[4.58a] P
z
= AC
z
= rk
z
+wl
z

[4.58b] P
t
= AC
t
= rk
t
+wl
t


A technical coefficient such as k
z
is defined as the number of units of capital required to
produce a bag of maize, etc. In order to get a diagrammatic solution, we solve for the
wage rate as follows:
r
l
k
l
P
w b
r
l
k
l
P
w a
t
t
t
t
z
z
z
z
=
=
] 59 . 4 [
] 59 . 4 [

Since maize is more capital intensive, we have
t t z z
l k l k / / > . Therefore, if we plot these
equations in the w-r plane as shown in Figure 4.14, the slope of curve Z
o
Z
o
is greater than
that for T
o
T
o
. Curve Z
o
Z
o
traces a set of pairs of factor prices or unit incomes which
equate product price and unit cost in the maize industry, P
z
AC
z
= 0. The curves are
downward sloping because, as the rental charge rises to increase unit costs or to reduce
unit profit, the wage rate has to fall so that the pricecost balance or zero profit condition
is restored. Given that Z
o
Z
o
is steeper than T
o
T
o
implies that with a rise in a given price,
capital tends to cause a larger decrease in maize profits than in textile profits, which then
requires a larger reduction in the wage rate in the maize sector than in the textile sector in
order to restore unit zero profit. Further, note also that there is an inverse relationship
between the capital-labour ratio and relative wage with movement along either curve,
(w/r) = (K/L). Equilibrium is obtained when zero unit profit is simultaneously achieved
and this condition is met at the intersection point E
o
of the initial two sectoral curves Z
o
Z
o

and T
o
T
o
. Shifts in the curves are caused by changes in the respective product prices.

Let us assume that the price of textiles rises while that for maize remains constant; that is:
P
t
> 0 and P
z
= 0. The T
o
T
o
curve shifts to the right at each wage rate such as to T
1
T
1

and with a stationary Z
o
Z
o
schedule, the new equilibrium point will be E
1
. As a result,
the nominal wage rate rises to w
1,
or

by (w
1
w
o
) = w > 0, while the capital rental falls
in absolute terms to r
1
by (r
1
r
o
) = r < 0. It should be easily shown that, if it were the
price of maize that rose, then the rental charge would rise while the wage rate falls. We
therefore see that the SST holds.




51
An Algebraic Proof of the SST
This demonstration can be easily generalized with the use of some higher algebra. Let us
express the unit price equations [4.48] in terms of weighted growths of input prices, so
that for the unit maize price, we have:

w
dw
P
w l
r
dr
P
r k
P
dP
z
z
z
z
z
z
+ = ] 60 . 4 [
Then for both products, this yields the simultaneous equation system:

t lt kt
z lz kz
P w r b
P w r a

] 61 . 4 [

] 61 . 4 [
= +
= +




The term is the share of an inputs cost in the price or in the AC of a given product.
The unknowns of the system are the rates of change in the unit incomes of inputs,
r and w . In matrix notation, the equation system becomes:

(

=
(

t
z
lt kt
lz kz
P
P
w
r

] 62 . 4 [




Due to our assumed factor intensities,
kz
>
kt
and
lt
>
lz
. With CRTS, we have these
useful relations:
kz
+
lz
= 1, so that
lz
= (1 -
kz
) and
lt
= (1 -
kt
). We therefore get a
positive determinant of the coefficients matrix: D =
kz

lt
-
kt

lz
=
kz
-
kt
> 0. The
comparative statics solutions for the rates of change in the respective factor prices are
computed as follows:

z wz t wt z
kt kz
kt
t
kt kz
kz
z kt t kz
t kt
z kz
t rt z rz t
kt kz
kz
z
kt kz
kt
t lz z lt
lt t
lz z
P P P P D P P D
P
P
w b
P P P P D P P D
P
P
r a

) (

) (
/ )

( /

] 63 . 4 [

) (
) 1 (

) (
) 1 (
/ )

( /

] 63 . 4 [

= = =
=

= = =

The first index letter on the betas is for equation type, for r or w, and the second index is
for the price, of Z or T. It can be seen that, since maize is more capital intensive than
textiles,
kz
>
kt
, means that for the same D, (1 -
kt
) > (1 -
kz
), so that
rz
>
rt
.
Similarly,
wt
>
wz
.

Let us now apply the result by assuming that the price for textiles rises while that for
maize remains constant; that is: 0

>
t
P and . 0

=
z
P In eqn [4.63a], this translates
into: 0

> > =
t t wt
P P w , which implies that the real wage has increased in terms of both
goods because the nominal wage has risen faster than the increase in price for textiles
while maize price is constant. However, the decline in the nominal return to capital by
t rt
P r

= , leads to a reduction in the real return in terms of both goods since the price of
52
textiles has risen even though maize price has not moved. By way of generalization (see
Table 4.2), if we suppose a higher rise in the price of textiles than for maize, the
following result emerges: r P P w
z t

> > > . Once again, the real wage increases in terms
of both goods as: 0

> >
t z
P w P w , which is greater than the increase in the real return
to capital.

Table 4.2: Hypothetical Calculations for the Stolper-Samuelson Theorem
kz 1-kz kt 1-kt D=kz-kt rz rt wt wz r-hat w-hat
0.97 0.03 0.8 0.2 0.17 1.18 0.18 5.71 4.71 8.24 67.06
0.95 0.05 0.75 0.25 0.2 1.25 0.25 4.75 3.75 7.5 57.5
0.85 0.15 0.65 0.35 0.2 1.75 0.75 4.25 3.25 2.5 52.5
0.45 0.55 0.35 0.65 0.1 6.5 5.5 4.5 3.5 -45 55
0.25 0.75 0.15 0.85 0.1 8.5 7.5 2.5 1.5 -65 35
Notes: The formulas for calculations are as in Equations 4.63 (a) and (b). Assumed price
increases for deriving the r-hat and w-hat are 10% for maize price and 20% for textile price.

Evidence on FPE Theorem and the Race to the Bottom Once Again

4.4.5 Income Distribution in the Specific Factors Model

The specific factors model (SFM) was proposed by Samuelson (1971) and Jones (1971)
in order to recognize the possibility of certain factors being specialized in certain sectors
such that, unlike in the HO environment, they cannot be easily shifted to other sectors,
while some factors are relatively mobile between sectors. This phenomenon would be
most likely to occur in the short run and not in the long run, which is the domain of the
HO model. From the point of view of factoral income distribution, while the SFM is
unambiguous in predicting that a specific factor gains when the price of the good to
which it is specific rises and it loses otherwise, it is ambiguous on the direction of the
income to the mobile factor. This result is the subject of our discussion in this section.

The basic SFM assumes two goods, two countries, but three factors of production. Let us
say that labour is perfectly mobile across sectors, maize and textiles, while capital is
specific to textiles and a natural resource or just land (N) is specific to maize production.
The key analytical tool we need for our discussion is the production function and the
marginal product of labour under constant returns to scale and increasing opportunity
cost. Thus the respective well-behaved production functions for the two goods are:

) , ( ), , ( ] 64 . 4 [
t T z Z
L K T Q L N Z Q = =

The marginal products of labour from each sector are drawn if Figure 4.15, which is in
turn explained as follows. In Panel A, labour employment in maize is measured from its
origin O
z
to the right and in textiles labour employment is recorded in the reverse
direction from O
t
to the left. The basic difference between Panel A and B is that in Panel
A, the MPL is measured in metres of textiles while in B maize is the numeraire. In Panel
A, the autarky values of marginal product of labour (VMPLs) for each sector are deflated
by the textile price (P
zo
/P
to
) p
o
to get:
53

t t
to
to
t z o z
to
zo
MPL MPL
P
P
and MPL MPL p MPL
P
P
= = , ] 65 . 4 [

In Panel A, the autarky marginal product in maize, p
o
MPL
z
, is downward sloping to the
right from the left vertical axis, while that in textiles slopes downwards from the right
vertical axis. The real wage rate measured in textiles is
t
= w/P
t
and is measured on the
both vertical axes. Joint autarky labour market equilibrium is at the intersection point A
with equilibrium real wage
to
. The respective variables for Panel B are derived by
deflating the sectoral autarky VMPLs by the price of maize, P
to
/P
zo
= 1/p
o
, to get:
t
o
z
MPL
p
and MPL
1
] 66 . 4 [
With the real wage in bags of maize of
z
, autarky equilibrium is at point E and
equilibrium real wage of
zo
. In Panels A and B, the autarky equilibrium employment in
maize is L
zo
and in textiles it is
zo
L L = .

Lets us now assume that the country under analysis has comparative advantage in maize
production vis--vis the rest of the world (ROW), so that with opening to trade the
improvement in its TOT will entail a rise in the relative price of maize form the autarky
p
o
to (P
z
/P
t
)
1
p
1
; or p
1
> p
o
. An immediate consequence of this outcome will be to raise
the MPL in the maize sector which is valued in textiles and reduce the MPL in the textile
sector which is measured in maize. In Panel A, this TOT effect shifts up the food sector
MPL from p
o
MPL
z
to p
1
MPL
z
. With the stationary MPL
t
, the labour market will be
cleared at point B, resulting in a rise in the real wage in textiles to
t1
. The TOT effect in
Panel B is to depress the textile MPL from 1/p
o
MPL
t
to 1/p
1
MPL
t.
With the labour
market cleared at point F, the real wage in maize terms falls to
z1
. The expansion of the
maize sector has gained employment by L
z1
L
zo
> 0, being the number of workers
withdrawn from the contracting textile sector by the same absolute magnitude.

What are the resulting factoral income changes? Starting with the payments to the
specific factors, the income to capitalists in the textile sector in Panel A, declines in terms
of textiles from area AKC to BKD. This is an income loss by BKD AKC = ABDC < 0.
The loss suffered by capitalists is attributable to two viciously reinforcing factors. First,
the rise in the real wage in terms of textiles has reduced their income base in absolute
terms from the product their capital produces exclusively. Second, the purchasing power
of their already reduced real income in textiles has been further eroded by the rise in
maize price relative to the textile price. Therefore, in terms of units of both products, the
income of capitalists has deteriorated. The opposite is true for landlords whose income,
in Panel B, has risen by GNF - HNE = GHEF > 0. There are two sources of this income
gain; one is the fact that the real wage has declined in maize terms, thereby appropriating
a larger share (from workers) of total income in maize. Further, the purchasing power of
their increased income in maize has been strengthened by the increase in the relative
price of maize as they command more textiles. From the perspective of fixed factors, we
can therefore conclude unambiguously that a specific factor gains when the relative price
54
of the product to which it is specific rises and loses when, either, it is not specific to that
product whose price has risen, or, its specific product price falls.

What is the status of the mobile factor, in our case labour? A priori, the overall direction
of change in labour income is ambiguous because, although the real wage has risen in
terms of textiles, it has declined in maize terms. This is due to the fact that as labour
shifts away from textiles, the fewer remaining workers there combine with relatively
more fixed capital stock and the MPL in textiles rises. However, the MPL in maize
decreases as increasingly more workers there find relatively less land to work with.
Consequently, the total labour income in textiles rises by area
to
CD
t1
in Panel A, while
in terms of maize, income falls by area
zo
HG
z1
in Panel B. To complicate matters,
additional workers have gone into maize sector where the real wage has suffered, while
fewer workers have remained in the sector where the real wage has risen. This ambiguity
could be resolved partly if we knew the relative importance or weights of maize and
textiles in the workers consumption or expenditure basket.
David Ricardos analysis here
The Race to the Bottom Once Again

4.5 Free Trade Equilibrium World Terms of Trade

In the preceding analyses the international TOT price ratio, p
w
, was only imposed or
assumed to be juxtaposed between the autarky price ratios for Home and Foreign, and has
been used to analyze domestic welfare and income distributional impacts of opening to
trade. Neither did Ricardo provide a solution. John Stuart Mill, in his book Principles of
Political Economy (1848), proposed the concept of reciprocal demand as a solution tool
for the determination of general equilibrium TOT. Following on this tradition and as
amplified by James Meade in the 1950s, this Section explores how this price ratio can
emerge under various configurations of demand and supply, depending on the relative
strengths of trading partners. In the process we take advantage to develop the tools of the
offer curve and the international trade indifference curve, both of which are derived from
the production possibilities frontier and the community indifference curves. However,
because the derivations of these tools depend on the trade triangles, we note first the
concept of equilibrium in the merchandise trade account of the balance of payments.
4.5.1 Trade Balance Equilibrium
International trade takes place as excess demands and excess supplies are created. Going
back to Figure 4.1, the excess supply of textiles in Home, or Homes exports of T
1h
T
2h
=
IH
1
, is Foreigns excess demand or imports of textiles T
1f
T
2f
= JC
6
. The excess supply of
maize in Foreign of Z
1f
Z
2f
= JF
1
, satisfies Homes excess demand of Z
2h
Z
1h
= IC
4
as its
imports. This yields the equivalent triangles: H
1
IC
4
C
6
JF. The equivalence of the
trade triangles is the basis for the condition of equilibrium in the merchandise (trade)
balance of the balance of payments. Taking Homes case, we see that the ratio of its
import volume (maize) to its export volume (textiles) is equal to the world terms of trade,
such that:
55
m
x
w
z
t
w
P
P
P
P
p
IH
IC
X
M
=
|
|

\
|
= = =
1
4
] 67 . 4 [
Cross-multiplying and rearranging terms yield nominal trade balance equilibrium
condition: P
x
X = P
m
M, which can be expressed in clearance form as:

0 ] 68 . 4 [ = = M P X P NTB a
m x


Taking bags of maize as the numeraire, real trade balance becomes:
0 ] 68 . 4 [ = = M X
P
P
TB b
m
x

The ratio
m x b
P P TT / = is the expression for the barter or commodity terms of trade as
already noted.

We start with the definition of the trade indifference curve, and then derive the offer
curve before finally demonstrating the determination of the international equilibrium
terms of trade.

4.5.2 Trade Indifference and Offer Curves

A trade indifference curve (TIC) shows the tradeoffs between different combinations of
exports and imports which yield the same level of a countrys welfare from engaging in
trade, given a PFF and a constant community indifference curve. Figure 4.16 is used to
illustrate the derivation of a TIC in the maizetextile plane, and the steps to be taken for
this purpose are as follows: Draw a PFF such as ACB in quadrant I with 0 as its origin;
make it tangent to a community indifference curve U
1
such as at point C; anchor the PFF
to that indifference curve; and then unplug the PFF from the origin so that its surface can
freely slide along the fixed indifference curve. Two experiments of this procedure have
been performed with slides from point C to points such as D and E.

As the PPF slides along U
1
a countrys trade regime changes in terms of changes in the
export-import combinations maize and textiles. At point C the country is in autarky or
self-sufficient by producing and consuming UC of textiles and VC of maize. At point D,
it produces ID of maize and DG of textiles. The community indifference curve, U
1,
shows
that the country consumes only HD of maize, leaving the surplus IH for export.
However, the country produces GD textiles while total domestic demand for it is FD, so
that the excess demand of FG constitutes textile imports. (Confirm that at point E, the
country is an exporter of textiles but an importer of maize). There are various
combinations of levels of exports and imports with the same PFF that are consistent with
a fixed level of welfare. As the PPF tangentially slides along the fixed community
indifference curve, U
1
, from point C to D (or C to E), its origin also moves from point O
to O
1
(or O to O
2
). The locus which traces an infinite number of such points, I
0
I
0
, is an
international trade indifference curve, which as defined above, is an export-import equal
preference curve, for a given but mobile PPF and a fixed community indifference curve.

56
There is a family of trade indifference curves each one associated with the same-sized
PPF but anchored and glided along a different community indifference curve. If our PPF
were anchored to a higher community indifference curve U
2
, another trade indifference
curve would have been traced up and to the left of I
o
I
o
. A higher community indifference
curve is associated with a higher trade indifference curve and vice versa. The slope of a
trade indifference curve measures the rate at which exports are substituted for imports in
order to maintain a certain level of a countrys satisfaction or welfare. Where the general
Pareto optimality condition holds, this marginal rate of import-export (or trade-regime)
substitution should be equal to the marginal rate of product transformation in production
(RPT), the marginal rate of substitution in consumption (RCS) and some price ratio. For
instance, if Pareto optimality holds at point D, it is also satisfied at point O
1
on the trade
indifference curve I
o
I
o
.

Trade Offer Curve: We now proceed to derive an international trade offer curve, which
by definition depicts levels of exports of one commodity a country is willing to offer in
exchange for imports of another commodity at various TOT. Figure 4.17 is used to
illustrate the derivation of an offer curve under increasing cost production conditions.
The procedure we use is to start with an autarky price ratio, p
o
, and then confront a
country with improving terms of trade in favour of textiles such that as: p
0
< p
1
< p
2
< p
3
.
Then record its export and import quantities as measured by trade triangles at each price
ratio. As terms of trade improve, the country specializes in textile production along the
PPF from point A through S, U to W, etc. The resulting general equilibrium consumption
points with rising welfare are from autarky point A through B, C and D, etc. We can now
use the trade triangles to construct an offer curve. The information on exports (X) and
imports (M) of Panel A is recorded in Panel B with exports along the horizontal axis and
imports on the vertical axis using the following chart.


Relative prices Trade Panel A Panel B
X
1
RS OR
1
p
1
> p
o

M
1
RB R
1
B
1
= OE
p
2
> p
1
X
2
TU OT
1
M
2
TC T
1
C
1
= OF
X
3
VW OV
1
p
3
> p
2

M
3
VD V
1
D
1
= OG


Starting at the autarky point A in Panel A, with autarky relative price p
o
, there is no
foreign trade and this information is recorded in Panel B as zero exports and imports with
price line p
o
. For higher price ratios, the trade triangles from Panel A of SRB, UTC and
WVD have their respective equivalents in Panel B of OR
1
B
1,
O
1
T
1
C and OV
1
D
1
. The
locus tracing equilibrium consumption points in Panel A of A, B, C, D to H
o
is an offer
curve, which has been redrawn in Panel B as a locus tracing counterpart points recorded
on their respective price lines as O, B
1
, C
1
and D
1
. Combining the offer curve just
constructed with the trade indifference curves, our countrys general equilibrium trading
positions are traced by points: O, B
1
, C
1
and D
1
in Panel B. At such points, the offer curve
crosses the price lines from below while the trade indifference curves cross the offer
57
curves but are tangent to the price lines in order to reflect the general equilibrium
condition, by which community indifference curves and the PPFs are both tangent to the
price lines in Panel A.

4.5.3 Offer Curves and Trade Elasticities

We can gain more insights into the usefulness of the offer curve by way of defining
import demand and export supply elasticities, which play significant roles in various
topics in trade theory and policy analyses. Let us define first the elasticity of an offer
curve. The elasticity of the offer curve at any point on the curve is defined as the
proportionate change in import volume of a product with respect to a proportionate
change in the volume of exports of another product. Using the notation M for import
volume and X for export volume, the offer curve elasticity elasticity formula is expressed
as:

X d
M d
M
X
dX
dM
X dX
M dM
orted quantity in
imported quantity in
a
ln
ln
/
/
exp %
%
] 69 . 4 [ = = =

=

For instance, to calculate the offer curve elasticity at point C, in Figure 4.18, we use a
tangent AC whose slope is dM/dX = BC/AB, with export volume, X = OB, and import
volume M = BC. With appropriate substitutions in the formula 4.58a we obtain:

AB
OB
BC
OB
AB
BC
b = = ] 69 . 4 [

The offer curve elasticity may assume different values along the curve. At point C it can
be seen that OB > AB, signifying that the elasticity of the offer curve at that point is
positive and greater than unity; or > 1. For a straight-line offer curve such as along
segment OG, the tangent collapses to the offer curve itself as point A is at the origin. In
this case = 1and is invariable along the line segment. At point E, dX = 0 as also AB =
0, which means that dM/dX , and, therefore, . For the backward-bending
segment of the offer curve such as at point F, the tangent is negative (dM/dX < 0) and
point A would be to the right of B, so that < 0. As shown next, the elasticity coefficient
of the offer curve is instrumental in defining the elasticities of import demand and export
supply.

The elasticity of import demand,
md
, is defined as the percentage change in import
volume (dM/M) divided by the corresponding percentage change in the relative price of
imports. The relative price of imports is derived from the trade triangles which are
reflected in the derivation of the offer curve. Since the trade balance is cleared, P
x
X =
P
m
M, the relative price of imports in volume terms becomes: P
m
/P
x
= X/M. Upon
differentiation of his ratio, the proportionate change in the import relative price is
expressed as:
58

X M
X dM M dX
M X
M
X dM M dX
M X
M X d
P P
P P d
x m
x m
.
) . . (
) / /(
) . . (
/
) / (
/
) / (
] 70 . 4 [
2

=

With substitutions and simplifications, import demand elasticity can be stated as:

X dM M dX
X dM
M X M X d
M dM
a
md
. .
.
) / /( ) / (
/
] 71 . 4 [

= =

Of interest is to define in terms of . In order to achieve this, divide all terms in both
the numerator and denominator by M and dX to get the following required result:

( )( )
( )( ) ( ) OB AB
OB
AB OB
AB OB
M X dX dM
M X dX dM
b
md

=
/ 1
/
1 / / 1
/ /
] 71 . 4 [

We can take notice of the following with respect to the coefficient of the elasticity of the
offer curve: that as, 1, - . But as, , -1. For = 0, then is also
zero. Finally, when is negative, o < , then is also negative but less that one in
absolute terms, -1 < < 0. These findings imply that import demand is highly elastic
when the offer curve approaches a straight line such as in segment OG; between G and E
demand elasticity declines to 1; and beyond E, in the backward-bending portion, import
demand becomes inelastic.

A question of concern is whether or not the response of import demand to prices for
developing countries exports is elastic enough to permit desired adjustment to currency
devaluation. It can be recognized, therefore, that elasticity pessimism on the import side
is based on or assumes a backward-bending offer curve.

The third type of elasticity to consider is the elasticity of export supply (
xs
), which is
defined as the proportionate change in export volume (dX/X) divided by the
proportionate change in export relative price, d(P
x
/P
m
)/(P
x
/P
m
= d(M/X)/(M/X).
Performing the same procedure used to derive the expression for the import demand
elasticity as above, the counterpart expression for the export supply elasticity can be
shown to be:

AB OB
AB
X M dM dX
X M dM dX
X M d
X dX
P P d
X dX
m m
xs

= =
1
1
) / 1 ( 1
/ 1
) / )( / ( 1
) / )( / (
) / (
/
) / (
/
] 72 . 4 [

Going through the profile of the offer curve we can see that: in segment OG, when
1 = ,
xs
; thereafter, supply elasticity declines to point E, where as , xs
0. Beyond point E into the backward-bending segment, export elasticity is negative
because in that region o < . This would be a seriously constraining factor to export
promotion via the price mechanism. In this case, export optimism is associated with the
straight-line offer curve such as the OG segment and diminishes as point E is approached.
59

4.5.4 Determination of Equilibrium Terms of Trade

In order to determine the equilibrium international terms of trade, we need the trade
indifference curve and offer curve for each trading partner. In Figure 4.19, Homes offer
curve traces points OAH
o
together with Foreigns offer curve OAF
o
. Foreigns terms of
trade improve as the price ratio rotates clockwise from the autarky price line, p
f
, to the
textile axis, while Homes terms of trade improve as her autarkys price line, p
h,
rotates
anticlockwise to the maize axis. The equilibrium terms of trade, p
w,
for both countries are
determined by the intersection of their offer curves, with their respective trade
indifference curves h
o
and f
o
which are tangent to each other and also to p
w
at point A. At
this point, Foreigns export volume OZ
o
of maize is Homes import volume T
o
A.
Foreign is importing OT
o
(or Z
o
A) of textiles, which happen to be Homes exports. The
terms of trade have improved for both countries from their respective autarky positions
because the equilibrium terms of trade line p
w
lies in the mutually beneficial range, p
f-
p
h
. Welfare has also risen for both countries because each one has moved from its autarky
trade indifference curve passing through the origin (not shown) to the highest possible
curve attainable at point A obtained through successive adjustments made along the offer
curves at various relative prices.

Stability of Equilibrium. A necessary condition for an equilibrium to be stable is that
when it is shocked away from that state, forces have to be created which cause market
adjustments that restore the original equilibrium position. Let us apply this condition to
equilibrium point A in Figure 4.18. At terms of trade, say p
1,
Foreign would like to offer
Z
1
maize in exchange for T
1
textiles, while Home demands Z
2
of maize in exchange for
T
2
of textiles. This means that there is an excess demand for (shortage of) maize Z
1
Z
2
and
an over offer of textiles by T
1
T
2
in the world markets. By market forces, maize should
become more expensive relative to textiles, thereby causing a deterioration of the terms
of trade against Home but amelioration in Foreigns TOT from p
1
to p
w
, so that joint
equilibrium is restored

The stability condition is traditionally stated more precisely in terms of trade elasticities.
A Marshall-Lerner condition for the stability of trade requires that the sum of the import
demand elasticities of the trading partners, in absolute terms, be greater than unity. That
is,
f
+
h
> 1. An unstable equilibrium would occur, according to this condition, if both
demand elasticities were sufficiently inelastic so as to sum up to less than unity. In terms
of the offer curves, this is especially when the traders offer curves are backward bending
at their intersection point.

4.5.5 Large Country versus Small Country

Under perfect competition, each firms or each consumers action has imperceptible
influence on aggregate outcomes so that a firm or a consumer is a price taker. It turns
out, however, that in aggregate, the total of these atomistic actions under perfect
competitive conditions can make a country to wield significant influence in the world
market as an exporter or importer of a particular product. This would be said to be a
60
large country whose supply or demand variations in a product would be capable of
causing changes in world prices that are either to its advantage or against itself. Figure
4.20 depicts offer curves for Home and the rest of the world (ROW), with initial
equilibrium terms of trade line p
w
, which

passes through point B
o
, at which the two
countries are in joint welfare maximization.

Suppose for some reasons, Homes textile exports contract at each quantity of maize, its
imports, so that her offer curve shifts from H
o
to H
1
. If Home is a large country, this
textile supply restriction will have the effect of driving the world price of textiles up, so
that its terms of trade will improve from p
w
to p
1
at point B
1,
while the terms of trade
deteriorate against the ROW. Consequently, Homes welfare rises as she goes to a higher
trade indifference curve h
5,
at B
1
, while the ROW experiences a welfare loss to f
2
. But if
Home is a small country, it will be facing the ROW as the large country whose offer
curve coincides with the world terms of trade line Op
w.
In this situation, Home, the small
country, would be facing an infinitely elastic export market for textiles. As a result, its
offer curve H
1
will intersect this price line at point B
2
without causing any shift in the
world terms of trade. As a result, its volume of trade shrinks, thereby leading to a welfare
loss while the ROW is unaffected by its unilateral action. It should be verified that since
the Home country maximized welfare at world TOT at point B
o
, then at point B
2
her
welfare status must have deteriorated.


























61
CHAPTER 5

EMPIRICAL TESTS AND EXTENSIONS OF THE COMPARATIVE
ADVANTAGE THEORY


5.1 Empirical Tests of the HO Theorem and Measurement of Inter-Industry Trade
5.2 Growth and Trade Orientation
5.3 Supply Shocks, Natural Resource Exploitation and the Dutch Disease
5.4 Technological Progress and Trade Patterns
5.5 Technological Gaps, Product Cycles and Intra-Industry Trade
5.6 Quantifying Technological Progress
5.7 Transport Costs and Comparative Advantage

5.1 Empirical Tests of the HO Theorem
Empirical test of the HO theory of trade has been conducted at two levels; one is the strict
approach based on two factors, two countries, and two commodities, which was
popularly used from the 1950s to the 1970s. The second one, which emerged in the early
1980s is based on a multidimensional view of trade in more than two products, factors
and countries. We have postponed discussion of tests of the HO theory up to this stage
because, since the pioneering work of Wassily Leontief in the early 1950s, the scientific
work on testing the theory has spawned not only more advanced quantitative techniques,
but has also made significant contribution to the development and to more understanding
of the strengths and weaknesses of the HOS theory of comparative advantage itself. Thus
the purpose here is not only to review tests of the theory but also to show theoretical
extensions and empirical directions.

5.1.1 The 2x2x2 Tests of HO Theory
The logical flow in the proof of the HO theory relates proportions of factor endowments
and factor prices to trade patterns through factor intensities. In order to operationalize the
theory, requires a careful definition of the term factor endowment and those mentioned in
the statement of the theorem. In terms of relative factor endowment, it was generally
believed during the immediate post-WW2 period

that the USA was a capital endowed
country relative to the ROW. In order to define factor endowments, Leontief singled out
physical capital and labour in aggregate terms and in this way he pioneered this twoness-
type of test. Using the 1947 trade data and input-output table for the USA (construction
of which he was also the pioneer in the Western world), he estimated that an aggregate
basket of export industries worth $1 million required capital units (K
x
) worth of
$2,550,780 and 182 labour years (L
x
), while US-based import-competing industries
required $3,091,339 worth of capital (K
m
) and 170 labour years (L
m
) to produce an
aggregate basket of imports worth $1 million. These figures included capital and labour
inputs involved in the production of inputs and components used in the final products.
The relative capital intensities in the exportable and importable sectors were computed to
be as follows: K
x
/L
x
= $14, 015 and K
m
/L
m
= $18,184.

62
The computed results then contradicted the HO hypothesis because the USA's exports
were revealed to be less capital intensive than its imports. In fact the ratio of the factor
intensities was found to be (K
x
/L
x
) (K
m
/L
m
) = $0.77, indicating that the capital intensity
in the export sector was only 77% that of import equivalent sectors, or that the capital
intensity in the import sectors exceeded that in the export sectors by a factor of 1.3. This
result, which actually falsified or rejected the HO theorem, became instead to be dubbed
the Leontief Paradox. Leontief himself repeated the test using the 1947 production
structure but with the 1951 trade structure and found a ratio of 0.94. Although an
improvement, this still failed to support the HO model or to reverse the paradox.
The early Leontief-type tests were criticized on statistical and theoretical grounds.
Statistically, it was argued that the data used were imperfect and the research methods
suffered specification errors, which therefore rendered the results unreliable.
Theoretically, the models assumptions were challenged. More specifically, it was
argued that there were consumption biases, factor intensity reversals and gross
aggregation of factors into K and L which distorted the results. These issues are taken up
next in turn.

Preference Bias and Trade Specialization
On consumption bias, recall that the HOS model is based, inter alia, on the assumption of
identical preference indifference maps across countries. In autarky this assumption
makes it possible for the dissimilar PPF to be tangent with the highest possible
indifference curves at different slopes or opportunity costs. In this fashion, demand
patterns do not bias the existence of comparative advantage based on relative factor
abundance. However, an extreme case of demand bias occurs when countries possess
different preference structures but have similar endowments. Under such conditions,
mutually gainful trade can also take place. In Figure 5.1 two countries, Home and
Foreign, are depicted to possess similar endowments as they share the same PPF in
production of two goods. With dissimilar preference structures Homes autarky
equilibrium production and consumption at point H
o
is more biased to maize than
Foreigns at point F
o
, which instead is biased to textiles; that is, Z
oh
/T
oh
> Z
of
/T
of
. As a
result, maize will be relatively more expensive in Home than in Foreign or that textiles
will be relatively less expensive in Home than in Foreign; that is,
h z t h f f z t
P P p p P P ) / ( ) / ( > . With free trade each country will increase production
of the product which is relatively cheaper for export and import a product in which it has
a consumption bias. For instance, at world terms of trade
w z t w
P P p ) / ( = , Home expands
textile production and reduces food production with movement on the PFF from H
o
to J
while Foreign expands food production from F
o
to J. The respective post-trade
consumption points which are outside the PPF and on higher indifference curves are F
1

and H
1
for Foreign and Home, respectively. Foreign exports of maize JB are Homes
maize imports H
1
A and Home exports of textiles AJ are Foreigns imports BF
1
. The
terms of trade have improved, such as
h w
p p > for Home and for Foreign,
f w
p p / 1 / 1 > .
The product which was relatively cheaper in autarky is relatively expensive as an export
product with trade while, conversely, the consumption intensive product becomes
63
cheaper with trade. It is possible therefore that this trade might lead to specialization in
consumption.
In the context of the Leontief paradox, the argument was that the US tastes and
preferences were heavily biased in favour of commodities which were intensive in
capital, thereby making them relatively more expensive than labour-intensive products.
Consequently, the US may have specialized in exporting labour-intensive commodities,
which would have then contradicted the HO theorem. Fortunately for the theory,
Houthakker (1957) reported results from his study of household consumption patterns
which showed that income elasticities of demand for a range of commodities were
substantially similar across countries, which then could be evidence of similarity of
preferences and tastes across a number of countries. As we shall see in subsequent
Sections and Chapters, alternative theories of trade also maintain the assumption of
preference similarities.

Factor Intensity Reversal

The assumption of absence of factor intensity reversal was presented in Chapter 3,
Figure 3.8. Violation of this assumption leads to the possibility of "factor intensity
reversal", which is explained with the aid of Figure 5.2. We see in Panel (A) that for the
relative wage
o
= (w/r)
0
maize is more capital intensive than textiles as technique OE >
OH, or the K/L ratio is greater at E
1
than at H
1
in Panel (B). However, for the higher
relative wage
1
, OG < OF in Panel (A), or the K/L ratio is less at G
1
than at F
1
in Panel
(B). This implies that at the higher relative wage, maize has become less capital intensive
than textile production, thereby violating the assumption of "no factor intensity reversal.
The possibility of factor intensity reversal arises when there is a sharp distinction in
factor substitutions in the production of different goods, with some goods characterized
with very low factor substitutions while others exhibiting very high degree of factor
substitutability. A measure of the degree of factor substitutability is the elasticity of factor
substitution (EFS), and as shown by the shape of the maize isoquant, it is evident that the
EFS is very low (close to zero or with fixed proportions) as contrasted to that of the
textile isoquant with a very high EFS (close to infinity or being flat).

In this case we cannot predictably and uniquely rank or identify goods by the criterion of
factor intensity, which invalidates the HOS theorem and its corollaries, including
especially the FPE theorem. By way of illustration of this breakdown of the theorem, let
the foreign country be relatively capital rich with relative wage v
1
, while Home is labour
rich with relative wage v
0
. Then by the design of Figure 5.2, foreign firms should
specialize in product T, which is capital intensive at point F or F
1
. However, home firms
should specialize in T at point H or H
1
, since that is suitably labour intensive for the
country. This would predict intra-industry trade in a homogeneous product, T, which the
HOS theory was not designed to predict.
This failure of the HOS theorem would invalidate of the FPE theorem, as we show next.
Suppose the labour-rich Home calls the shot first by exporting T to Foreign. Then with
the rise in the derived demand for labour, the relative wage will be rising. If Foreign
64
avoids the race in T and decides instead to specialize in Z, which is labour intensive
there, the relative wage will also be rising there. This will make a priori prediction of
equalization of factor prices quite tenuous. At one extreme, FPE will be obtained if the
home relative wage grows faster than the foreign relative relative wage, thereby reducing
the initial inequality. At the other extreme, the international inequality gap would widen
should the home relative wage grow at a lower rate than the foreign relative wage. Then,
finally is the case of equiproportionate growth in both relative wages, which would leave
the wage inequality gap unchanged with trade. The case of the race to the bottom would
ensue if the foreign country decided first to specialize in the capital intensive good there,
T, but Home specialized in the capital intensive Z. This would generate downward
pressures on wages in both countries.

Empirical literature on FIR is rare and results from it give inconclusive evidence in
support or rejection of the assumption of absence of FIR. Minhas (1962) conducted
studies of industries that were used by Arrow, Chenery, Minhas and Solow (1961) to
estimate the first CES production function to measure FIR. He found that the EoS
between capital and labour differed markedly in six industries that he studied and that in
a third of them FIR was present. In another test, he ranked 20 industries on the basis of
their K/L ratio for the USA and Japan. The idea was that although the US industries
would be more capital intensive than Japanese industries, still the ranking would of the
industries would turn out to be uniform. He, however, found a rank correlation of of
0.34, thereby strongly suggesting wide prevalence of FIR. The findings by Leontief
(1964) and Ball (1966) contradicted Minhas results. Having calculated the EoS of all the
21 industries used to estimate the CES production function, Leontief found non-factor
intensity reversal was supported in 92% of the observations, which increased to 99%
when two natural-resource intensive industries were excluded. When Ball excluded these
two industries and agriculture from the same sample, he found that the rank correlation
increased to 0.77.
Factor Omissions and Aggregation
Instead of challenging assumptions of the HOS theory, empirical researchers and
theorists realized that Leontief-type tests were applied too rigidly without proper
operationalization of the analytical categories, especially the putative aggregation of
factors into just K and L. The earlier reformulation of the tests involved re-definition or
sub-division of capital and labour, and inclusion of other factors excluded in the early
tests. This was, however, facilitated by the pioneering studies on human capital theory by
Schultz (1961) and Becker (1964). For instance, instead of a homogeneous capital
variable, types of it were identified such as physical capital and human capital, and
various labour categories such as skilled or unskilled labour force. Some factors also
included in tests were research and development (R&D) and natural resources. When the
HO hypothesis was then retested by using the two-by-two dimension, it was revealed that
the USA was endowed in capital, skilled labour and R&D, but that it was scarce in
natural resources and unskilled labour, which led to the disappearance of the Leontief
Paradox, thereby vindicating the HO hypothesis (Kravis, 1956; Keesing, 1966; Kenen,
1965; and Baldwin; 1971).

65

5.1.2 Reformulation and Generalization of the HO Theory and Tests

Trade theorists have struggled to get out of the strictures of the two-dimensional HO
model and therefore to venture into a multi-dimensional theory which is also capable of
being subjected to empirical tests. Attempts have therefore been made with various
combinations of assumptions regarding the number of products, factors and countries.
From the work by Jones (1956) and up to the early 1980s, the focus centered on the
relevance of the factor price equalization (FPE) theorem. Although in certain
circumstances it has been shown to be crucial, in other cases it is not a necessary
assumption in the reformulation and generalization of the HO theory. Furthermore, the
problem still remains as to the validity of using what is a corollary of the HO theorem as
an assumption to be used for the reformulation of the HO theory itself! However, two
schools can be identified that have emerged in this research programme; one which is
about the generalization of the HO model; and the other which generalizes the FPE
theorem itself (Gale and Nikaido, 1965). We review the first line of research here and in
the context of two versions of the HO model; namely, the factor content version and the
commodity version. We start with a simplified approach of the former.

The Factor Content HO Version
Vanek (1968) redefined the theory of comparative advantage with the proposition that a
country's commodity exports embody the services of its abundant factor(s) while its
imported goods embody the services of its scarce factor(s). This model maintains all the
assumptions of the original HO model, but includes as an assumption that factor prices
are equalized across countries, hence the Heckscher-Ohlin-Vanek (HOV) model or
theorem. It then postulates a systematic relationship between net exports and the set of
factor endowments of a country or countries through factor intensities. This is achieved
by postulating a linear transformation of the net merchandise trade or trade balance by
factor intensities and then relating the result to a country's endowment relative to the
world endowment. From now on we follow Leamer's (1980) work to demonstrate this
approach theoretically and empirically.
We revert to the simple case of two factors, K and L, two goods for country h, and factor
requirements defined as: k
j
= units of capital required to produce one unit of output of
product j. The net trade of a given good of a given country is denoted by b
jh
= X
jh
M
jh
,
and the world factor endowments are K
w
and L
w
, which are summations of endowments
of all the individual countries; that is:

=
=
W
h
h W
K K
1
and

=
=
W
h
h W
L L
1
. Given a positive
scalar, , a countrys endowment can be related to the world endowment using Vaneks
propositions in the following linear system:
(

=
(

=
(

+
+
w h h
w h h
L L
K K
b
b k k
b b
b k b k
a

2
1
2 1
2 1
2 2 1 1
2 2 1 1
] 1 . 5 [


In compact matrix notation we get:
66
[5.1b] Ab = e
h
-
h
e
w


Where A is the matrix of the factor requirements which, with the assumption of factor
price equalization and constant returns to scale, means that all firms in all trading
countries are applying the same factor intensity in the production of a given good; b is the
vector of commodity net trade balances; and e is a vector of factor endowments.
An important step to take here is to relate domestic consumption to net trade. First, note
that factor market equilibrium, as it entails equality between factor demand or use and
factor supply in the production goods, Q, in vector q, implies that Aq
h
= e
h
. Summing up
for all countries, the world factor market clears when Aq
w
= e
w
. Second, with identical
homothetic consumption patterns across all countries, consumption is proportional to
world output as C
hj
= Q
wj
, and consumption vectors, c
h,
for each country are
proportional to the world output as c
h
= q
w
. Therefore, net exports and consumption are
related by B
h
= Q
h
C
h
, so that the equation system in 5.1 becomes:
[5.2] Ab = A(q
h
c
h
) = Aq
h
Ac
h
= e
h
- Aq
w
= e
h
- e
w


Let us state the implicit trade in factor services as:

w h h b w h h b
L L L and K K K = = ] 3 . 5 [
The factor services that are not embodied in trade are embodied in domestic consumption
goods so that:

b h c b h c
L L L and K K K = = ] 4 . 5 [
Factor abundance is then stated in terms of the proportion of a country's factors in world
totals. Thus, country h is said to be relatively endowed or abundant in capital iff the share
of worlds capital stock located in h exceeds the share of world labour force; or K
h
/K
w
>
L
h
/L
w
. This factor abundance is revealed through comparison of the vector used to
produce various goods. Capital is revealed by trade to be abundant for country h by this
inequality:

h c h c
c
h
c
h
b h
h
b h
h
K L K L
L
L
K
K
L L
L
K K
K
> >

>
) ( ) (
] 5 . 5 [

This states that a country is revealed to be capital abundant if its overall production
vector q
h
is more capital intensive than its consumption vector, c
h
. In order to relate
factor contents in trade to those in the consumption vector, cross-multiply the left hand
inequality of [5.5] to get: K
h
(L
h
- L
b
) > L
h
(K
h
- K
b
), which is -K
h
L
b
> -L
h
K
b
. Using the
definition of K
h
= K
c
+ K
b
from equation [5.4], and similarly for L
h
, then this inequality
with the necessary substitutions for K
h
and L
h
becomes: -K
c
L
b
> -L
c
K
b
, which in absolute
terms can be written as:

[5.6] K
b
/L
b
> K
c
/L
c

67

This states that a country is revealed by trade to be relatively abundant if the capital
intensity of net exports exceeds the capital intensity of domestic consumption. Leamer
then respecified the HO test as follows:
c c m x m x m x m x
L K L L K K L L K K / ) /( ) ( , 0 , 0 ] 7 . 5 [ > > >
That is, the USA is revealed to be capital endowed and not as found by Leontief. Further,
using his redefined method as shown in Table 4.1, Leamer then reports that K
b
/L
b
>
K
c
/L
c
, indicating that the USA was revealed to be a capital endowed economy.

Table 5.1: Production, Consumption and Trade Intensities
Capital
(US$millions)
Labour (million
labour years)
K/L;$/labouryear
Production
K
q
: $328,518 L
q
:47.273 K
q
/L
q
:$6,948
Net Exports K
b
: $23,450 L
b
: 1.99 K
b
/L
b
: $11,783
Consumption K
c
: $305,069 L
c
: 45.28 K
c
/L
c
: $6,738
Source: Leamer (1980), Table 8.3


Generalization of the HO Theory
At the theoretical plane, Deardoff (1982) has proved that in the absence of the
assumption of factor price equalization, both the factor content version and the
commodity version of the HO theorem are valid in an on average sense when generalized
to a multi-country, multi-product and multi-factor framework. He used the correlation or
covariance to conduct his proof to the relevant variables of the theorem, and therefore
this may be termed the weak version of the theory in order to distinguish it from the strict
original HO theory. In the factor content version he used the factor abundance principle
of the negative relationship between factor prices and physical factor abundance and the
postulated positive relationship between the latter and the pattern of trade. For each
country, there will be a vector of autarky factor prices for all factors, v
h
, and the vector of
net exports, b
h
, embodying services of factors for all products. Then when these are
combined in an ordered cross-sectional data set for all the countries, we should find that:
cov (v
w
, b
w
) < 0, for all h = 1 to w. The intuitive meaning of this general hypothesis is
that countries on average will tend to be net exporters of their abundant (relatively cheap)
factors and net importers of their scarce (relatively expensive) factors.

In the commodity version three vectors are considered; namely, physical factor
abundance vector, e
h
, the factor intensities, A
h
, and net exports, b
h
. Then for all
countries, the prediction is that countries will tend on average to be exporters of products
which use the abundant factor relatively intensively and on average importers of goods
which use the scarce factors relatively intensively. If covariance among these three
vectors, or comvariance, can somehow be symmetrically computed, then we would find
68
that: Comv(e
w
, A
w
, b
w
) > 0, for all countries, commodities and factors. [See also, Dixit
and Woodland (1982); Ethier (1982); Svensson (1984); Helpman (1984); Bowen, Leamer
and Sveikauskas (1987); Forstner and Ballance (1990)].
Bowen-Leamer-Svekauskas Study: An influential study done by Bowen, Leamer and
Sveikauskas (1986) used a generalized test of the HO theorem in which, apart from
physical capital and general labour, they identified 7 categories of workers for the USA
(professional, managerial, clerical, sales, services, agricultural, and other production), and
three types of natural resources (arable land, pasture land, and forest). These were used to
predict net exports on USA's data for 1967 for 324 cases across 27 countries. They then
calculated the predictive success of each of the 12 factors in terms of the fraction of cases
for which net exports of factor services was in accord with the HO theorem. The highest
score of 0.7 was in agricultural, production workers and forest; the lowest of 0.22 was in
managerial class, while capital and labour scored 0.52 and 0.67, respectively. The overall
average predictive fraction was 0.615, meaning that almost 62% of trade was on average
predicted by the HO model, while the model failed to account for 38% of trade.

The UNIDO Study
Forstner and Balance (1990) carried out a study for UNIDO (the United Nations
Industrial Development Organization) in which they applied statistical test methods to
test the weak version of the HO theorem. We review how they defined the variables and
the logical design they followed to execute the overall test.

Factor Endowment and Measurement. The study identified physical capital (K), and
three classes of labour: skilled labour (S), semi-skilled labour (C), and unskilled labour
(U).
Relative Factor Endowment. In the two-by-two model, this is expressed as a ratio such
as K
h
/L
h
and K
f
/L
f
for home and foreign countries, respectively. This approach is
unsatisfactory in a multi-country case and recourse is made to shares of a country's factor
in the world totals as we saw in Leamer's (1980) case, such as K
h
/K
w
, etc.

Factor Orientation. This seeks to establish the relationship between trade structure and
factor endowments and they applied the commodity version of the HO theory by
postulating a regression equation with net trade balance as the dependent variable and
factor availabilities as the explanatory variables as:

j jh j jh j jh j jh j jh
U C S K B + + + + =
4 3 2 1
] 8 . 5 [
Where
ij
is the postulated regression coefficient of factor i (for i = 1 to 4), which
measures the factor orientation of an industry j and its net exports, B, and is a random
term. Unit variables were computed for each variable so that the regression coefficients
become beta coefficients that measure the response in standard deviations of net exports
to a change in one standard deviation of the respective factor endowment. These
coefficients (which can be positive, negative or nonexistent) are hypothesized to show
both the direction and intensity of the abundance or availability effect exerted by each
69
factor on net exports for a particular product. The study run regressions for each of the 90
manufactured goods at the three SITC digit level across 46 countries for 1970 and 1985
and a sample of three such product groups are shown in Table 5.1. The output consists of
four vectors,
w
= (
1j
,
2j
,
3j
,
4j
), which can be interpreted as the cov (b
w
, e
w
). Under
each vector
ij
there are 90 coefficients.
Table 5.1:
Industry (SITC) Physical capital Skilled labour Semi Skilled Unskilled
1970 1985 1970 1985 1970 1985 1970 1985
Organic chemicals (512)
1.98
1
0.35 -1.15
1
0.41 -0.29 -0.74
3
0.58 0.19
Manufactured of leather
(612)
-0.47 -0.53 -0.26 -0.24 0.94
2
0.51
3
-0.46 -0.02
Articles of rubber (629)
-0.32 0.55 -0.50 -0.67
3
1.37
1
0.44 -0.65
2
-0.06
Scientific, medical,
optical instruments (861)
1.25
2
1.02
1
-1.23
3
-0.76
2
0.64
3
0.15 0.05 0.15
Notes: SITC is Standard International Trade Classification number. The superscripts 1, 2 and 3 indicate
statistical significance at 1%, 5% and 10% levels, respectively. Source: Forstner and Balance, 1990,

Factor Intensities. Factor intensities in the Leontief tests are the capital-labour ratios of
the type K
j
/L
j
for product j. In most empirical studies, a factor intensity is proxied by the
share of a given factor's earning or value added to total value added in a particular
industry; that is, s
ij
= VA
ij
/VA
j
. Forstner and Ballance computed these shares using data
for the USA for 1982, which yielded four vectors of factor intensities as the A matrix: A
w

= (s
1j
, s
2j
, s
3j
, s
4j
). Under each share vector there are 90 factor intensities. In doing so they
assumed that the US economy was representative of the world production technology
(due to the assumptions of uniform technology, CRTS and FPE).
Results from the Weak HO Test. In an attempt to test the hypothesis comv(e
w
, A
w
, b
w
) >
0, the study instead tested for cov (b
w
, A
w
) > 0. On the basis that e
w
has been correlated
with net exports via the beta coefficients, cov(e
w
, b
w
), then it suffices to test only the
correlation between each of the 4 vectors of those coefficients and each of the 4 vectors
of factor intensities. This yielded 16 correlation coefficients computed between the factor
intensities in turn with beta coefficients corr (
w,
A
w).
When all the beta coefficients were
pooled together, a correlation coefficient of 0.246 was obtained and was found to be
statistically significant at the 1% level (See Forstner and Ballance, 1990, Table 7.2, p.
124). This was interpreted as confirming the weak version of the factor abundance
hypothesis that "even in a complex trading world of many factors, goods, and countries,
net trade appears to be influenced (in an on-average sense) by interaction between factor
intensities and factor endowments. More generally, not only does factor abundance exert
a visible effect on a substantial portion of net trade, but its overall impact is of a form
predicted by the generalized HO theory". (Forstner and Ballance, 1990, pp. 123-124).
Although some weak test versions have been rather sympathetic to the HOV model, tests
based on its strong assumptions have rejected Leamers (1980) demonstration that
Leontiefs (1953) results were not paradoxical at all. Leamers support for HOV world
factor content version has been rejected by Brecher and Choudhri (1982, 1988) and
Maskus (1985). Brecher and Choudhuri (1982) have found that the USAs trade
embodies net export of labour, which is in accord with Leontiefs (1953) estimates.
70
Further, they find that the US consumption per unit endowment of labour is paradoxically
less than for the world as a whole. Testing the HOV model using data for 1958 and 1972,
Muskus (1985) reports estimates which reveal that the US is a labour abundant country
and that there is substantial difference between the actual and its predicted value of the
consumption-to-labour ratio (76.4% in 1958 and 69.8% in 1971). In the light of
emerging evidence pointing to rejection of the HOV model, Brecher and Choudhri (1988)
set out to test the model in a two-country framework. Their focus was on the models
prediction that factor contents per dollar of consumption expenditure are the same for the
US and Canada for each factor. In the negative, they report: Our results show that these
per-dollar amounts differ significantly between the two countries for (natural resource
and farming-fishery-forestry labour) factors associated with primary industries and for
skilled labour, thereby casting doubt on the two-country version of the HOV model
(p.14).
In his commentary on the study by Brecher and Choudhuri (1988), Maskus seemed to
pronounce the HOV model as a foregone theory of international trade as he sated:
The authors have taken the Heckscher-Ohlin-Vaneck (HOV) model, as explicated by Leamer (1980), and
put it through its paces to develop a well-specified version that should apply to the total, or multilateral,
trade of two countries (or, indeed, of any number of countries), each of which is assumed to satisfy the
strict assumptions of the model. The empirical results, which are negative, continue to solidify what by now
must be universal skepticism about the ability of the HOV model to hold in any strong empirical sense.
(Maskus, 1988, p. 19)
Then after observing some reservations on the Brecher-Choundrhi study regarding
measurement errors, Maskus concludes:
I think this paper provides important additional evidence against the strict assumptions of the HOV
theorem. The theorem continues to suffer diminishing status as a major foundation for empirical
determinants of international trade. I do not believe that the evidence we have to date is sufficiently
decisive or general to remove the factor-proportions theory from the shelf of important sources of
comparative advantage. It is clearly time, however, to determine which other hypotheses deserve at least
equal positions on the shelf. This will require considerable effort, both in subjecting HOV to additional
tests and in carefully specifying and testing competing theories. (Maskus, 1988, p. 21)
Since these remarks were made, the research programme on testing the HO theorem has
continued unabated. Studies conducted in the 1990s (Brecher and Choudhri, 1993;
Wood, 1994 and 1997; Leamer, 1993 and 1995; James and Elmslie, 1996) World Bank,
1995) test some restricted forms of the theorem and report qualified results in support of
the theorem. It is quite striking that some tests (Harrigan and Zakrajsek, 2000; Schott,
2001; and Davis and Weinstein, 2001) that have relaxed the assumption of homogeneous
technology across countries by allowing for differences in technology, have reported
results which show strong support for the factor abundance theory. Davis and Weinstein
designed their test on ten industrialized countries (Australia, Canada, Denmark, France,
Germany, Italy, Japan, Netherlands, United Kingdom and USA) relative to the rest of the
world, and allowed for differences in technologies and prices across countries,
transportation costs and presence of non-traded goods. Using data for the period 1970-
1995, they conclude that countries export products that are intensive in their abundant
relatively cheap factors. Studies that have included developing countries have also
71
validated the HO theorem. For example, the studies by Wood (1995) and the World
Bank (1995) show that trade between HDCs and DCs is based on differences in relative
supplies of skills and land. Harrigan and Zakrajsek used data for the period 1970 and
1992 for both HDCs and DCs and, by allowing for technological differences, found that
trade follows the HO pattern.
We want to leave this matter on a positive note that: (1) The HO theory seeks to explain
only a part of world trade of an inter-industry type and a declining part for that matter.
We need other theories of trade to explain the increasing part of world trade of the intra-
industry type. (2) Comparative advantage is a dynamic process as factors of production
change quantitatively and qualitatively and static tests may be unsuited to capture this
dynamic.

5.1.3 Revealed Comparative Advantage
Measures of revealed comparative advantage (RCA) seek to discover comparative
advantage a posteroi from actual trade data. A country has RCA in a product if that
product is traded on the average. Some measures are based on trade overlap or trade
position for a given product while others are based only on output or export. Balassa
(1965) proposed the following index for products j = 1 to n and given country, h:
( )
( )
1
/
/
] 9 . 5 [
1

+
+
=
h h h h
hj hj hj hj
hj
M X M X
M X M X
RCA a
where,

=
=
n
j
hj h
X X
1
is the countrys total export value. According to this index a country
has a revealed comparative advantage if the RCA index is positive and a disadvantage if
it is negative. If instead of a countrys trade balances, only export values can be used and
normalized by world export totals. Such an index can be calculated using the following
formula for country h;
1
/
/
] 9 . 5 [
2
=
w h
wj hj
hj
X X
X X
RCA b
In essence, this index is a ratio of the share of countrys export value of product j in
world trade in that product to the share of the countrys total export value in total world
trade. It is supposed to reveal a countrys competitiveness. If a one is not subtracted,
the interest is on whether or not the index is greater than unity; if, however, a one is
subtracted, then the interest is on whether or not the index is negative or positive as in the
case of [5.9a]. One problem with this index is that it fails to discriminate re-exports and
it may exaggerate the degree of competitiveness. However, it is simple to use and handy
to apply under conditions of data limitations on the import side.


72

Table 5.2: Calculation of Revealed Comparative Advantage
year Xhj Mhj Xh Mh Xwj Xhj-Mhj

Xhj+Mhj Xh-Mh

Xh+Mh RCA1 Xw RCA2
1990 7219 5292 62091 53345 104350 1927 12511 8746 115436 1.03293 3438600 2.83122
1995 13918 10914 148780 132084 151620 3004 24832 16696 280864 1.03503 5162000 2.18489
2000 16135 12832 249203 225095 154180 3303 28967 24108 474298 1.24334 6449000 1.7082
2004 33428 15304 593329 561230 194734 18124 48732 32099 1154559 12.3772 9153000 1.64811
1990 9669 48 62091 53345 108129 9621 9717 8746 115436 12.0683 3438600 3.95213
1995 24049 969 148780 132084 158340 23080 25018 16696 280864 14.5191 5162000 4.26963
2000 36071 1192 249203 225095 197413 34879 37263 24108 474298 17.4152 6449000 3.72848
2004 61856 1542 593329 561230 258097 60314 63398 32099 1154559 33.219 9153000 2.69715
Notes: Values for exports (X) and imports (M) are in millions of USA dollars. The top set of data is for
textiles while the bottom set is for clothing.

Table 5.2 illustrates the calculation of both types of RCA index for a given country
covering a period 1990-2004 for the two products; namely, textiles and clothing,
respectively. The data used were extracted from: WTO, International Trade Statistics
(Various Issues). It can be seen that, on account of RCA1, this countrys revealed
comparative advantage consistently increased for the two products, and especially for
clothing. However, the RCA2 indicates that the country was losing competitiveness in
both products.

5.2 Endowment Changes and Comparative Advantage
The preceding Chapters have focused essentially on tracing the welfare, income, terms-
of-trade, and redistributive effects of opening up to foreign trade based on comparative
advantage or relative factor endowment. In this respect we have been assuming that
factor endowments are constant. In this Section an analysis is made of the reverse effect;
that is, allowing for changes in factor endowments or economic growth of an already
trading country on its trade structure, direction and welfare. Growth in this context is
measured by changes in aggregate output of an already trading economy resulting from a
quantitative or qualitative change in its resource base. Sources of quantitative changes in
resource base include changes in indigenous stocks of capital, labour and natural
resources and also in inflows and outflows in capital and labour. Technological progress
affects the qualitative availability of factors. We employ two classic extensions of the
traditional trade theory in the case of quantitative factor changes the Rybczynski
Theorem and the Bhagwati Immiserizing Growth Proposition and examine the effects
of technological progress thereafter. Before presentation of these topics it is necessary to
provide some definition of growth and taxonomy of the trade biasedness of growth from
the production and consumption sides.

5.2.1 Taxonomy of Growth Biasedness.

If a countrys factors of production increase by the same proportion, then under constant
returns to scale, its aggregate output will expand by the same proportion. As shown in
Figure 5.3 both the capital and labour dimensions of the Edgeworth box ane extended by
the same proportion (Panel A) and the production feasibility frontier (PFF) will be
73
displaced outward by the same proportion regardless of factor endowment orientation and
factor intensity biasedness (Panel B). The intercepts of the PPF will be displaced equally
by ( ) ( )
0 0 1 0 0 1
/

/ X X X X M M M M = . However, the structure of production
and growth will be affected variously if different factors of production change by
different rates which alter the endowment proportions.
Effects of growth on a trade regime may arise depending on how that growth affects
production or consumption. We shall use Figure 5.4, which depicts a country that is
already trading and having specialized in production at point B (from an imaginary
autarky point A) on the PPF traced by M
o
ABX
o
. The world terms of trade, p
w,
is tangent
at point B and the maximizing consumption bundle is at point C to the left of B. Suppose
that there is growth which shifts outwards the initial PPF to the new PPF traced by
M
1
UX
1
and that the terms of trade are constant p
1
p
w,
so that the new post-growth
production equilibrium is at point U.

Starting with the production side, three broad classes of trade regimes are possible;
namely, neutral growth, export biased growth, or import biased growth, which are
explained in turn as follows:

Neutral growth: Neutral growth arises if 0

> = M X , which would occur along the ray
OBUF, meaning that growth in factors of production leaves the trade regime (mix of
exportable and importable) or the ratio M/X unchanged.

Export oriented regimes: Pro-Export biased growth would be revealed by
0

> > M X , signifying that, although both sectors expand, growth leads to
greater expansion of the export sector than that of the import sector. This would
be in the zone UF along p
1.
Ultra Pro-Export biased growth would occur down to
the right of F and would be characterized by 0

> X and 0

< M as the exportable

expands while the importable sector contracts in absolute terms.

Import Oriented Regimes: A pro-import biased regime would occur when
0

> > X M between points U and W on p
1
. Ultra Pro-Import biased regime would
result when 0

> M and 0

< X , which would be leftwards beyond point W.

Turning now to the consumption side, income growth may also affect the composition of
demand between the two goods at constant terms of trade. In order to classify demand
biasedness due to growth we invoke the concept of income elasticity of demand. Since
the focus here is on income effects at constant prices we can as well consider real income
level as the only determinant of consumption. We need two elasticities, one for the
exportable good and the other one for the importable good. The income elasticity of
home demand for the exportable can be stated as

0 .
%
%
] 10 . 5 [ > =

=
x
x
X
X x
xy
APC
MPC
D
Y
Y
D
Y
D
a

74
where, MPC = D
x
/Y is the marginal propensity to consume the exportable good out of
income and APC = D/Y is the average propensity to consume out of income. The
elasticity of demand with respect to income for importables is defined as:

0 . ] 10 . 5 [ > = =

=
m
m
m
m
my
APC
MPC
D
Y
Y
D
b

The ratio of the two elasticities is related to consumption growth as follows:
Dx Dm
Dx Dx
Dx
Dm
Dm
Dx
my
xy
/
/
. ] 11 . 5 [

where D
m
/D
x
is the pre-growth equilibrium consumption ratio at point C in Figure 5.2.
For normal products the income elasticities will be positive.

The reference point for classification of trade regime is the position of the consumption
or welfare maximization point after growth along the price line p
1
. A neutral
consumption effect arises when exportables and importables are consumed in the same
ratio before and after income growth as represented by points C and C
1
along ray
OCC
1
G. This means that export and import income elasticities are equal, so that growth
in both consumption levels are also equal. Export-demand biasedness arises when
xy
<

my
, implying that growth raises consumption of the importables faster that it induces
home demand for exportables as when the post-growth consumption mix lies between
points C
1
and Z. This act tends to generate more goods for the export market after growth
than before it. Income growth switches demand to increase consumption of the
importable goods. The consumption effect is said to be import-biased when
xy
>
my
,
indicating that income growth expands domestic consumption of export goods faster that
it increases the consumption of importables. This effect is represented by post-growth
consumption points lying in the range of C
1
V.

As discussed in Chapter 4, the possibility of negative income elasticities cannot be
completely ruled out when inferior goods exist. A negative income elasticity of demand
for exportables,
xy
< 0, given
my
> 0, signifies that these export goods are inferior
because their domestic consumption falls in absolute terms due to income growth, D
x
<
0 while D
m
> 0. This is the case of ultra-export-biased consumption effect arising
when post-growth demand mix is to the left of point Z. The opposite case, when imports
are inferior goods,
my
< 0,
xy
> 0, means that Dm < 0, which results in ultra-import-
biased consumption effect which occurs to the right of point V.

The analysis of the growth effects of trade has some bearing also on the BOPs. Export-
biased trade tends to raise exports more than imports. In this case the real trade balance
tends to improve as a result. From the real trade balance equation, the change in the
balance will be positive, that is: 0

> = M X P B
W
, if M X

> at constant terms of trade.


75
5.2.2. The Rybczynski Theorem.

The Rybczynski theorem, which is an extension of the HOS model, states that growth in
the relatively abundant factor, with constant terms of trade, leads to ultra-export led
growth by expanding the production of the export product intensively produced by the
abundant factor and contracting absolutely the import good intensively produced by the
scarce factor. The theorem is alternatively illustrated using the PPF, the box diagram and
more precisely algebraically.

As drawn in Figure 5.5A, the country is assumed to have a HOS-type comparative
advantage in the exportable product, which is assumed to labour intensive. The country
is already specialized at pre-growth production point B, which is associated with
equilibrium consumption point C at world terms of trade p
1
. A faster growth in the
abundant than in the scarce factor, K K L L / / > , displaces the PPF with greater
increase in the production of the exportable good than for the importable as shown by
0 0 1 0 0 1
/ ) ( / ) ( M M M X X X > on the respective axes. The post-growth equilibrium
production mix settles at point B
1
, while consumption goes to point C
1
. Although the
terms of trade are constant, p
1
p
2,
welfare rises from U
4
to U
6
and, while the exportable
sector expands production from X
1
to X
2
with X = X
2
X
1
> 0, the importable sector
contracts in absolute terms from M
1
to M
2
with M = M
2
M
1
< 0. This is the
Rybczynsk growth effect, as shown by the Rybczynski line RR, and you are asked to
verify that point B
1
is ultra-export biased relative to pre-growth production point B.

The Rybczynski theorem can also be illustrated using the responses of resource
reallocation as done in the Edgeworth-Bowley Box diagram of Figure 5.5B. Initial
endowments are
0
L and
0
K of labour and capital and the initial post-trade factor market
equilibrium is settled at point B, which indicates production levels X
1
and M
1
of
exportables and importables, respectively with equilibrium relative factor price ratio of
r w/ . The consequent resource allocations are: L
x1
of labour into production of X with
1 0 1 x m m
L L L = into production of M. For capital, these allocations are K
x1
and
1 0 1 x m
K K K = , respectively.

Assuming that only labour endowment grows to
1
L by ( ) 0 /

0 0 1
> = L L L L , while
capital remains constant at
0
K , then the Box elongates only horizontally from
0
L to
1
L
while the capital axis remains fixed. Respecting the Theorem, we see that, at constant
relative wage and constant terms of trade, the post-growth equilibrium will be at point B
1

with a rise in production of exportables to a higher isoquant X
2
while importables
contract to a lower isoquant M
2
. With constant relative wage, factor intensities remain
unchanged: In the exportables sector it is
1 1
BB B O B O
x x
= = , while in the importables it
is as shown by O
m1
B
1
which is parallel to O
m
B. This gives us a proof of the Theorem.
The exportable good has risen since distance O
x
B
1
is further a way from its zero output,
Ox, than O
x
B, thereby yielding a proportionate expansion of O
x
B
1
/O
x
B > 0. The
absolute contraction of the importable sector is visibly seen when viewed from its origin
76
O
m
; that is, O
M1
B
1
= O
M
D < O
M
B, which gives a proportionate output contraction of M
by O
M
D/O
M
B < 0.

Algebraic Proof
The predictions of the Rybczynski Theorem can be more precisely illustrated
algebraically. Full factor employment is given by the equation system.
T l Z l L b
T k Z k K a
t z
t z
+ =
+ =
] 12 . 5 [
] 12 . 5 [

Allowing for growth in both factors we get

T a Z a L b
T a Z a K a
lt lz
kt kz

] 13 . 5 [

] 13 . 5 [
+ =
+ =


A coefficient such as a
lz
= l
z
Z/L is the proportion of the labour force which is employed
in the production of maize, etc. Since maize is capital intensive while textiles are labour
intensive, we shall have a
kz
> a
lz
and a
lt
> a
kt
. With constant terms of trade (so that factor
intensities remain constant), we can simultaneously solve for the unknowns Z

and T

.
Since a
lt
= (1 a
lz
) and a
kt
= (1 a
kz
), the determinant of the coefficients matrix in [5.13]
is 0 > = =
lz kz kt lz lt kz
a a a a a a D . Then the comparative statics solutions become:

D K a L a T b
D L a K a Z a
lz kz
kt lt
/ )

(

] 14 . 5 [
/ )

(

] 14 . 5 [
=
=


If, at constant terms of trade the labour force grows, but the capital stock remains
constant, 0

> L but 0

= K , then, by [5.14b], the production of the labour intensive textiles

will expand by 0

) / (

> > = L L D a T
kz
, while maize production, by [5.14a], will contract
in absolute terms by L D a Z
kt

) / (

= . Since a
kz
> a
kt
, textile expansion will be greater
than the absolute contraction in maize production. If textiles are exportables, then this
will be the case of ultra-export based growth, by which production occurs to the right of
point F in Figure 5.4. More generally, if both factors grow but at different rates, such as
if the labour force grows faster than the capital endowment, K L

> , then we shall see
that .

Z K L T > > >
Some Economic Implications of the Theorem. By way of concluding this sub-section, we
should reiterate that the assumption of constant world terms of trade and therefore
constant relative factor prices makes the Theorem to be suited to the situation of a small
country which takes world prices as given, so that it is incapable of influencing those
prices. As such, the domestic relative wage guarantees constant factor techniques, which
means that growth leads to withdrawal of capital and labour from the importables sector
so as to maintain the sectors intensity and redeployed in the same proportion in the
exportables sector.
77

5.2.3 Immiserizing Growth: The Large Country Case

Using the HOS model of comparative advantage, it is possible that a growing and trading
large country may experience a deterioration of its standard of living. The possibility of
the occurrence of this phenomenon, known as immiserizing growth, was suggested by
Jagdish Bhagwati in the late 1960s. Growth, spearheaded by proportionately greater
increase in the abundant factor of production as shown in Figure 5.6, moves the trading
country from pre-growth production point B to post-growth point B
1
. In the process,
however, its terms of trade deteriorates against the export product, from p
1
to p
2,
which is
associated with welfare loss from higher welfare point C to a lower welfare point C
1.

This means that increased specialization that is induced by factor growth which is biased
to the export sector, can be counter-productive to the consolidation of previously gained
higher standard of living.

An interesting observation to make here is that the loss in welfare has been shown in
Figure 5.6 to the left of the TOT switch-over point S. Suppose this country had a
structure of preferences as shown by U2 and U3 which were different from U4 and U6.
Then observe that to the right of S, notwithstanding the TOT loss, growth would raise
welfare from consumption point C2 to C3. This apparent inconsistence can be explained
using the concept of income terms of trade. The case of immiserizing growth will occur
because the deterioration in the barter TOT exceeds the rate of export volume expansion,
so that the income TOT deteriorate as well. However, welfare will improve in the
scenario whereby the rate of export growth exceeds the absolute decline in barter TOT,
so that income TOT improve.

A key condition for the Bhagwati effect is that the foreign demand for the home export
product be relatively inelastic with respect to the export commoditys own price. That is,
since inelasticity of foreign demand for domestic exports means
dx
= %X/%P
x
< 1,
then a given export expansion induces a more than rapid absolute drop in export price,
%X < |%P
x
|.

The possibility of growth immiserization has prompted large producers to engage in
supply rationing and collusive practices such as cartels or commodity stabilization
agreements. Popular in the 1960s and 1970, these agreements have had mixed results and,
except for OPEC, most of them have been shelved since the mid1980s.

The immiserizing growth phenomenon is also illustrated using the offer-curve diagram of
Figure 5.7. The expansion of the exportable product is depicted by the rightward shift of
the exporting countrys offer curve from H
1
to H
2.
In order to portray the large-country
effect we present the analysis by starting with the small-country case in which the
growing economy is facing constant world TOT at p
1,
which are represented by the
straight line rest-of-the-world (ROW) offer curve. Since the country is facing a perfectly
elastic demand, export expansion leads to a new trading equilibrium at point S along the
world TOT, thereby increasing exports by AR and imports by RS. Point S seems to be an
78
unstable equilibrium position since, with an unchanged trade preference structure, it is
inconsistent with the pre-growth position A. This is because we cannot have another
welfare curve which is tangent at point S, unless welfare curve h
7
bent backwards, or
some other curve existed, so that it is tangent there. Another possible post-growth
equilibrium is at point B on the relatively elastic ROW offer curve RW
1
at which, in spite
of the growth in importation by UB, export expansion by AU leads to a welfare loss from
welfare curve h
7
to h
5
. This is because this export expansion leads to deterioration in the
TOT from a steeper price ratio p
1
to the flatter one p
2
. This TOT deterioration is
measured by the decline in the quantity of imports per unit of export. For example, the
same OX
1
now purchases only X
1
A
1
at p
2
which is less than X
1
A at p
1
. The decline in the
slope of the price line is the deterioration in the TOT is by: dp = p
2
p
1
= (X
1
A
1
)/OX
X
1
A/OX = (X
1
A
1
X
1
A)/OX

< 0. (Note that the difference in the parenthesis is negative).
Concomitantly, welfare loss is measured as movement from point A on the higher
international indifference curve h
7
to point B on the lower curve h
5
. In the case of an
inelastic foreign import demand as shown by the ROW offer curve RW
2
, the deterioration
in the TOT due to export expansion by VC is so worse that even imports decrease by AV.

5.2.4 The Commodities Problem: The Prebisch-Singer Hypothesis
The growth immiserizing thesis provided fertile ground to put up a pessimistic scenario
for exporters of primary products and culminated in what came to be known in the mid-
1960s as the Prebisch-Singer hypothesis. In effect this is a two-part hypothesis. The first
part asserts that in the short term prices of primary products fluctuate unpredictably more
than fluctuations in the prices of manufactured export goods. The second tenet of this the
thesis being that exporters of primary products or commodities tend to experience a long-
term or secular deterioration of their TOT. The idea is that, as shown in Figure 5.8, the
barter TOT may fluctuate in the short term, but over time there is a negative trend which
can be stated as follows:

[5.15] TT
b
= a + bt, b < 0

where TTb = Px/Pm represents the commodity or barter TOT, b is the time trend
coefficient, and a is a constant representing some initial TOT. Let us deal with the
instability component before tackling the trend aspect of the thesis.

In the short term the argument is that prices of commodity exports experience a greater
degree of instability than prices of manufactured goods because commodities face
relatively inelastic own-price demand and supply conditions. We know that changes in
demand lead to price changes in the same direction, but that supply shocks, and prices
move inversely. Take export demand shocks facing export supply and the own-price
supply elasticity defined as follows:
xs
= %S
x
/%P
x
%P
x
= %S
x
/
xs
. Given equal
changes in import demand, D, price changes or variations will be greater (but in the
same direction) if
xs
is smaller than if it is larger, and vice versa. Similarly, export supply
shocks will exert wider swings (in opposite direction) when facing relatively inelastic
demand than with relatively elastic demand conditions. Therefore, the short-term
79
movements in the TOT will be dominated by changes in the price of exports relative to
prices of imported manufactured goods.
Whether or not this explanation for short-term instability obtains, the Prebisch-Singer
hypothesis for long-term negative trend is premised on the following factors:

(1) The demand for primary products faces lower income elasticities than the
demand for manufactures, so that, according to Engels Law, as incomes rise,
prices of manufactures will experience a stronger rising trend than that for
commodities and over time the ratio Px/Pm will be declining.
(2) Technological breakthroughs have been weakening demand for raw natural
materials in two respects. First, the discovery of synthetic materials such as
polyester and plastics as substitutes for materials such as rubber, cotton and
leather. Second, the use of technologies which use less natural material
content, entails shift in demand to less natural material intensities, thereby
depressing overtime their world prices.
(3) The gains from these and other technological breakthroughs in the form of
reduced prices for manufactures do not trickle down to exporters of
commodities for two main reasons. First, manufacturing in those countries
takes place under imperfect market conditions and strong labour unions which
combine to prevent prices from falling to competitive levels. Second,
commodity producers experience competitive production conditions and
compete for marketing outlets, so that combined with weak unions
(unorganized labour) raw material prices tend to have a downward bias.
Therefore, due to a combination and accumulation of these forces the TOT of commodity
producers will deteriorate over time.
This argument took center stage in the subject of Trade and Development and was highly
popularized with the establishment of UNCTAD (the United Nations Conference on
Trade and Development) in 1964 with Raul Prebisch as its first Secretary General. The
extreme version of this thesis revealed itself in variants of Marxist writings such as
"unequal exchange" and "development of underdevelopment", etc. Both of these versions
however, were instrumental in agitating for the establishment of the New International
Economic Order (NIEO) in the early 1970s. The whole working hypothesis of this
argument was that the global division of labour or specialization was working to the
advantage of producers/exporters of manufactured goods - the industrialized countries of
Western Europe, North America and Japan (collectively called the North or Center) at the
expense of suppliers of commodities - then the less developed countries, grouped as the
South, Third World or the periphery of the global economic system.
A number of interventions and initiatives have since then been instituted both at the
world cooperation level and unilaterally by individual countries that have aimed in one
way or another at dealing with the commodities problem. At the international level the
following approaches have been attempted: Compensatory payments schemes for loss of
export earnings; foreign official aid; international commodity agreements and cartels
(Chapter 8); regional integration or South-South cooperation (Chapter 9); preferential
80
market access of products from LDCs; etc. At country level, individual governments or
with advice from donor agencies have variously implemented some of the following:
stabilization of farmers' incomes/revenues; orderly marketing of commodities; export
diversification; pursuit of macroeconomic stabilization, policy reforms and structural
adjustments; import substitution industrialization; production of higher value added
exports; etc.

These measures have had mixed results and it is not the intension here to evaluate their
relative contributions to trade performance, only to point out three related aspects. First,
that since the 1970s a number of countries in the LDCs camp of that time have
transformed their economies with strong industrialization bias, starting with the first
generation of the NICs (South Korea, Hong Kong, Taiwan and Singapore), which had
emulated the Japanese post-WW 2 model. Other countries in Asia, Latin America, and
Europe are become second generation NICs. Second, that the commodity problem as it
existed in the Trade and Development literature largely subdued the price-deflationary
role of agricultural subsidies and support schemes pursued by the developed countries, as
we have recognized them above. Lastly, that the pessimistic outlook of world markets has
now been replaced with a positivist stance which is being used to fight for increased
access of LDCs' products in the HDCs' markets within the WTO framework. These
issues are tackled variously in this and subsequent chapters.

5.3 Supply Shocks: Natural Resources and the Dutch Disease

The possibility that in the same economy a positive shock can lead to some sector(s)
booming while causing stagnation and depression in some other sector(s) led to
application of the Rybcyzynski analysis in the 1970s to what has since been known as the
Dutch Disease. In particular this was based on the observations that the discovery and
rapid exploitation of the North Sea oil by the Netherlands (hence the name of the disease)
and the United Kingdom, caused stagnations in the traditional sectors especially
traditional manufacturing, hence the disease revealed itself in the process of de-
industrialization. This phenomenon was observed to have spread to other countries, and
in the case of Nigeria it was the traditional agricultural sector that experienced the
negative shock, say de-agrarinization, from the booming oil industry. Since then a
debate has ensued as to whether natural resource, especially discovery of oil, is a blessing
or a curse to an economy.

In order to illustrate these effects, we move in two stages; first, we examine the case
whereby an economy produces only traded goods grouped into only two sectors, say T
and N. Then, at the second stage, the discussion will consider the case where we have a
traded goods sector and a non-traded goods sector. It is useful to assume that some
factors of production are sector specific while others are mobile across sectors. Further,
for analytical purposes we shall use the Corden and Neary (1982) model, in which a
positive shock which is associated with rapid exploitation of a natural resource consists
of two transmission mechanisms into the overall macro-economy; namely, the resource
reallocation or factor movement effect and the spending or income effect in a comparative
static environment.
81

Figure 5.9 sets up our framework of analysis where starting with the traded-goods model,
we start with the PPF traced by F
o
AF
1
with point A depicting the pre-shock equilibrium
production mix of T measured on the horizontal axis and N on the vertical axis. Let us
then assume that it is sector T which experiences a rapid positive shock. Through the
operation of the factor movement effect, there will be rapid derived demand for factors
into this sector and in order to attract them firms will bid up factor prices affecting both T
-specific and mobile factors. The combination of the withdrawal of mobile factors from
sector N and the rising of mobile-factor costs squeezes profitability and becomes a
negative supply shock to that sector, and it will contract while the T sector is booming.
Without considering the expenditure effect and at constant international TOT, this
scenario portrays the Dutch Disease or de-industrialization if N is a basket of
manufactures or de-agrarianization if N is agriculture. This overall result is shown in
Figure 5.7 as an outward shift of the PPF to FoBF
2
to indicate the biased expansion in the
T sector so that the post-growth production mix is at point B, with contraction in the N
sector by N
1
N
2
. The fixed world TOT are shown by parallel price lines p and p', which
are tangent at points A and B, respectively.
Traded Versus Non-Traded Goods. A major constraint on the traded-goods model is that
since both sectors are traded the domestic intersectoral terms of trade cannot move in
response to the structural change taking place in the economy. In order to allow for
variations in the domestic TOT, we now assume that the two traded goods form a
composite product called traded good, T, and have another good called non-traded good,
N. In this reformulation the TOT, p and p' are defined as the relative price traded goods,
(P
T
/P
N
), which defines the real exchange rate (RER) or as e = EP
f
/P
N
= P
T
/P
N
. Here P
T
=
EP
f
, where E is the nominal exchange rate and P
f
is the foreign currency price of traded
goods. We assume that P
T
is invariant in this analysis.

We then start from where we stopped at point B, but now assuming that the boom is
occurring in the traded goods sector. In order to examine only the effects of the resource
movement, without those of the expenditure effect, we momentarily assume that the
income elasticity of demand for nontradables is zero, so that the income offer
(consumption) curve is the horizontal line N
1
AA
1.
With this design, position B is
characterized by an excess demand for goods created by a shortage measured by the
contraction N
1
N
2
and, consequently, P
N
has to rise, which means that the RER declines
and the domestic currency appreciates as the relative price of traded goods falls. This
will have two subsidiary but opposing effects. The positive supply-side effect is that there
is improved relative incentive to increase production of non-tradables, which is
movement from point B towards A
1
. But the rise in P
N
will be contractionary on the
demand side which will be diminishing the expansionary supply-side force. For
discussion sake the economy might settle down somewhere in the range A
1
B, such as at
point B
1.
This result is due to resource movement effect alone. It should be verified that
at any point between B and A
l
the price ratio will be flatter than at B, indicating a relative
rise in P
N
or a RER appreciation. However, output of N has declined at B
1
compared with
N
1
. A comparative result we can state so far is that, with only the resource shift effect,
the rapid expansion in sector T is less painful when N is a non-traded sector that when it
is another traded sector.
82

Taking up the expenditure effect, we can perceive of the heavy investment and working-
capital expenditures on and revenues from the traded sector to have raised real incomes
with economy-wide spill-over effects, including on increased demand for non-tradables.
From here we proceed with the scenario that non-traded goods are normal goods with
respect to income and later on we shall consider the case of them being inferior goods.
For the non-inferior case then a likely income offer curve would be ray OAA
2
and, by
freezing the resource shift effect (but after the PPF has moved), we make the price lines
tangent at points A and A
1
. It turns out that with initial production mix at A1,
consumption will be rising along line AA
2,
so that at A
2
there will be excess demand for
N equivalent to N
1
N
3
. As previously, the RER has to appreciate between points A
1
and
A
2
with the attendant opposite forces on the supply and demand sides. Consequently, on
account of the expenditure effect alone, the economy might settle down at a point such as
B2, but with higher output produced of N than at point A. The problem we now have
after all this exercise is that the resultant effect of the initial positive shock in the traded
sector will depend on the relative weight of the negative resource effect with respect to
the positive effect on non-tradables. But what is apparent is that tradables will increase
beyond T
l
, in spite of the RER appreciation due to variations in P
N
, a constant T
T
and the
resource flows into the sector are overwhelming.
In the case of N being an inferior good then both the resource re-allocation and the
expenditure effects would combine to impact negatively on the non-traded sector such
that the final production mix would lie below point B on the post-growth PPF. In that
case, the demand effect on tradables would be so weak as to lead to shift in the TOT (real
currency depreciation) strongly in favour of tradables. A problem with such a case is that
if pushed too far, the economy may end up with complete specialization in traded goods
as in the original formulation (when both T and N were traded). However, a case can be
made to suppose that some inferior non-tradables will be substituted by varieties of
traded goods, which can be handled better using intra-industry trade analysis.

The case of the resource-cum-expenditure effects on an inferior sector has firmly rooted
historical precedents and one of them is the destruction of cottage and artisan industries
with the advent of industrial revolution in England and eventually in other industrialised
countries. As Eric Roll has cogently described:
With the transition to industrial capitalism in the eighteenth century...(the) amount of capital required for
industrial enterprise increased with the growing complexity of the manufacturing process. Few craftsmen
were capable of competing effectively either against the cheaper production made possible by a greater use
of capital equipment or in markets wider than their immediate environment....Sooner or later, when the few
tools they owned had become out of date compared with new processes and equipment, they and their
apprentices would succumb to the comparative security of being regular wage earnersThere, they would
be joined by others recruited from the rural population dispossessed by successive enclosure
movements....The whole of this process created not only industrialists and wage-earners; it supplied also a
market for capitalist industry. The destruction of the domestic workshop of both town and country and the
commercialization of farming created the demand which absorbed the products of factory industry. (Roll,
1973, p. 96)
83
Competitive or imperial rivalry in Western Europe during the making of industrial
capitalism generated rapid derived demand for cheaper raw materials and markets for
consumer goods, and with the independence that led to the creation of the USA in 1776,
colonies and territories were acquired in Asia, the Middle East and Africa. This led to
rapid exploitation of mineral resources and production and extraction of natural raw
materials. In a typical Sub-Saharan African peasant economy, the new resource
mobilization effect due to imposition of colonial division of labour faced the challenge of
inducing labour away from traditional socio-economic pursuits into the more dynamic
traded sector. In situations whereby insufficient labour was forthcoming, coercive
instruments such as taxation were used in order to make labour more elastic to the
expanding sectors. An effect of this resource transfer was a reduction in the production of
goods (both consumer and industrial/artisan tools) and services which were intensive in
the transferred labour. Those left behind, especially women, were factors that were
specific to other activities and they must have used survival cope-up mechanisms to make
up for the lost output in essential goods. Since capital was pre-paid in countries of origin,
the expenditure effect was mainly in paying for local labour and other services.
Abstracting from considerations of fairness, the income effect was acquisition of superior
imported consumer and utility products. Over time, therefore, while the demand for some
traditionally used products rose, production of inferior ones progressively declined due
both to resource and expenditure effects. Unlike in Western Europe or North America
where industrial capitalism created demand-supply wage-based labour markets, in SSA
the peasantry was not completely destroyed for its existence worked in favour of
maintaining a reservoir of cheap migrant-based labour supply to the resource extractive
industry.
Management of Natural Resource Rents

5.4 Trade Effects of Technological Progress
Our analysis of growth and applications of the HO theory has been based on physical
units of factors of production. Technical progress or innovation leads to qualitative
change in factors of production by altering their productivity and therefore affecting the
production functions themselves. This Section examines the major effects of technical
progress on trade and the terms of trade, after a review of its nomenclature next.

5.4.1 Classification of Technical Progress
Technological progress (TP) can occur in various ways by affecting productivity
exogenously or endogenously. (Differentiate between embodied vs. disembodied TP).
We shall use the Hicksian concept of disembodied TP, which is defined in terms of
whether it is biased to a factor of production or affects all factors uniformly in terms of
changes in productivity at constant relative factor price. In the two-factor case of capital
and labour and at constant relative factor price, a neutral TP leaves factor intensity
constant and raises the marginal products of both factors with equiproportionate growth.
This is shown in Figure 5.10A with movement from point A to B. In this case note that
although the factor intensity is the same, OA OB, the same unit of output, QQ Q'Q',
is produced with both less labour and capital at B than at A. Another important result to
84
record for subsequent use is the observation that one advantage of technical progress is
that the total cost of producing one unit of output of Q'Q' is lower than the total cost of
producing the same unit of QQ at A because the isocost line has shifted inwards at
constant relative factor cost.
A labour-saving TP (which is also a capital-using TP) raises the MPK by a higher growth
than it raises that of labour. This is demonstrated in Figure 5.10B. Initially, factor
combinations are l
o
and k
o
of units of labour and capital, respectively, required to produce
one unit of a product with unit isoquant QQ. At the relative wage, v = (w/r), optimal
factor employment is at point A, where the ratio of marginal products or the RFS equals
the relative wage; that is: (MPL/MPK)
A
= (RFT)
A
= v. The optimal technique or capital-
labour ratio is ko/lo measured by ray OA. A labour-saving TP will lead to a higher
capital/labour ratio or technique OC, and at constant relative wage, v' v (the isocost
lines are parallel) and the new optimal employment is at point C. It should be understood
that isoquant Q'Q' also measures one unit of output but produced with the less units of
capital k
1
and less labour units l
1
than before the advent of this technological change; that
is: 1
o
/1
1
> k
o
/l
o
. Since the relative wage is constant, this means that the slopes at points A
and C are equal and therefore the RFS is also the same so that the ratio of the marginal
products is the sam; that is (MPL/MPK)
A
= (MPL/MPK)
C
. However, at point B with the
pre-TP technique (k
o
/l
o
), the slope of Q'Q' is lower than at the pre-TP optimal point A,
which means that the MPK must have risen faster than the MPL, so that: (MPL/MPK)
B
<
(MPL/MPK)
A
. But since point B is sub-optimal there will substitution of K for L with a
shift to a K/L at point C. This then defines the case of a labour-saving TP.
Figure 5.10C depicts the case of capital-saving TP represented by change of technique
from OA to OC, such that the K/L ratio falls, (k
l
/l
1
) < (k
o
/l
o
), at constant relative wage.
However, at point B on the pre-TP the MPL has risen faster than the MPK, so that the
slope at B is greater than at A. Starting with the case of neutral TP, we now proceed to
analyze the sectoral impact of TP.

5.4.2 Neutral Technical Progress in the Capital-Intensive Sector

In order to demonstrate the effects of neutral TP on trade, we assume that it occurs in the
capital-intensive sector, maize, and that the labour-intensive textile sector experiences no
type of TP. We use the factor allocation box diagram of Figure 5.11A where the initial
optimal factor use is at point X. With the relative wage v
6
the production levels are
captured by isoquants Z
o
and T
o
for maize and textiles, respectively, and the factor
intensity for maize of O
z
X is greater than for textiles of O
T
X. The advent of neutral TP in
maize will initially raise maize output with the same capital and labour units (same factor
intensity) at constant relative factor cost and international TOT, while leaving the output
level of textiles unaffected. This initial effect is represented by the same point X at which
isoquant T
o
represents constant textile production while neutral TP is represented by
isoquant Z
o
, which has now been renumbered or re-indexed so that it represents a higher
level of maize than before TP took place. At constant relative factor cost and with the
same number of factor units means that the total cost of producing maize is constant and
therefore the higher post-TP output level is produced at a lower average cost than the pre-
TP lower maize output. Combined with unchanged commodity prices, the relative decline
85
in costs in favour of maize means also that maize profitability has risen which is a
positive supply shock in this sector but a negative shock to the textile sector.
As the maize sector booms, resources have to be withdrawn from the labour-intensive
textile production but with lower K/L ratio than required in the maize sector. As the
derived relative demand for capital rises, its relative cost also has to rise and
consequently both sectors will have to economize on capital by shifting to less capital
intensive techniques. This adjustment process will continue until a new labour market
equilibrium is obtained where the RFS is equal to the new relative factor cost which is at
point Y. The relative wage has declined, as v
1
is flatter than v, factor intensities (verify)
have become less capital (more labour intensive) so that the MPL has fallen relative to
MPK. However, still more maize production has been realized, Z
1
> Z
o
, while textile
output has contracted, T
1
< T
o
. From this outcome, so for, we can generalize that: At
constant commodity TOT, the advent of neutral technical progress in a sector reduces the
intensity in both sectors of the factor used relatively intensively in that sector and its
relative reward increases.

The output effects we have just observed can be shown in the output space as done in
Figure 5.l1B. The pre-TP transformation frontier is F
o
F
o
with initial equilibrium
production mix at point X and world TOT ratio p. Technical progress in the maize sector
and as it booms the PPF shifts upwards only along the maize axis as the textile intercept
is unaffected. When all the adjustments have taken place, the new PPF is F
1
Fo. At
constant TOT, p' p, the new production mix is at point Y, having moved along the
Rybcyzynski line RR, showing an absolute increase in maize production and a fall in
textile output.
What we have done so far can be interpreted as representing the small-country case or an
intermediate case for a large country. In the former case, point Y could be ultra-export
biased growth if maize is an exportable product or ultra-import biased case if it is an
importable good. In the large-country case then we have to consider the world TOT
effect of technical progress, depending on whether it affects exportable good or the
importable good.

In the case of an exportable product, maize expansion would tend to create an excess
supply in the world market, thereby reducing its price and leading to a deterioration in the
countrys TOT. There is no hard and fast criterion to guide the exact position of the
deteriorated TOT, but as shown in Figure 5.11B neutral growth would be at point W with
world price line p
1
which means that the relative price of maize has fallen. This will also
depend on the elasticity of the foreign offer curve. As shown in Figure 5.7, export
expansion of maize from the exporter's offer curve H
1
to H
2
will cause a less TOT
deterioration from p
1
to p
2
with an elastic rest-of-the world offer curve R
1
than with an
inelastic curve R
2
to price line p
3
. In reverse, if maize is instead an importable then the
TOT improvement due to creation of shortage in the world market would lead to better
TOT improvement with the inelastic R
2
, from p
3
to p
1
, than with the elastic R
1
, from p
2
to
p
l
.

86
5.4.3 Capital-Saving Technical Progress in the Capital-Intensive Sector

Before we proceed with the case at hand, let us first point out two technical features
which obtained in the case of neutral TP by referring again to Figure 5.11A, and these
are: one, neutral TP in the capital-intensive sector, maize, did not initially change the K/L
ratio as maize output rose at point X. Then, secondly, the efficiency curve did not change
as the factor market equilibrium positions were all along curve OzXYO
T
. Bearing these
points in mind, the advent of a capital-saving TP in the capital-intensive sector, maize,
means an initial shift to labour-using technology in the sector. This is shown in Figure
5.12 as movement from optimal factor allocation X to X'. Note that the factor intensity
for maize O
z
X', is more labour (less capital) intensive than the pre-TP one at point X,
while that in textiles is unaffected at both X and X'. This initial effect of this TP has now
led to a rise in maize output from Z to Z
1
combined with contraction of textile output
from T
o
to T
l
. The observation that both positions are characterized by optimal factor
allocation at constant relative factor cost, means that points X and X' are on different
efficiency curves (not shown), with point X' lying on an inner new curve than point X on
the old curve. From here we can then apply the idea that at point X' the average cost of
producing maize, and therefore its profitability, has decreased, thereby generating a boom
in the sector and a negative supply shock into the textile sector. The adjustment process
will settle down at point Y with the attendant results that we recorded in the previous
case. Note here especially the further shift to more labour-intensive (less capital-
intensive) technique in the maize sector and a shift to more labour-intensive (less capital-
intensive) in the textile sector from X or to Y at lower relative wage, v
1
< v
o
.

Since we have shown that maize production rises while textile output contracts, we can as
well precede using Figure 5.11B as we did in the case of neutral TP in the capital-
intensive maize. The analysis of the international TOT effects may proceed with the
proviso that since points X' and Y lie on the new efficiency locus while X on the old
curve, the new PPF would be different from F
1
F
o
which is

shown in Figure 5.11B.

5.4.4 Labour-Saving TP in the Capital-Intensive Sector
In the previous case of capital-saving TP in the capital-intensive sector the initial effect
was to make the maize sector less capital intensive at fixed relative factor cost. In Figure
5.13 this was a movement from X to X'. In the advent of a labour-saving innovation
occurring in the capital-intensive sector, as it leads to capital-using, makes the maize
sector initially even more capital intensive. This is shown in Figure 5.13 as a movement
from point X to point X' along the constant textile technique O
t
X O
t
X' as it intersects
with a steeper maize technique O
z
X'. At the same factor ratio v
o
, maize output has
contracted to Z
1
while textile output has risen to T
1
. At point X' the average cost declines
as profitability rises in maize production, which triggers a boom there but a
contractionary effect in the textile sector, thereby causing a fall in the relative wage.
From here on, the position of the optimal factor allocation is ambiguous even in the
small-country case at constant world TOT and we can only take some probable of such
positions. First, as production becomes less capital intensive in both sectors, the
economy might settle down somewhere between points X' and X such as at point Y with
a reduced relative wage v
1
. In this scenario maize production would have declined while
87
textile production would have risen with respect to the initial pre-TP equilibrium position
X. Second, it may happen that from point X, the boom might in the process move
equilibrium to less capital-intensive technique towards the pre-TP one, O
z
Y, but with the
new textile technique at point Y'. In this case maize output rises and textile output
declines. The case of point Y" is what was realized in the previous two cases, which on
the PPF were the Rybcyzynski effects. In the small-country case, what is firm is that the
relative wage will fall so that the reward to labour will fall while capital's real return will
increase. In the large-country case the TOT effects will be indeterminate due to the
ambiguity as regards the final optimal production mix.
In conclusion we may surmise some important results from our discussion of TP as
follows:
(i) In the small-country case, neutral TP in the capital-intensive (labour
intensive) sector, or, capital-saving TP (labour-saving TP) in the capital-
intensive (labour-intensive) sector will tend to reward capital (labour) and
penalize labour (capital). When the condition of fallacy of composition
obtains, the results are those of a large country case as we summarize next.
(ii) In the large-country case, neutral TP in a given industry will lead to a fall
in the price of that industry's product and this will be turned into the
country's TOT deterioration (improvement) if the product is an exportable
(an importable).
(iii) In the large-country case, a product which experiences TP that saves its
intensive factor will have its price fall and therefore a country's TOT will
deteriorate (improve) if that product is an exportable (an importable).
(iv) In a large-country case, a labour-saving (a capital-saving) TP which
occurs in a capital-intensive (a labour-intensive) product may lead to a rise
(fall) in its price if its output declines (increases) and the TOT will
therefore move according as to whether the product is an exportable or an
importable.

5.5 Technological Gaps, Product Cycles and Intra-Industry Trade
(Toward Dynamic Comparative Advantage)
After the end of the Second World War (1944), the countries of Western Europe, with the
aid of the USA-sponsored Marshall (Reconstruction) Plan, gradually emerged to regain
their industrialization to the point of collectively rivaling that of the USA. Other
countries such as Japan, Australia and Canada emerged as developed industrialized
economies. While the trade between these countries and the underdeveloped or less
developed countries (LDCs) remained that of a manufactured-primary-commodity type
or inter-industry trade, the trade among DICs increasingly assumed two characteristics.
First, this became an exchange of similar but differentiated manufactured goods within
same industrial branches. Second, this intra-industry trade was associated with the
emergence of modern multinational or transnational enterprises (TNEs) and later, from
late 1970s, with the emergence of globalization of production processes. By the 1960s,
some economists had started looking for explanations to account for the rapid changes in
the structure of world trade, which apparently could not be explained by the HO model
88
(or the comparative advantage theory). The theoretical attempts that are briefly reviewed
in this Section are precursors to the more sophisticated models that are based on
imperfect competitive market structure which have been developed since the late 1970s
and early 1980s. These are taken up in subsequent chapters.
(Footnote)It is important not to forget that as alternative models to the orthodox trade
model were being searched from within the tradition, in the 1960s and 1970s, a group of
scholars in the realism of political economy sought to explain trade relations between
DICs and LDCs by variously applying Marxist or Marxian concepts. This led to what
some termed "unequal exchange or development of underdevelopment". These
theoretical orientations, or the theories of underdevelopment or dependency have been
largely diluted with the collapse of the "cold war" and the communist block in the late
1980s as LDCs and former communist/socialist countries have embraced more market -
oriented economic regimes.
Early intra-industry trade accounts had a shared vision of providing a theory of dynamic
comparative advantage within the context of lead-lags in innovation and technological
dissemination, imitation and adoption across firms or countries. Some of the now classic
pioneers in this tradition include Linder (1961), Posner (1961), and Vernon (1966). These
models share the view "that a product has to be tested in the home market first to take
advantage of economies of scale before it can be an export.

5.5.1 The Preference-Income Similarity Hypothesis
The objective of Linder's (1961) proposition, also known as the overlapping demand
hypothesis, is to provide a basis for trade in similar but differentiated manufactured
products and it is premised on the existence of potential trade which is defined in terms of
presence of a representative demand for an exportable or importable product in a given
country. The contention is that a potential export product is one which is determined by
existence of consumption or demand for it in a particular country. A potential import
product is one that is determined also by domestic demand otherwise no imports of it
would flow into a country. Then for a given country there will be an overlap between
potential export and import of a given product. At an inter-country level, potential trade
will be positively related to the extent of similarity in demand structures so that trade will
be largest between countries with the most similar tastes and preference structures. To the
extent that per capita income is a major determinant of preferences and the size of a
market, trading countries will be similar in two respects. First, with similar preferences
and tastes, their per capita incomes will be similar or they will be at the same level of
development. Second, trading countries will be similar in terms of factor endowments or
technological capacity in order to produce similar products.
According to Linder, the realization of potential trade into actual trade is based on the
simple principle that "the same forces that give rise to trade within each of the countries
create trade between them. There is no difference between trade among countries with the
same per capita income and trade within a country" (Linder, 1961, p. 102). The conduit
for this is the realization by entrepreneurs of the power and unlimited scope of product
differentiation, which whether.. "real or advertized could, in combination with seemingly
89
unrestricted but idiosyncrasies, make possible flourishing trade in what is virtually the
same commodity" (Ibid., p. 102).
The upshot of this thesis is that trade will be greatest among countries which possess
similar factor endowment and level of development. Under Ricardian and HO
assumptions such trade is infeasible. However, just as the orthodox theory does not
explain the sources of dissimilarities in factor endowments, Linder's thesis does not
explain how countries achieve similarities in levels of development and factor
endowments. Further, it is imprecise in predicting or explaining the structure of intra-
industry trade or product group specializations.

5.5.2 Technology Gaps and Product Cycles
As this heading suggests, we now review what is known as the Technology Gaps model
due to Posner (1961) and the Product Cycle model identified with Vernon (1966) and
Hirsch (1967). Both of these models share with Linder's precondition of the existence of
a domestic demand for potential and actual trade. Both, however, share a dynamic view
of the complementarity between trade in commodities and the diffusion of technical
progress and innovations across countries. The conduit for this is dynamic and
continuous pioneering and imitation of innovations that are embodied in traded
commodities through creation and closure of technology gaps between leaders and
followers in this game. In order to jump-start the process, the starting stage is the
innovation, guided by entrepreneurship, of a new product through scientific and market
research and development. An important aspect at this stage is that the product has to be
experimented on, perfected, win consumer confidence and be successfully
commercialized in the domestic market. This gives the pioneer firm full and flexible
control of the whole process which protects it from competition and earns some rent from
its monopoly of the innovation. From this stage then a dynamic process begins of how the
innovation is imitated by, and lost to, foreign firms through international trade.

Posner charts this process in terms of two lags called imitation lag and demand lag. In
turn, imitation lag is defined in terms of three sub-lags or periods. Let us assume that the
foreign country's firms are the potential imitators while the innovation firm is in the
Home country. Then, first, there will be a foreign reaction lag, defined in terms of the
time between the innovation has successfully led to commercialization of the new
product in the Home market and when the new product is first recognized by foreign
firms as a potential competing importable to their products in their domestic market. The
second is the domestic reaction lag which is the time period necessary for all foreign
firms to discover that competition has stiffened from imports of the new product. Lastly,
is the learning period by foreign firms about how this product is produced and how to
actually produce it and then successfully commercialize it in their own markets. From the
imitation lag has to be netted out the demand lag, which is the time duration between the
introduction of the new product in the Home market and the emergence of a demand for
it in the foreign market. This means that the Home innovators will reap rents during the
demand lag period but will start experiencing market or technological adaptation threats
during and after the learning period.
90
Exchange in new products will be facilitated by development of a technological
dynamism, which is governed by two elements; first, is the flow of innovations, which is
defined as the number of new products that firms in a given country successfully
introduce per given time period; and two, is the speed with which a country's firms
imitate foreign innovations. Then intra-industry trade will be high and generalized
between countries with similar degree of technological dynamism. This will ensure fast
rate of innovation of new products among themselves. Less dynamic countries will face
the problem of: (a) the use of traditional export goods to pay for imports of "new"
products at deteriorating TOT; (b) require huge future investments in order to catch up;
and (c) will remain in a low level of dynamic trap.
The Product Cycle Model postulates stages through which a new product undergoes
from some low level of standardization to a very high degree of standardization (Figure
5.14 can be used as an aid). In Stage I, the new product becomes successfully accepted in
the home market as stated above and the pioneer firm has monopoly in the home market.
Then in Stage II, it enters a maturation phase such that it can be tested in potentially large
markets in developed countries. Initially the innovating firm's exports are produced using
the plant(s) based in the home country under technological monopoly. At some stage the
product gains further standardization which poses threats from imitators in the foreign
markets. At this stage the innovating firm has to undertake a cost-benefit analysis in order
to determine how effectively it can compete in the foreign markets. This will involve
calculation of comparative profitability of supplying either from the home plant(s) or
establishing production plants in those foreign markets. If foreign firms successfully
imitate the product, then in Stage III, the pioneer firm, innovating firm will find it
imperative to establish its own production plants in those markets and at this stage it has
become a TNE through FDI. An attendant result of this is the displacement of exports
from the home plants to foreign markets.
With the ensuing stiff competition from firms in the major markets, the pioneering firm
(in Stage IV) will start losing market share in its Home market from exports of imitating
firms in the major export markets. By this time the standardized product no longer
requires to be produced by highly skilled labour and production processes can be
operated by even semi-skilled workers. Competition at this stage is through price-cutting
strategies rather than by brand names in the global market. In Stage V, global
competition now requires locating production plants in low-cost zones under different
business arrangements, such as full ownership by TNEs, technology licensing,
subcontracting, outsourcing, production sharing, etc. However, with complete
technological imitation and loss of direct markets and in order to complete the cycle, the
pioneer firm has to go back to its drawing board in order to pioneer another differentiated
new product.

In order to appreciate the versatility of these techno-product cycles, let us finally surmise
some of the key results that have emerged from the preceding discussion and their
implications as follows:

91
Finding 1: Research and development and innovation have created Ricardian-
cum HO-type comparative advantage of the innovating country into R & D
intensive export product(s). Capital is immobile but there is trade in goods.

Finding 2: Capital mobility into the major export markets supplants exports from
the home plants. This is the case of substitutability between capital mobility and
trade flows - the Mundell (1957) result.

Finding 3: Comparative advantage gap has been closed between innovating and
imitating countries. Now they have similar technology and factor endowments, so
that the respective basis for Ricardian and the HO-type trade no longer exists.
Factor prices and commodity prices have tended to equalize between the two
countries.

5.6 Quantifying Technological Progress: The Solow Residual (Factoral TOT)

5.7 Transport Costs and Comparative Advantage

The pure theory of trade we have so far been using is based on a frictionless world in
which there are no obstacles or hindrances to the movement of goods by assuming away
the role of transport costs and government in the determination of comparative advantage
and hence the demonstration of the gains from trade. While the role of government is
more explicitly introduce in the next Chapter, we introduce transport costs so as to
examine how they modify and concretize the predictions and conclusions based on that
theory. Transport is a component of the whole corpus of infrastructure such as logistics
and communications that play two vital roles in our lives. First, they service, support and
facilitate the spatial movement of persons and goods; and, second, as services they are
also traded in their right both domestically and internationally. The focus in this Section
is limited to transport costs with respect to international trade in goods. This
encompasses the main transport modes of air, rail, road and water. Transport costs here
include freight charges and insurance cover on shipments, and logistical costs of
packaging, storage, holding or inventory costs in transit, the opportunity cost of time
spent across countries or borders, administrative and management costs.

A good destined for the export market incurs both domestic and international transport
costs. The domestic cost element is in two parts, one is from the farm or factory gate in
the exporting country to the point of exit or border post. International costs are
associated with movement from the export point to the importing countrys entry point or
border. Then the other domestic cost element is from the import point to the designated
importing agents destination. Therefore, in the absence of customs duties, the landed
value of the good is its cost value, or free on board or rail (FOB, R), at the official export
point plus the insurance and freight charges up to the point of entry in the importing
country. This landed value is on the cost, insurance and freight (CIF) basis. A
commonly used measure of transport costs is the either the unit cost IF or the ratio
CIF/FOB as an ad valorem index.

92
The main objectives now are:

To model the impact of transport costs on comparative advantage and therefore
trade
Review the determinants of transport costs and efficiency ; and
Draw some lessons for economic development of sub-Saharan Africa.

5.7.1 Trade and Welfare Effects of Transport Costs

We start with a hypothetical partial equilibrium model, as in Figure 5, in which the
introduction of transport costs acts like a negative supply shock, which is unconventional,
and then demonstrate how comparative advantage export competitiveness are eroded
accompanied by net welfare loss. The country is initially in autarky equilibrium in Panel
A at point A. Since it has comparative advantage in product Q, opening to trade will lead
to an increase in the domestic price from P
0
to P
x
. The small country will be facing an
infinitely elastic world demand curve D
w
at P
x
in Panel B. The consequent production
and consumption effects will be as follows: In Panel A domestic production rises to q
x

while consumption declines to C
h
, which creates an excess supply of q
x
C
h
=CH0. This
constitutes costless, transport-free export volume X
0
at point W
0
in Panel B, which is
consistent with export supply curve XS
0
. Total export revenue is P
x
X
0
= OP
x
W
0
X
0
. The
associated welfare and distributional effects are as follows: Consumer surplus has
declined by P
0
P
x
CA while producer surplus has risen by P
0
P
x
H
0
A, which includes the
total loss in consumer surplus, so that the net gain from free trade and zero transport cost
to the economy is ACH
0
.

Suppose a unit transport cost is introduced of magnitude AT
0
. The exports problem is to
supply the product to the importer at the quoted price P
x
inclusive of the transport costs.
As shown in Panel A this negative supply shock shifts the domestic supply curve
vertically upwards to S
1
but intersects the stationary domestic demand curve at point A
1
.
Consequently, domestic excess supply contracts to CH
1
in Panel A, which shifts the
export curve to W
1
and reduces export volume to X
1
and export earnings fall to P
x
X
1
in
Panel B. Domestically, as shown in Panel A producer surplus has declined by area
P
0
P
1
A
1
H
1
H
0
A. Part of this has been used to absorb the loss in comparative advantage by
domestic firms. The unit transport cost would have led to comparative advantage gap of
(P
x
P
0
) (AT
0
) = (P
x
P
0
) (P
2
P
0
) = P
x
P
2
. But because domestic demand is not
perfectly inelastic, the remaining gap is P
x
- P
1
. A further increase in unit transport cost
by T
0
H
2
would put domestic production at point A2 with further reduced excess supply of
CH
2
and export volume to X
2
and export earnings to P
x
X
2
.

In the limit there is some prohibitive unit transport of AT
i
which will put the economy in
autarky at the world price with production and consumption both at point C and not at
point A (Why?). This would make product Q untradable. Beyond that, the country would
find it more advantageous to switch over into a net importer of the product in question.

From this simplified model it is clear that not only introduction of transport costs reduce
the volume of trade, but also that the higher the trade friction the less the trade volume.
93
Empirically, studies have found that despite technological progress and the proclamation
of the death of distance, transport costs are the most important component of trade costs.
A study by Radeler and Sachs (1998) showed that for the previous three decades covered,
countries with lower transport costs register faster manufactured export and general
economic growth than countries with higher transport costs. It has also been empirically
found that an increase in international transport costs by 10% can reduce trade volume by
about 20%. (Limao and Venables, 2001). Further, that a decline in transport costs
accounts for 8% of the average growth in world trade in the post-WW 2 era (Baier and
Bergstrand, 2001).

5.7.2 Determinants of transport costs and efficiency

A number of factors determine transport costs and the efficiency or effective utilization
of trade-related infrastructure. These include: the type of transport mode and nature of
merchandise; distance and other geographical locational characteristics; the quality of
facilities and technological changes; economies of scale in trade and transport; market
structure and government intervention in the transport industry; quality of other
supportive services.

Type of Transport Mode and Nature of Product
Countries differ in terms of the importance of each mode in their trade depending on their
locational disadvantages or disadvantages and their structure of their export and import
bundles. On transport modes landlocked countries tend to have a larger proportion of
road-rail than maritime transport. For example, an island country such as Japan more
than 99% of its international trade by weight is transported by water while the
comparable figure for the USA is about 77% and land 22%. However, in terms of
value/weight ratios, products with higher ratio will be transported by air than by surface
transport. For the same countries Japans air share which accounts for 0.5% by weight
(same for the USA) accounts for 39% (23.4% - 34.4% for the USA) on trade value basis.
(WTO, World Trade Report, 2004, p. 116)

Distance and other Geographical Features
Studies have estimated that on average doubling distance increases overall freight rates
by between 20% and 30%. Further, landlocked countries face higher transport costs on
average by 50% than an average coastal country. This is because historically land
transport has been more expensive than sea transport by a factor of up to 7 times (Limao
and Venables, 2001). Given that the African continent has the largest number of
landlocked countries than any other continent the export and growth prospects of these
countries are more severely constrained than the ROW. As can be seen from Figure 5,
SSA countries are at staggering disadvantage with freight costs as share of import value
at 13.84% which is more than twice the world share. Particularly disadvantaged are the
Southern cone and land-locked African countries. For individual countries estimates are
as high as 22.7% for Burkina Faso and Malawi, and 32.8% for Mali (UNIDO, IDR, 2004,
p. 84). Limao and Venables estimate that landlocked countries stand to lose up to 40% of
export business on account of high transport costs. Remoteness from import sources of
intermediate inputs and capital goods will reduce these countries international
94
competitiveness. In this respect, it has been estimated for instance that capital equipment
in South Africa is twice as expensive as in the United Kingdom (Venables, 2005)


This seems to validate the gravity model of an inverse relationship between distance and
trade volume. But developed countries trade more among themselves far apart than SSA
countries trade with their neighbours. Why? In the case of large countries, as stated in
the context of the similarity thesis, the large sizes of these countries overcome the
distance market access barrier. Intra-SSA trade is constrained by two factors. One is the
lack of good neighbours. The other reason, taken up next, is the quality and management
of infrastructural facilities and borders.

Figure 5. : Freight Costs as Percentage of Import Value by Region





















Regions are: Industrialized countries, World, Developing countries, North Africa, Indian Ocean countries,
East Africa, Africa, Sub-Saharan Africa, West Africa, Southern Africa, Land-locked African countries.
Source: Adapted from UNIDO, Industrial Development Report, 2004, Table B3.5, p. 84.

Adequacy and Quality of Infrastructure
It is not only international transport costs that pose barriers to trade. Domestic costs are
equally important. In SSA it has been stated that it costs more to transport a vehicle
from Abidjan to Addis Ababa than to Japan (Africa Commission Report). This is due to
a number of factors. Historically, the transport and logistics systems were crafted to meet
the interests of colonial trade and not intra-SSA trade and this is increasingly outdated as
the direction of trade is rapidly shifting from inter- to intra-industry type. Civil wars have
led to the destruction of facilities and recapitalization has been slow. It has been recorded
that 31% of the 111 civil conflicts that occurred during 1940-2000 were in SSA Africa.
5.12
6.11
8.7
11.21
12.23 12.35
12.65
13.84 13.9
16.42
20.69
0
5
10
15
20
25
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Cost share
95
(W B, WDR, 2009, p. 285). Due to the highest density of countries per square kilometer
and the highest number neighbours (at four for SSA and 2.3 for Latin America) SSA
countries have the highest trading time across borders than other regions. Further, poor
countries have far much poorer roads, rail and airports than rich countries. For instance,
it is estimated that the availability of paved roads is 13 times more in rich countries than
in poor countries. Overall, there is a negatice correlation between transport cots and
quality of inland infrastructure. (Check with World Development Indicators).

Economies of Scale in Trade and Transport
Transport costs are influenced by traffic density, which in turn may be different for
exports and imports in terms of trade imbalances and/or the type of goods. The early
HO-type of colonial trade created the problem of backhauling whereby traffic to colonies
consistent of manufactured and capital goods while the reverse journey consisted of
bulky raw materials mostly of a seasonal nature. This meant that freight charges were
made to be higher for colonial exports than for colonial imports. This tariff structure has
since been maintained. However, because traffic densities differ across regions freight
rates will higher from regions with lower traffic than from more trafficked sources. The
distribution of total container port traffic across regions has been estimated to be: 45% in
South East Asia, 23% in Europe, 16% in North America, 6% in Middle East, 4% in
Central and South America, and 3% in Africa. (WTO, WTR, 2004, p. 117) For example,
it costs about $400 to ship container from China to the USA, about $800 from India and
about $1, 300 from Sierra Leone to USA. (WB, WDR, 2009, p.172) The increasing
production levels and volume of trade has led to declining transport costs over the past 40
years which has been associated with rising share of intra-industry pattern of trade. A
circular causation whereby falling transport costs reinforce economies of scale in
production, and higher production and trade also lead to economies of scale in transport.

It is widely believed that most SSA countries have not been able to capitalize on this
cumulative causation

Market Structure and Government Regulation















96
CHAPTER 6

TRADE POLICY UNDER COMPETITIVE MARKETS

6.1 Effects of International Trade Taxes
6.2 Effects of Trade Subsidies
6.3 Quantitative Restrictions: Import Quotas and Voluntary Export Restrictions
6.4 Measurement of Protection
6.5 Quantitative Restrictions in Global Trade: The Role of Safeguards
{Rewrite intro: Role of gov in trade; types of instruments; objectives; tariffs vs NTBs
etc.}
A governmental action, conduct or instrument that is not a straightforward trade tax but
affects or interferes with the business of foreign trade is a non-tariff barrier (NTB) to
trade. While a tariff directly works through the border price, NTBs variously affect trade
either indirectly through the price mechanism or simply to frustrate trade business. NTBs
may be classified or identified according to their mode of impact on trade, and they may
be quantitative or non-quantitative NTBs. Quantitative NTBs or quantitative restrictions
(QRs) are designed to directly restrict the volume of trade and they include prohibitions,
sanctions, quotas, and voluntary restraints that place a ceiling on the volume of trade.
Non-quantitative NTBs may be of technical, administrative, policy or legal natures that
indirectly affect the volume of trade by either increasing the cost of engaging in foreign
commerce or by creating an unfavourable environment that leads to uncertainty in the
conduct of business. Key non-quantitative NTBs which have received prominence and
are subject to various international trade agreements, including the WTO, are:
Domestic content requirements
Government procurement and State trading policies and practices
Technical specifications and labeling standards
Sanitary and phytosanitary requirements
Customs, currency and payments regulations and procedures
Rules of Origin
This Section will focus only on QRs while relegating coverage of non-quantitative NTBs
to subsequent Chapters.
External trade taxes are levied for various purposes. They are used to raise government
revenue and collected with relative ease (except for illegal practices by some importers
and tax officials). Most governments depend heavily on this source of revenue. Tariffs
are levied also with a view to protecting domestic industries from foreign competition
based on economic and non-economic arguments. The extent to which a tariff has a
protective or revenue bias may be difficult to identify. A tariff imposed on imported
goods that are not currently produced locally may have purely revenue motives. Another
example of a revenue tariff is a compensatory tariff, which is levied on an imported good
97
and is equivalent to the local tax rate imposed on a similar good produced locally.
Finally, countries resort to trade interventions in order to pursue and achieve BOP s
objectives.
We carry out assumptions of the competitive market model to analyze some of the key
consequences of the role of governments to pursue trade objectives, which has been
excluded in our preceding analyses. The trade policy instruments covered in this Chapter
include import tariff and subsidy; export tax and subsidy, and non-tariff barriers (NTBs)
to trade.
In general, an import or an export tariff a tax on internationally traded goods as they cross
borders. There are two types of tariff; namely a specific or ad idem tariff and a
proportional or ad valorem tariff. An ad idem tariff is expressed in terms of monetary
units per unit quantity, such as volume, weight or just number, of a product: for instance,
it may be K15.00 per litre of paraffin or kerosene. This means if the landed or border
price of kerosene is K55.50 per litre, then the domestic price with duty (excluding other
domestic charges and profit margins) will be K55.5 + K15.00 = K70.50. An ad valorem
duty is imposed as a percentage of the landed value of an imported good, such as 40% per
unit price. In kerosene case, the monetary duty would be 0.4 x K55.50 = K22.20, giving
a duty-inclusive price of K77.70 or 1.4 x K55.50. A combination of ad idem and ad
valorem duties yield a compound tariff, whose domestic price effect can be computed in
two ways. One method calculates the types of tariff separately as: K15.00 + 0.4 x
K55.50 = K15 + K22.2 = K37.2, which would give a domestic price of K92.70. By the
other method, an ad valorem tax is levied on the price which is inclusive of ad idem duty.
That is, 0.4 x (K55.5 + K15) = 0.4 x K77.50 = K28.20, so that the unit tax is K15 +
K28.20 = K43.20 and the domestic price would be: K70.50 + K28.20 = 1.4 x K70.50 =
K98.70.
In general, if the free trade border price of an imported item is Pm in local currency and
the specific or unit duty is u, then the after tariff price would be:
u P P a
m d
+ = ] 1 . 6 [
If the ad valorem rate is t%, then:
m m m d
P t tP P P b ) 1 ( ] 1 . 6 [ + = + =
where tPm is the amount of the tariff collected per unit, which is an equivalent of the
specific tariff in monetary terms. The compound tariff, assuming the above two
computational methods, will raise the domestic price to:
u P t tP u P P a
m m m d
+ + = + + = ) 1 ( ] 2 . 6 [
or:
) )( 1 ( ) ( ) ( ] 2 . 6 [ u P t u P t u P P b
m m m d
+ + = + + + =
98
Between the two compound methods, the first one leads to a lower domestic price while
the second one yield more government revenue that the first one. Under some
circumstances, ad valorem duties are preferred to unit duties because, one, it is easier to
assess revenue to be collected with ad valorem duties than the collectible revenue based
on quantities. Second, when uniformly applied, ad valorem taxes are more equitable that
the specific duties as they translate into lower tax incidence on low-priced goods than for
high-valued goods. For example, a 40% duty on K10 is K4, while on K100 is K40.
However, a specific duty of K4 on K10 per kilogram of salt is 40%, but only 4% on a
price of K100. Third, ad valorem duties are easier to apply for purposes of international
comparisons, especially in international negotiations and agreements.
The basis on which duty is levied is called the value for duty purposes (VDP) which may
be different from the price an importer actually declares to customs officials. It is
common to use FOB values although some countries choose to use CIF prices as basis for
duty calculations. In the latter case even transportation and insurance charges will be
taxed, thereby increasing the tax yield and consequently the domestic consumer prices.
Conventions, however, do exist which attempt to harmonize international tariff practices.
The analyses of trade policies will be carried out at two levels; first, through both general
and partial equilibrium framework, and, second, by making a distinction between small
and large open economy cases. Trade policy under competitive markets means that,
however that policy is arrived at, atomistic consumers and producers react to policy
instruments as price takers, leaving adjustments of excess supply and demand to the
functioning of the invisible hand. A small-open economy, or its government, is a price
taker in the global markets and since its actions are inconsequential in foreign markets,
the only strategic game it can play on behalf of domestic firms and consumers will be to
lead them to take advantage of given opportunities existing in the foreign markets in
order to pursue domestic objectives. In contrast, a large open economy (or its
government) acts as a collective monopolist or monopsonist in order to influence foreign
market outcomes in order to achieve its global and domestic strategic interests.
Following the traditional analysis, the effects of these instruments are evaluated in terms
of the distortions they introduce and the efficiency and welfare consequences and
distribution. We shall start with import taxes, followed by export taxes before
considering NTBs.

6.3 Effects of International Trade Taxes

6.3.1 Small Country General Equilibrium Analysis
Figure 6.1 depicts a country already trading and it will be assumed to be initially in a free
trade general equilibrium condition, which is characterized in following fashion. Its
specialization production mix is at point B at its PPF with production level of the
exportable good at qx1 (= qm1B) and quantity of the importable good at qm1 (=qx1B).
Given the free trade TOT of pw, welfare maximization is obtained at point C6 on the
welfare curve I6I6. The direction of trade is defined by the trade triangle BGC6, so that
99
the country is exporting excess supply GB of the exportable and importing GC6 of the
importable good. A fundamental point to know at this initial juncture is that economy as
a whole is trading with the rest of the world at the free trade TOT which maximizes the
its income and welfare, and resources are most efficiently allocated to the two goods
according to its comparative advantage. With hindsight, when this country opened up to
free trade, it must have moved from some autarky position such as A to C6 and enjoyed a
consumption gain from pure TOT gain and an efficiency gain due to specialization in
production to point B. These two gains resulted in total welfare improvement from point
A to C6 (see Figure 4.1).
Suppose then that the countrys government imposes an ad varolem duty, t, on the
importable good so that the domestic price becomes Pmt = (1 + t)Pm > Pm. Then the
domestic relative price for the exportable with import tax will be: ). 1 ( / t P P p
m x dt
+ =
The immediate result will be a fall in domestic relative price or profitability of the
exportable product, which will be a rise in the relative price for the importable:
w
m
x
m
x
dt
p
P
P
P t
P
p = <
+
=
) 1 (
] 3 . 6 [
In order to understand what it means to say that the relative price of the importable has
risen, it is advisable to recognize that domestic producers of the product whose output is
not subject to the import duty suddenly experience a rise in their price because they can
price their output at the same price as the duty-inclusive price at which imports are
selling domestically. Further, under perfect competition domestic producers cannot
charge a lower price in order to undercut foreign imports. They will just move up their
domestic supply curve.
We can now analyze the production and consumption adjustments. In production, there
will withdrawal of some resources from the exportable sector, which will experience
contraction, and to be reallocated into the increased production of the importable good.
In order to locate the new production mix, we assume that the tariff imposed is not
prohibitive in the sense that it is not sufficient to wipe out all the trade and drive the
economy back to autarky point A. From inequality [6.3], it should be reckoned that the
tariff inclusive relative price line will be flatter than the free trade line, and one such
tariff-ridden price line is labeled pt1, which is made tangent to the PPF at point D. The
production consequence is that production of the exportable good declines to qx2 by (qx2
qx1) = qx < 0, while the production of the importable increase by (qm2 qm1) = qm
> 0. The contraction of the exportable sector has enabled a domestic import substitution
effect and has resulted in a production cost or efficiency loss associated with the partial
loss in international specialization. This because production point D is inferior to point B
due to the fact that resources are now less efficiently reallocated at D than at the free
trade point B. To grasp this clearly, it can be discerned that if government removed the
tax completely, point B would be reestablished as the most efficient production mix.
Technically, the imposition of the import tariff is sad to have introduce a production
distortion which has led the economy to lose some of its comparative advantage as has
been forced to despecialize. This distortion is measured by the decline in the marginal
100
rate of product transformation from RPTb, at free trade, to RPTd. This is equivalent to
the slope decline 0 / ) (
1
<
w w t
p p p and is represented by angle at point Z. In order to
show the welfare effect of this efficiency loss, due to this production distortion, we
assume that domestic consumers have not yet responded to the changed price regime, so
that while trade is still being conducted at the free trade TOT, domestic production takes
place at the distorted relative price pt1. Shifting the pw to the left so that is crosses point
D, we get an equivalent world price line pw1., which tangent to welfare curve I4 at point
C4. Therefore, the welfare loss due to efficiency loss is movement from the higher free
trade welfare maximization point C6 to lower welfare point C4.
Tariff imposition introduced an exchange or consumption distortion. This is in the form
of an opportunity cost by which consumers are denied the opportunity of exchanging
products at the better free trade TOT and forced to trade at the inferior domestic tariff-
ridden relative price. This is because at the tariff-inclusive TOT, a unit of the exportable
good exchanges for less units of the importable good than at the free trade TOT. Given
that the country is a price taker, and that some trade still takes place (non-prohibitive
tariff), there is a distorted consumption at pointC2 where utility curve I2 is made tangent
to a tariff-ridden domestic price line pt2, which is along a world price pw1. This echange
loss leads to a further decline in welfare from C4 to C2. The resultant loss in welfare,
C6C4 + C4C2, due to efficiency loss and consumption loss, respectively, is known as the
Deadweight Loss (DWL) due to tariff imposition. Thus:
0 ] 4 . 6 [
2 4 4 6
< + = + = Loss n Consumptio Loss Efficiency C C C C DWL
It should be immediately recognized that this is a rollback of the gains from trade
recorded in Equation [4.1] as a country opened to free trade. However, the assumption
non-prohibitive tariff means that at point C2, the country still has a higher welfare level
that at autarky.
There are other effects that ensue from the tariff imposition in addition to or in
association with welfare loss, and one of these is the decline in the volume of
international trade. This is shown by the fact that the trade triangle has shrunk from the
free trade triangle to DEC2. with the tariff, which indicate export loss by BG - DE
accounted for by contraction in the production of the exportable good of qx2 qx1.
Imports have contracted by GC6 EC2 due to two forces; one, is the increased domestic
import substitution by qm1qm2, and the other factor is the total import compression
equivalent to the vertical distance N1N2, which is associated with the DWL (C6C2).
These and other tariff effects are considered in partial equilibrium analysis next.

6.3.2 Small Country Tariff Effects in Partial Equilibrium Framework
The country depicted by Figure 6.2, Panel A, is a small open economy and is assumed to
a comparative disadvantage in the importable good. Therefore, when it opened to free
trade the domestic price fell from the autarky price Po to the import price Pm, so that its
supply curve became SoHBSw. Domestic production fell from o to q1 and consumption
rose from qo to C6, thereby creating an excess demand to be satified by imports of q1C6
101
or HB. At free trade price Pm, consumer surplus rose by area PmPoAB, while producer
surplus shrunk by PmPoAH. The increase in consumer surplus and the decline in
producer surplus were associated with a better reallocation of resources at the world
price. Panel B shows the word position for this country where it is facing a horizontal
world supply curve pegged at the world price, which is segment HBSw in Panel A. The
demand curve for its imports traces the countrys excess demand function.
Suppose now that the government introduces an ad varolem import tax of t which raises
domestic price to P1 = (1 + t)Pm. Starting with production changes, the domestic supply
curve rises to SoCDS in Panel A. The tariff leads to domestic expansion of production to
q2 with import substitution of q1q2. Total consumption has declined from C6 to C2 as
excess demand and therefore import volume has contracted to q2C2 or CD. We can
identify the welfare effects by first recording that the rise in domestic price has resulted
in decline in consumer surplus by area PmP1DB, which is in turn distributed as follows.
Part of this consumer surplus loss becomes a producer gain or surplus of PmP1CH, which
in monetary terms it is measured as: ) )( ( 2 1 ) )( (
1 2 1 m m
tP q q q tP a + = . The government
receives import tax revenue equal to the unit tariff multiplied by the import volume:
) )( (
2 2 m
tP C q ECDF c = = .
While part of the overall consumer surplus loss is visible appropriated by producers and
the government treasury, the rest represents a loss to the economy or DWL consisting of
two components: one of these is the production effect which is represented by area HCE
= b. Its economic meaning that due to protection accorded by the tariff, domestic
production has increased by q1q2 as import substitution, which cannot be produced
competitively at the world price. This then implies that some resources have withdrawn
from some sectors where they were efficiently engaged and have been reallocated
inefficiently in the protected sector, and in the process the country has lost its
comparative advantage. This is what was referred to as the production cost or efficiency
loss in the last section. In monetary terms this cost is equal to the triangle area HCE
under the supply curve; or ). )( ( ) )( (
2 1 2
1
2
1
m
tP q q EC HE b = = The other component of the
DWL is the consumption loss, which is defined as the loss associated with the decline in
total consumption of C2C6 at a higher price due to tariff imposition. This effect is
represented by the area of triangle FDB, which can be computed as: ). )( (
6 2 2
1
m
tP C C d =
Therefore, the deadweight loss is given by:
0 ) )( ( ] 5 . 6 [
6 2 2 1 2
1
< + = + = C C q q tP d b DWL a
m

In Panel B total import compression is from M1 to M2 or by ( 0 ) (
1
< = M M M
o
or by
IG, which gives government revenue as area PmP1JI, while the DWL is defined by:
) )( ( ] 5 . 6 [
2
1
M tP d b DWL b
m
= + =
Computation of the DWL: The DWL can be empirically estimated a priori or ex post
using the import demand function. Notice from the formula [6.5b] that the magnitude
tPm is known from the policy pronouncement of the tariff rate. If the previous rate was
102
to and the new rate is t1, then 0
1
> = = t t t t
o
. The word price Pm is the pre-tariff
change landed value, so that the price change will be: . 0
1
> =
m m
tP P P The only
unknown variable from the formula is the decline in import volume, which can be
estimated from own-price elasticity of import demand. Assume an import demand
function is:
0 , 0 ); , ( ] 6 . 6 [ >

<

=
Y
M
P
M
Y P M M
m
m

where, Pm is the price for imports and Y is real income. The own-price elasticity of
domestic demand for imports is defined as:
M
P
P
M
dm

= ] 7 . 6 [
The change in import volume is defined by: ; / ) . ( P M P M
dm
= M is the initial level
of imports just before the tariff change, or Mo in Panel B; and .
m
tP P = Using these
definitions in the formula [6.5b], we get:
0 / ) )( ( ) )( ( ] 8 . 6 [
2
2
1
2
1
2
1
< = = =
o m dm m o m dm m m
M P t P M tP tP M tP DWL
As a proportion of national income we get:
Y
M P
t
Y
DWL
o m
dm
2
2
1
] 9 . 6 [ =
where, the last ratio is the average propensity to import this good out of income.

6.3.3 Import Tariff in Large Country Case
Unlike a small country that is a price taker, a large country influences the price that it
faces in international market of its import or export product. A large countrys action is
capable of shifting its TOT, which could be in its favour or otherwise. One of the most
famous claims in favour of a large country imposing an import tariff is that that can lead
to favourable change in its TOT, and this argument is itself premised on the concept of
the optimum tariff. We start with the partial equilibrium analysis using Figure 6.3, in
which the large country is the foreign country in Pane A, which is assumed to not to have
a comparative advantage in the product. The large countrys free trade import demand is
curve DmDm in Panel B. The Home country which has possess comparative advantage in
the product is shown in Panel C and its supply to the world market is its export supply
curve Sx, which is Foreigns import supply curve. Free trade world equilibrium is
obtained at point A and with world price Pw, which also rules in the respective domestic
markets, so that: Pm = Pw = Px. Homes excess supply or export volume of UT is
Foreigns import volume or excess demand GN. Awhile a small country faces a perfectly
103
elastic demand curve and can import unlimited quantities at a given price, a large
importing country faces an upward sloping supply curve for its imports and can therefore
move along that curve in order to choose a price once it has imported the right quantity.
This, however, has to be achieved at some extra cost or expense, which increases as more
quantities are sourced. This gives a marginal expense or marginal cost of acquiring
imports indicated by curve H1Mem, which lies above the ordinary supply curve SmSx.
At the world free trade equilibrium point A, the marginal expense is vertical distance AK.
If the government of the large country imposes an import tariff, the tendency for
reduction in domestic excess demand becomes like demand restriction in the world
market and creates an excess export supply. This will tend to depress the world price at
which it sources its imports and the extent to tariff imposition splits into a rise in the
domestic price and a decline in the world price will depend on the elasticity of foreign
supply for its imports. In the small country case facing a horizontal supply curve, the
domestic price will rise by full tariff effect tPm, without a decline in the world price. In
the case of an extremely large country facing a completely inelastic curve such as the one
vertical at Mo through AK, the world price would decline by the full tariff rate and no
increase in the domestic price. The intermediate case of world supply Sx shown in Panel
C leads to a rise in the large country domestic price such as to P1 combined with a drop
in the world price to P2. This means that tPm = P1 P2, which consists of components,
the domestic price rise PmP1 and the decline in world price by PmP2. The rise in the
domestic price leads to production, consumption and welfare effects that are similar in
direction to those experienced by a small country, which are: consumer surpl;us loss of (a
+ b + c + d); produce gain a; government revenue c; and DWL of b + d.
The Home country experiences a drop in its export price to P2 at which the Foreign buys
its imports, which leads to a contraction in Homes production by q3q4and excess supply
shrinks to C4q4 = VW. This is because Foreigns excess demand has declined to to CD
= XY, which in the world market is quantity M1. The result in an oiverall reduction in in
producer surplus in the Home country by area P2PwTW. = (w + x + y + z), and it is
distributed as follows. Consumer surplus increases by area w, as domestic demand is
stimulated by C4C3 due to a fall in the price. This increase in domestic consumption is a
distortion in Home because it cannot be afforded at the tariff-free price Pw or Px (It is a
bonus to Home consumers due to the large country price effect). However, it leads to an
opportunity cost to the country as a whole represented by triangle x. he reduction in
domestic product by Q4q3 or RT is an efficiency loss due loss of comparative advantage
as measured by triangle z. These two triangles constitute the DWL in the Home
economy, which is area BDA in the world market.
In the Home country part of producer surplus loss is area VSRW = y, which is loss to
Home suppliers or exporters imposed by the Foreign government as part of the tariff
which reduces the price. In this way the Home country suffers deterioration in its TOT as
its export price has fallen relative to its import price index. In turn the Foreign country
experiences a TOT gain, which is the form of an extra government revenue of magnitude
e = XEJY. This large country TOT gain is area P2PwDB in the world market. The large
countys TOT gain has to be compared with the DWL, so that the countrys relevant net
welfare change should be defined as: NW = TOT Gain DWL = e (b + d). In a
104
situation whereby DWL > e, the large country would be worse off with the imposition of
a tariff. If e > DWL, then the importing country is better of with the tariff as the net
welfare gain is positive. If e = DWL, then foreign exporters exactly compensate the large
countrys welfare loss. A tariff which equates the TOT gain to the DWL maximizes
welfare and it is known as the optimum tariff. The welfare position of the two countries
can be summarized as follows.

Panel A Panel B Panel C
Consumer loss/gain -(a + b + c + d) w
Producer gain/loss A -(w + x + y + z)
Government rev C -y
DWL -(a + d) -(DMA+BDA) -(x + z)
In order to gain insights on the optimum tariff from a partial equilibrium framework, it is
advisable to think in terms of some trade of between marginal gains and marginal losses
from a tariff change. Suppose the foreign government imposes a small tariff t over the
existing one which is t = (P2 P1)/P2. A possible incremental cost of this is to reduce
imports or demand by M, which is a movement along the demand curve slightly to the
left of points M and M1 and causes consumer surplus loss by .
2
t
M
tP

A possible
incremental gain from this small tax increase in price P2, at which the large country
sources its imports by forcing exporters to pay part of the tax while they are still
supplying its imports. This small gain is represented by .
1
M
t
P

The optimal import

tariff tm is the one which equates the marginal gain to the marginal loss; that is:

t
M
P t M
t
P
m

2 1
=
Solving for the optimum rate and using the own-price supply elasticity coefficient we
obtain the following relationship:
sm
m
P
M
M
P
M P
t
t
M P
t

1 .
] 10 . 6 [ = = =
The right hand side expression is the inverse own-price supply elasticity coefficient of the
supply curve Sx. Note that the extreme case of a vertical supply curve with zero small
change in imports, the elasticity coefficient would be zero also and the optimum tariff
would be infinite, which is rather unrealistic. The other extreme case of zero change in
price is the small country case of perfectly elastic supply curve and zero optimum tariff.
Overall, the relatively inelastic import supply is the greater the optimum tariff.
105
Optimum Tariff in General Equilibrium
The general equilibrium effects of an import tariff are demonstrated using Figure 6.4, in
which Foreign, the large country, exports maize and imports textiles from Home. Free
trade equilibrium is at point E where Homes offer curve H0 intersects Foreigns F0 with
free trade TOT line pw. Foreigns TOT are defined as the relative price of maize,
(Pz/Pt), which is measured as metres of textiles per bag of maize. The trade indifference
curve for Foreign I2 is tangent to the world price line at E. Imposition of an import tariff
by the large country on textile imports means that the domestic of textiles has risen in its
domestic market relative to maize price, which is a negative supply shock to the maize
sector but an expansionary stimulus to the textile sector. Consequently, Foreigns offer
curve shifts downward and rightward to the new curve F1, which crosses Homes
stationary curve H0.
In order for the large country to experience a TOT gain and maximize welfare, four
conditions have to be satisfied. One of these is that with tariff imposition, the trading
TOT should improve. If Foreign were a small country it would still face the free trade
TOT pw and would be at point E1 on its new offer curve. As a large country its
improved TOT is p2 which passes at the intersection between its new offer curve and
Homes stationary offer curve H0. The TOT improvement is indicated by the fact at p2,
each quantity of maize fetches more metres of textiles than at pw. For example, Z2 bags
of maize buys Z2C of textiles which is more than Z2X at the free trade TOT.
Alternatively, note that at free trade prices BY bags used to purchase OB textiles while at
the tariff-ridden prices Foreign only spends BC bags to acquire the same OB textiles.
Therefore the TOT gain is by:
BY
OB
BC
OB
p p TOTGain
w
= =
2
. The second condition is
that the domestic consuming and production TOT, say pd, have to be worse that the
external trading TOT, p2. This means that the relative price of maize in the large country
should be lower than the TOT at the country sources its imports from Home, and the gap
between these two relative prices is the tariff defined as:
.
2
BC
OA
BC
AB
BC
OB
p p t
d n
= = =
The third condition for welfare maximization is that some Foreigns trade indifference
curve together with its domestic TOT should be tangent to Homes offer curve where its
external trading TOT crosses both offer curves. This is satisfied at point C, where I5 is
the highest possible Foreigns welfare curve which is tangent to Homes offer curve, and
any higher welfare curve, such as I7, would be in Homes infeasible space. The last
condition to be satisfied is about the elasticity of supply for Foreigns imports at point C,
which is explored next. Recall (from Section 4 of Chapter 4) that the elasticity of an
offer curve at any point is defined in terms of proportionate change in import quantity
with respect to proportionate change in export volume. Since from Foreigns side its
supply of imports are from Home country, we then define the elasticity of Homes offer
curve at point C as: AB OB = . Then the export elasticity of Homes supply for
Foreigns imports is defined by:
106
AB OB
AB
xs

=
1
1
] 11 . 6 [

The small country case faces an infinitely elastic supply conditions, and this is when
, 1 = which gives .
xs
In this case Foreign would be facing the free trade price
line and tariff imposition would not yield TOT gain. The solution for an optimum tariff
is when , 1 < < at the tangency point C. This elasticity coefficient is the same as the
one reported in Equation [6.10], and it turns out the tariff rate defined above as t
n
is
equivalent to the optimum tariff in this solution.
Profile of Welfare and Tariff Level
The advantage of the TOT gain for a large country over a small country in terms of
welfare maximization is shown in Figure 6.5, in which welfare is measured on the
vertical axis and tariff rate on the horizontal axis. A country in autarky can enjoy a
maximum of A level of welfare, while if it opens to free trade (at zero tariff) a maximum
E welfare level would be maximized. A trading country that imposes a prohibitive tariff,
t
p
, will enjoy a welfare level equivalent to the autarky level at Z. When a small country
introduces an import tax on the free trade price it will experience deterioration in its
welfare due to emergence of the DWL which is not compensated by TOT gain. In the
general equilibrium framework of Figure 6.1, welfare loss was from C6 to C2 with the
flattening of the tariff ridden TOT. A continuous increase in tariff rate would lead to
flattening of the domestic TOT until in the limit it coincided with the autarky TOT at the
PPF. In Figure 6.5 this would entail a continuous welfare loss from point E down
through X to point Z, which is the welfare level at the prohibitive tariff. In the partial
equilibrium framework, this would be case with the rise in the domestic price and
enlargement of the DWL triangles until all the gains from trade were wiped out. This
leads us to the famous conclusion that the welfare maximizing optimum tariff for a small
importing country is the zero tariffs, which yield its maximum welfare at the free trade
level E in Figure 6.5. For a large country, continuous tariff imposition from the free trade
position E will initially to welfare improvement, reach a maximum at the optimal tariff
tm, and thereafter star to deteriorate and eventually converge to the welfare level
associated with the prohibitive tariff.
Effects of an Export Tax
Having evaluated the effects of import tax, turn now to examine the effects of the same
instrument on the export side. Taxation of export business seems to be antithesis to
enhancing economic growth, market share expansion and foreign exchange
maximization. However, governments that experience narrow tax base have taken
recourse to measures that directly or indirectly exact a tax burden on the export sector or
selected export products.
An export tax is levied on the world export price at which exporters base their revenue
calculations. When an export tax is imposed on exporters the immediate effect is to shift
it to domestic suppliers so that the domestic price is lower than the free trade world price.
In the small country case, given the world price, Px, the lower tax inclusive domestic
107
price will be ), 1 /( ) 1 (
1
t P P t P
x x t
+ = = having dropped by tPx. This drop in the domestic
price received by domestic producers, as shown in Figure 6.6, is a supply-side
disincentive, which causes output contraction from q1 to q2. On the demand side,
consumption will be encouraged as it increases from C1 to C2. For a small country the
contraction in export supply from C1q1 to C2q2 will leave the world price unaffected and
no adjustments would occur in the foreign markets. The consequent costs and benefits to
the small country can be summarized as follows:

Producer loss = -(a + b + c + d + e)
Consumer gain = (a + b)
Government revenue = d = (Px P1)(q2 C2)
DWL = -(c + e)
The DWL is due to two factors, and one of these is the loss in production efficiency (area
e), which arises as resources move to industries that are not competitive at free trade
prices and the country loses its comparative advantage in the taxed export product. The
other source of the DWL, area c, is due to the increased consumption which cannot be
afforded without the export tax. We see that for a small country, free trade would be the
better option than taxing the export product.
For a large exporter country, the contraction in the domestic excess supply means its
export volume contracts, which creates a shortage in the world markets (not shown),
thereby raising the world price to P2. The large country export tax imposes an import tax
on the importing country in which the domestic price rise leads to loss in consumer
surplus by (u + v + w + x), which is distributed in the exactly the same fashion we
analyzed the case of an import tax in a small country with a DWL of (v + x). However,
instead of government collecting revenue of area w, this accrues to the large country as
extra government revenue, f, on account of improvement in the countrys TOT. This
revenue gain for a large country means that its DWL be adjusted to give a net welfare
position of: f (c + e) = f DWL. An export tax that maximizes a countrys welfare is
an optimum export tax.
The Stolper-Samuelson Theorem Once More
The Metzler Paradox

5.2 Effects of Trade Subsidies
We start with an analysis of an import subsidy. In a small country, introduction of an
import or consumption subsidy leads to a decline in the domestic price of the product
below the free trade import price, Pm, by the full rate of the subsidy. That is, if the
108
subsidy rate is s, the fall in the domestic price will be by sPm to . ) 1 (
1 m s
P s P = In
Figure 6.7, we have a small country partial equilibrium setup with domestic demand
curve DD, supply curve SoS and import demand Dm. At the free trade import price Pm,
As we did with the case of tariff, let us examine the subsidy effects in terms of changes in
production, consumption, government revenue and welfare.
From the supply side, the drop in domestic price is a negative shock which leads to
contraction in output by q0q1 and, as a result, producer surplus declines by (a + b). On
the consumption side, there is an increase in excess demand by (q0q1) + (C0C1) which is
met by import expansion shown in the world market diagram from M0 to M1 or by (M1
M0) > 0. The concomitant rise in consumer surplus is by (a + b + c + d + e), of which
(a + b) is a redistribution from producers loss. The cost of the subsidy to be finance by
government is due to the import volume q1C1 = AD = M1 which is incurred at a unit
subsidy of , ) (
1 m m
sP P P = so that the subsidy bill is (sPm)(q1C1) or area ABCD = (b + c
+ d + e + f). The net welfare effect of an import subsidy in the small country is DWL due
to efficiency loss of b and inefficient consumption by f. We therefore see that for a small
country, import expansion that is supported by a subsidy causes a net welfare
deterioration just as an import tariff did by compressing imports. However, the subsidy
penalizes domestic production instead of protecting it, and rewards domestic
consumption instead of hurting it.
Import Subsidy in the Large Country Case. In the large country the domestic price
effect of a subsidy will depend on the elasticity of export supply. With and intermediate
export supply of Sw in the world market, the subsidy has been split into two components,
namely, the small-country reduction in the domestic price by (P1 Pm), and the rise in
domestic price by (P2- Pm). The drop in the domestic price due to the subsidy leads to
the same effects identified for the small country. However, the ensuing increase in
excess demand in the large country case causes an increase in the world price to P2 as the
world demand shifts upward to Ds and intersects the supply curve at point F.The trouble
for the large country is that imports have to be bought in the world market at the subsidy-
ridden price P2 and sold in the domestic market at the lower price P1. This raises the
subsidy financing requirement above the small country level by area: BEFC + (h + I + j),
so that the total subsidy bill becomes: ABCD + BEFC = AEFD. This means that the
total net welfare cost to the large economy is greater than the DWL by BEFC, which is (b
+ f + h + i + j).
The price increase in the exporting country leads to a combination of output expansion by
q2q3 and contraction of consumption by C2C3, which generates sufficient excess supply
to satisfy the excess demand in the large country at P1. Note that in the process, the extra
subsidy in the large country of BEFC is in the exporter country an increase in what would
be exporters revenue by (v + w + x + y + z) from C3q3 exports. However, their net gain
is only by (w + x + y), while areas v and z represent the DWL due to consumption loss
and efficiency loss, respectively. This means that at the world level, the net welfare or
real income loss due to large country import subsidy is (b + f) + (v + z), which is larger
than in the small country case.
109
An Export Subsidy
An export subsidy is an income transfer to exporters per unit of export volume and its
immediate effect will be a rise in the domestic price received by exporters beyond the
free trade export price, such as to: . ) 1 (
1 x s
P s P + = As shown in Figure 6.9 then in the case
of a small exporting country, domestic production will be stimulated by q1q2 while
consumption will necessarily contract by C1C2. This will lead to export expansion from
C1q1 to C2q2. The small country costs and benefits due to export subsidy will be as
follows:

Producer surplus: (a + b + c)
Consumer surplus loss: -(a + b)
Subsidy expense: -(b + c + d) = -(P
1
P
x
)(q
2
C
2
)
DWL: -(b + d)

The DWL is due to consumption loss, b, and efficiency loss, d.
For a large country its export subsidy causes an excess world supply which depresses the
world price to P2. Consequently, the country incurs a TOT loss (as its export price has
fallen) that leads to a further subsidy expense of (g + f + e) over the small country cost.
This means that its welfare loss will be larger than the DWL at: -(b + d) (g + f + e) =
ABCD.
The external economic effects of a large country subsidy can be felt in importing and
exporting countries. The domestic adjustments for a small importing country are shown
in Figure 6.9. The drop in the import price entails a TOT gain which favours
consumption at the expense of production as consumer surplus increases by (u + v + w)
while producer surplus declines by (u + v). However, the reduction is production leads to
efficiency loss of v while increased consumption induces inefficient consumption
represented by are x, which constitute DWL of (v + x). This leaves area w as the net
welfare gain to an importing country. Note that since (g + f + e) = (v + w + x), then the
net welfare cost to the world due to large country subsidy will be by (b + d) + (v + x),
which again is larger than for the small country case.
Exporter countries in the ROW experience a TOT loss, which favours consumption at the
expense of domestic production, which leads to DWL due to contracted competitive
output and induced consumption.

110
6.3 Quantitative Restrictions: Import Quotas and Voluntary Export
Restrictions
An import quota is a quantitative restriction (QR) that sets a maximum quantity beyond
which no further units of the product affected may be imported into the country whose
government is imposing the quota. Since a quota is normally used to protect a local
industry, it set at a level which satisfies only a fraction of the domestic excess demand at
the free trade world price. In our analysis of the effects of a quota we shall evaluate these
effects in comparison with or contrast to those of an equivalent tariff in partial
equilibrium setting of both small and large country cases.
In order to make meaningful comparative evaluation of a quota and a tariff we assume
that in a small country a quota of Q would raise the domestic price of the product in
question by a margin which is equivalent to that of some tariff. As shown if Panel A of
Figure 6.10, at the free trade import price Pm, domestic production is q0 while demand is
at C0, giving a total excess demand for the product of C0 q0 GN. A quota of Q = GQ
will satisfy only GQ of the prevailing excess demand, leaving a balance a balance of QN.
The total domestic supply inclusive of the quota is ,
0
Q S + which has shifted the
domestic supply curve to the right of the domestic supply schedule S0. The unsatisfied
excess demand QN exerts upward pressure on the domestic price until the market is
cleared at a higher price P1 at point D. Note that at this new equilibrium price the excess
demand is exactly met by the quota CD = GQ. The rise in the domestic price by (P1 -
Pm) due to imposition of the quota, could have been achieved by a unit tariff tPm = (p1
Pm) or by and equivalent tariff rate t = (P
1
P
m
)/P
m
, which would also have cleared the
excess demand QN or GD.
The equivalence between the quota and the tariff lies in the equivalence of their effects as
follows: (i) domestic price has risen by the same margin; (ii) domestic producers are
favored as import substitution increases in both by q0q1 with producers gain of area a;
(iii) consumers are injured as consumer surplus shrinks by PmP1DN and consumption
loss has been compressed by C0C1; (iv) the economys welfare has declined due to
emergence of DWL = (b + d). The equivalence ends here and one of the non-
equivalences between the two trade policy instruments is that while in the case of the
tariff area c = ECDJ accrued to government as external tax revenue, in the case of the
quota the government may not have automatic control over or direct access to it. We
shall come back to discuss some of the possible means of how this economic rent may be
appropriated after noting the case of a large country.
For a large country under a quota Q its import demand curve in the world market as
shown in Panel B consists of segment F1M and the vertical portion MDBM1. As
domestic price tends to rise with the quota restriction, the reduction in domestic demand
excess demand tends to create excess supply of the product in the world market with the
attendant effect of a collapse in the world price to a new price P2. At this price, which is
lower than the free trade world price Pm, the exporters excess supply has shrunk (in
Panel C) G1N1 to C1D1, so as to much the quota level which is selling at P1 in the
111
importing countrys market as CD. Finally, all the effects are those of the small country
case except, as in the large country tariff case, for the TOT gain e = XEJY and the DWL
in the exporter country of (x + z).
Distribution of the Economic Rent
The problem to be solved regarding the economic rent involves someone (in the small
country setting) buying the quantity q3C3 = C1D1 from the exporter country at the free
trade world price Pm and selling it as C1 q1 = CD at P1 in the importing countrys
market, so that, with per unit markup of P1 Pm, an income is made of the magnitude:
ECDJ q C P P Q P P a
m m
= = ) )( ( ) )( ( ] 12 . 6 [
1 1 1 1

In the large country case, the relevant economic rent amounts to:
XEJY ECDJ q C P P P P q C P P b
m m
+ = + = ] )][ ( ) [( ) )( ( ] 12 . 6 [
1 1 2 1 1 1 2 1

Interested parties to this rent include: the importer government; the importer private
agents; the exporter government; and the exporter private agents. The following could be
the options:
(1) Naturally the government imposing the quota may decide to appropriate the
revenue completely, directly through some governmental marketing or
procurement agency, which could be importing the product and selling it in the
domestic economy. There are efficiency questions as to the involvement by a
government agency in what may be purely a private business affair and not an
emergency operation.
(2) The government might extract some portion of the rent by means of: (i)
Auctioning import license at a fee. It is presumed that this will be done
transparently using some pre-set criteria and procedures. This will involve
incurring some administrative costs. (ii) As discussed below, the government
may use a quota-tariff combination (or tariff rate quota) in order to capture some
revenue.
(3) The importer government may decide to give rights to: (i) its private agents to be
importers under the quota; or (ii) Foreign private agents as exporters under the
quota.
Under options (1), (2) and (3)(i), the domestic importing economy stand to benefit from
the rent and in a large country would be in a position to maximize its welfare in terms of
the TOT gain versus the DWL. Option (3)(ii) would be most preferred by exporters
wishing to be compensated for the TOT loss their country incurs from the quota.
Whichever option is adopted to appropriate the rent, the small country will still be worse
off due to the DWL and in the large country case the world as a whole is a net loser due
to its quota policy. There are other areas of non-equivalence between a tariff and a quota
that are taken up.

112
Quota versus Tariff: Further Issues
There other areas in which QRs and tariffs may be non-equivalents and one of these is
evidenced under a market adjustment condition. Under a quota the adjustment process is
through changes in domestic price while in the presence of a tariff this is through a
quantitative adjustment. Let us take the case of an exogenous increase in the demand for
the importable product from D0D0 to D1D1 as shown in Figure 6.11. With an existing
quota of GQ = CD as in Figure 6.10 which raised the domestic price to P1 from the free
trade price Pm, demand expansion will lead to a further rise in domestic price to P3 and
with the same quota CD = G1Q1, there is increased protection of domestic industry by
q1q2, which leads to worsening of the efficiency loss from area GCE to GG1Q. In the
case of a tariff the incremental excess demand is met by further increase in quantity
imported of DN2 = C1C2 without a change in the original tariff-ridden price P1.
From a business perspective, domestic firms will tend to prefer a QR to a tariff. This is
because a quota provides a more assured protection than a tariff. The problem is that a
tariff works through supply and demand elasticities which may be difficult to predict or
costly to investigate as they may be changing over time. In this case protection aganst
foreign competition may not be known with a good degree of certainty. A quota,
however, sends clear quantitative signals on the level of imports that are permitted to
enter the home market and the gap that remains for domestic players to fill. Under a
tariff this gap can easily be filled by competing imports and consumers can easily evade
local products especially if they tend to be more expensive than foreign products. This is
especially true in the case of a domestic monopoly, which is dealt with further in the next
Chapter.
There are pros and cons between QRs and tariffs from a public policy viewpoint. First, it
is more difficult to promote exports under a QR than under a tariff system, and this
especially true under the rebate method on imported materials. Under a tariff the
exporter will simply be reimbursed for paying duty on qualifying imported material
inputs that were used in the production process. A quota will simply raise the price of an
input, which may be difficult to establish for refund purposes, even if a tariff equivalent
is estimated.
Second, however, an import quota has some advantage over a tariff, which deserve
mention. QRs are easier to effect than tariffs, which take time to be effected as they
would normally require legislation, changing customs books, gazetting and might take
tike time to produce results. In the short term, when the gravity of a situation requires
some drastic measure to be instituted quite quickly, the QRs would be appropriate and
more effective in curtailing imports than tariffs, which work slowly through elasticities.
On this score a QR is definitely superior to a tariff. Therefore the relative advantages of
the two instruments need to be carefully evaluated against particular situations and
conditions that have to be redressed.
Third, however, a QR is more amenable to breeding corruption than a tariff. The
potential for reaping monopoly rents puts heavy pressure on import licenses and raises
their value. Potential importers can use whatever means in order to a license even if it
113
means illegally paying (bribing) the officials for it. Further, the administrative allocation
of licenses may be quite arbitrary. The competition for such economic rents leads to
what has been termed rent seeking behaviour, or in a culture practice as a rent seeking
society.
From an efficiency viewpoint, what emerges from the preceding discussion is that
whereas and import tariff distorts the free functioning of international commodity
markets, a QR completely blocks that market system. While a tariff is transparent and
leads to distorted prices and deadweight loss, there is still, albeit diminished, market
allocative mechanist taking place regarding the flow of commodities and therefore some
market-determined efficiency is preserved. A QR introduces further inefficiencies and
costs above the DWL that is associated with a equivalent tariff. Therefore from the
resource allocation standpoint, a tariff may be preferred to a QR import regime. This is
why in trade liberalizations QRs, which tend to be hidden, tend to be eliminated and/or
converted into tariffs, which are more transparent. This process, whereby QRs are
converted into their tariff equivalents, is known as tariffication.
Voluntary Export Restraint
A voluntary export restraint (VER), also known variously as a voluntary restraint
agreement (VRA) or an orderly marketing arrangement (OMA), is a QR by which the
government of an importing nation secures a voluntary commitment from some foreign
government by which the latter government undertakes to restrict its nations export
volume into the importing nations market. The term voluntary in this context is a
misnomer because traditionally the government of the importing nation initiates the
restraint from a position of political-cum-economic strength, which is supported with
quite a substantial leverage of coercion over the exporting nations government. A VER
is an import quota from the importing nations point of view but administered by the
exporting nations government as an export quota.
The primary objective of a VER is to protect an industry in the importing country and it
may be targeted only at major sources of export that are perceived to be causing injury to
that home industry. A key motive for taking recourse to a VER by the initiating
government is to avoid being seen to contravene some multilateral trade rules if some
other protective instruments were instead used. But why should foreign governments be
voluntarily willing to accept and comply with a VER? Several factor explain why
exporters cow down to the demands of VERs. First, with threats from the importer
government to use more restrictive trade measures, exporters may find a VER to be a
necessary and lesser evil. Second, it is better to be an open insider than an outsider for
purposes of maintaining some market share and leaving the option to subsequent
negotiations. Third, and very attractively, is the advantage of reaping the quota rents to
the benefit of the exporting country. By administering the license, exporters will be
supplying to the VER-imposing country market t higher prices than those prevailing in
VER-free markets, thereby appropriating the quota rent. This is a redistributive effect
and a source of TOT gain from the importing country to the exporting countries, which
tends to dilute the TOT arguments for protectionism by a large country.
114
As with many trade instruments, suppliers tend to find loopholes in order to circumvent a
restriction. It has been found that in order to extract even higher premiums from a VER,
exporters have used a practice known as quality upgrading to shift the quota mix by
increasing products in the same industry which have are of higher quality and reducing
those similar products of lower quality. This is because a VER is not stated in monetary
terms. In other situations, a market access restriction such as a VER, has been an
inducement to MNCs to jump over the VER barrier by moving to establish or increase
production capacity within the country imposing the barrier.
6.4 Measurement of Protection
So far we have looked at various measures a government can use to achive whatever
objective in order to influence production, consumption and trade. The impact of these
measures needs to be conveniently summarized in some index in order to capture the
extent or degree of government intervention. For now we shall briefly review the
concepts of nominal protection rate and the effective rate of protection. A common
objective of these indexes is to compare the extent of divergence between free-trade or
world prices, Pw, and domestic prices, Pd, which are influenced or distorted by
government intervention instruments.
Nominal Protection Rate
The nominal protection rate (NPR) for a commodity of industry j is the percentage
deviation of the domestic price over the free-trade price. In the small-country case with
an import tax, the NPR will be computed as:
100 100
mj
mj mj j
mj
mj dj
j
P
P P t
P
P P
NPR

=

=
The world price is the border or landed price valued on cif basis net of any domestic
distortions. A related index is the nominal protection coefficient which is defined as:
NPC
j
= P
dj
/P
mj
. With this the nominal protection rate can be re-expressed as: NPR =
(NPC 1)100. Let us use an obvious example to illustrate this index. Let the border
price of a dress be P*
m
= US$55.00, the exchange rate be E = K150.00/US$, then the
free-trade price is Pm = E P*m = K8,250.00. With the prevailing ad valorem duty of t%
= 120% or t = 1.2, the domestic retail price (without profits and other charges) is Pdt =
K18, 150.00. The NPC = K18,150.00/K8250.00 = 2.2, while the NPR = ((18,150
8250)/8250)100 = 120%. We said obvious example because the NPC happens to be (1 +
t), which is the absolute wedge between the world price and the domestic price due to the
customs duty rate, while the NPR is simply the duty rate itself. The advantage of this
approach, however, is that by comparison of some estimate of the world import price and
the observed domestic price for a given product, one can get an estimate of the NPR
which captures distortions not only due to tariffs but also due to non-tariff measures such
as subsidies, quotas, VERs, and other sources of distortions. In this sense the NPR is an
indirect way of getting the tariff equivalents or tariffication of these non-tariff measures.
115
In the case of large country, the appropriate border price is the landed price adjusted by
the coefficient of the own-price elasticity of import supply calculated as:
m
sm
m
P P
|
|

\
|
+ =

1
1
This marginal import price will be equal to the border price in the small-country case for
an infinite import supply curve, but will be greater than Pm for relatively less elastic
supply conditions. This will be translated into lower NPRs than in the small-country
case.

Effective Protection Rate

The concept of effective protection takes into account input taxes in addition to taxes on
final product in order to understand the extent of protection accorded an industry. In this
sense it uses more information than the NPR which is based exclusively on the tax on a
given product without consideration of the tax structure an industrys value chain. The
point of departure for the concept of effective protection is that a nominal tariff rate on an
imported item as published in customs documents does not indicate the degree of
protection given to domestic production activities or value added. This is done by the rate
of effective protection (REP), which in essence may be defined as the percentage increase
in domestic value added made possible by the tariff structure (that is, tariffs on both the
final product and on imported inputs), compared to a free-trade situation. An import tariff
on the final product protects domestic import competing industries while an import tariff
on imported inputs taxes the users of these inputs by raising their cost. Effective
protection finds the net result of these two duty effects.
In order to derive an expression for the REP we need to define value added at free trade
prices and value added at domestic prices. Starting with the former, the gross value of a
traded product Q of industry j, produced by factors of production labour ,L, and capital,
K, and intermediate inputs of components, Fi, measured at international prices without
government intervention can be defined as:

=
+ = + + =
n
i
n
i
ij i j ij i j j j j
F P IVA F P rK wL Q P
1

In turn value added at international prices can be stated as:

= + =
n
i
ij i j j j j j
F P Q P rK wL IVA
Dividing through by Qj we obtain free-trade unit value added as:

116

= + =
n
i
ij i j j j j
a P P rk w iva
Where and k are physical labour and capital technical coefficients, respectively,
required to produce a physical unit of output Q in industry j, and a
ij
represents the
intermediate input coefficient of material input i.
Value added measured at domestic prices takes into account effects of trade intervention
instruments on the prices of goods produced and inputs. Assuming the tariff is the only
intervention instrument and t
j
and t
i
are ad valorem import tariffs on the final product of
industry j and input i, then the tariff-inclusive domestic value added per unit of output
would be:

+ = + + =
ij i i ij i j j j ij i i j j j
a P t a P P t P a P t P t dva ) 1 ( ) 1 (
Since the effective rate of protection measures the excess of domestic value added over
the international value added, with substitutions and rearrangements of terms its formula
can be expressed as:

=
ij
ij i j
ij j j
ij i i j j
j
j j
j
z
z t t
a P P
a P t P t
iva
iva dva
REP
1

The last term on the right has been derived by dividing through by Pj, so that
j
ij i
j
ij
j
i
ij
P
a P
Q
F
P
P
z = =
which is the share of expenditure or cost of input i in the production of output Q in sector
j. This means that international prices are normalized at unity in the last case of the
formula.
In order to concretize our grasp of this formula, let us use our previous example of a dress
with the addition of the following information: To produce one dress requires the use of 2
metres of imported cloth at K40 per metre, 10 metres of thread at K5 per metre and 4
buttons at K10 each; further, the import duties on these inputs are 10%, 5% and 2%,
respectively. We shall use the expression for the REP which contains the a
ij
s. To
calculate the free-trade unit value added, the free-trade input cost per dress is: (K40)(2) +
(K5)(10) + (K10)(4) = K170. Then the iva = K8,250 K170 = K8,080. We know that
tjPj = 1.2(K8250) = K9900 and the value of inputs with taxes is: (0.1)(K40(2) +
(0.05)(K5)(10) + (0.02)(K10)(4) = K11.2. This gives the numerator as K9900 K11.2
K9898.8. Therefore, the REP = (K9898.8/K8080)100 = 122.4%. This means that import
taxes on both the finished dress and its inputs has increased domestic VA or the return to
domestic factors of production by 122.4% over IVA. In this example, it turns out the
REP is slightly greater than (or roughly equal to) the nominal tariff on the dress. If we
define the effective protection coefficient as: EPC = dva/iva, and REP = (EPC - 1)100,
117
you can verify that the EPC can be recovered as 2.224, again which is almost equal to
NPC. We next provide explanation of the factors that lead to various scenarios of the
magnitudes of the REP.
In this regard it should be observed that the formula for the REP is expressed as a
function of nominal tariff on the final product j, nominal tariffs on inputs, and on the
input-expenditure share z
ij,
which also embodies intermediate input coefficient a
ij
. The
relationship between effective protection and these variables is demonstrated for a single
input in Table and the results indicate that: (1) When the tariff on the final good is
greater than the nominal tariff on an input, then the rate of effective protection will be
positive and greater than the tariff on the final good. This is case I of the Table. Another
way of stating this is that when the nominal tariff on the final good rises faster that the
input tariff the REP will increase, meaning that protection accorded to domestic industry j
will increase as DVA
j
rises faster than IVA
j
. (2) The case of a uniform or neutral tariff
structure is when the levels of nominal tariffs on the final product and inputs are equal,
which makes the REP equal to the nominal tariffs. This is Case II. This also means that a
uniform rise in both nominal tariffs leaves the ERP
j
constant. (3) When the nominal tariff
on the final product is less that the one on the input, then the REP will be positive but less
than the tariff rate on the final product. Case III is not protective of the domestic
industry. This case reveres the result in (1), in that a higher increase in the input nominal
tariff rate than in the final product nominal rate would reduce ERP
j
and expose the
domestic industry more to international markets as DVA
j
moves closer to IVA
j
.

Table comparison of nominal and effective protective rate (one intermediate input)

Case t
j
t
i
z
i
z
i
t
i
(1- z
ij
ERP
ji
Evaluation
I 80% 20% 0.6 12% 0.4 170% t
j
> t
i

ERP
j
> t
j
> t
i

II 20 20 0.6 12 0.4 20% t
j
= t
i

ERP
j
= t
j
= t
i

III 16 20 0.6 12 0.4 10% t
j
< t
i

ERP
j
< t
j
< t
i

IV 80 20 0.4 8 0.6 120% a
ij


z
ij

ERP
j

V 10 20 0.6 12 0.4 -5% t
j
> t
i
z
ij

ERP
j
< 0

(4) A reduction in the intermediate input expenditure share, zij, reduces the rate of
effective protection and vice versa. This is shown by comparing Cases I and IV. A
reduction in z
ij
as can be deduced from its definition could be due to improvements in
technology as represented in a reduction in the technical coefficient aij or an increase in
the world price of the product relative to prices of inputs, Pi/Pj, thereby increasing
efficiency and competitiveness, which will be reflected in lower effective rate of
protection. (5) A negative effective rate of protection means that domestic activity or
value added (sum of factor incomes) in the industry concerned is actually taxed instead of
being protected. This will result when: (a) the numerator of the formula is negative; that
118
is, if t
j
<

t
i
z
ij,
indicating that tariffs increase the cost of the inputs by a larger monetary
value than the increase in the price of the final product: either ti or inefficiencies, z
ij
, are
so high that the product t
i
z
i
outweighs the nominal tariff on the final product; or (b) z
ij
>
1, indicating that the value of imported intermediate inputs is greater than the value of the
final product at world prices.

Some Policy Implications of REP
Calculations of the REP has important implications to trade policy analysis and in trade
negotiations. First, it formalizes calculations which nominal tariff policy making
exercises use informally in deciding upon applications from various domestic industries
for protection. Second, it explains the cascading or escalating nature of nominal tariffs.
Tariff escalation refers to the commonly observed structure of tariffs which involves
levying lower nominal tariffs on inputs than on finished products (Case I in Table); that
is, the average level of nominal tariffs for each commodity class tends to be increasing
function of the stage of manufacturing. For example, since the end of WWII most LDCs
embarked on import-substitution industrialization under heavy tariffs using the infant-
industry argument. The concept of effective protection has been very instrumental in
revealing the degree of this protection and whether the manner in which resources have
been allocated has been efficient. The cascading tariff structure would tend to discourage
the domestic production of intermediate inputs. As another example from a
developmental point of view, the analysis of REP has revealed that a cascading tariff
structure in industrialized countries has been targeted at products in which LDCs tend to
have comparative advantage, which the latter claim discourages export-oriented
industrialization in these generally poorer countries. This is why (as shown in Chapter
11) international negotiations about tariffs reductions, the aim is to ensure that reductions
in nominal tariffs leads to reductions in the effective rates of protection in products of
interest to LDCs.

Some problems encountered in calculations of ERP

Here only three such problems are mentioned. (i) Aggregation Problems: There exists
the problem of finding theoretically sound averages of nominal tariffs for a group of
commodities belonging to a statistical class of an industry in the customs data. It is a
question of choosing to use one of the averages -- simple mean, medium or weighted
average of the rates. In practice researchers often choose averaging methods for practical
convenience on the assumption that the results are not significantly sensitive to the
averaging method chosen. (ii) Technology: In the real world the technologies keep on
changing so that a
ij
s may be constantly changing over time and across countries at a
particular period. This makes comparisons across countries and over time difficult. (iii)
ERP only uses ad valorem tariffs and all non-tariff barriers or restrictions on trade are not
included in formula. However, specific duties would have to be converted to their ad
valorem equivalents (AVEs). Most NTBs are not amenable to quantification so that ERP
may understate the degree of protection accorded to domestic production. It is, therefore,
necessary to bear in mind the existence of these NTBs in deciding the degree of
protection.
119
6.5 Quantitative Restrictions in Global Trade: The Role of Safeguards
As we have seen in the preceding sections, trade restrictions imposed by governments are
aimed at protecting their domestic producers against competition emanating from foreign
goods. Under certain circumstances domestic companies lobby their governments to
increase that protection by using trade laws that provide for remedial actions. Such trade
remedies are in the forms of safeguard measures, anti-dumping duties and countervailing
duties. The latter two measures address alleged unfair pricing practiced by foreign
companies which may have some detrimental effects on domestic companies. In the case
of anti-dumping duties the domestic firms claim that foreign competitors are charging
unfairly lower prices in the export (domestic firms) market than in the export-originating
markets and the target of the allegation is the foreign producer or supplier. In the case of
countervailing duties the unfair pricing is attributed to the provision of unlawful or
improper subsidies to foreign competitors by their governments and so the allegations are
directed to those governments. These two trade practices are taken up in Chapters 7 and
8, respectively. The focus here is to understand some basics of the role of safeguard
measures in regulating international trade. Unlike anti-dumping and countervailing
measures which address unfair trade practices, safeguards are emergency measures
designed to arrest a sudden upsurge of imports which, whether fairly or unfairly
conducted, are deemed to be destructive to a domestic industry, and the government is
called upon to impose some measures, such as tariffs and NTBs, as remedies or for relief.
The WTOs multilateral arrangement on trade in goods generally forbids the use of QRs
in international trade but then attempts to regulate their application by governments. We
shall cite the key provisions that regulate the use of QRs and then focus in more detail the
use of Safeguards. The prohibition of QRs is stated in Paragraph 1of GATT (1994) Art
XI (General Elimination of Quantitative Restrictions) as:
No prohibitions or restrictions other than duties, taxes or other charges, whether made through
quotas, import licences or other measures, shall be instituted or maintained by any contracting
party on the importation of any product of the territory of any other contracting party or on the
exportation or sale for export of any product destined for the territory of any other contracting
party.
This general rule is based on the principles we have reviewed as regards the comparative
differences between tariffs and QRs and two of these are that: one, QRs tend to be more
restrictive, introduce more inefficiency, and supplant the functioning of the market
mechanism; and two, that QRs are less transparent, hidden, and less tractable than tariffs.
While the multilateral trade negotiations strive to reduce and remove trade interferences,
it is understood that tariffs, once bound, are easier to monitor and more amenable to
renegotiation for further reductions than QRs. Having recognized these principles, the
WTO provides for exceptions and safeguard provisions to Para. 1, which permit the use
of QRs under special conditions, and three major ones are governed by the follows.
Paragraph 1 of GATT (1994) Art. XII (Restrictions to Safeguard Balance of Payments)
states:
Notwithstanding the provisions of paragraph 1 of Article XI, any contracting party, in order to
safeguard its external financial position and its balance payments, may restrict the quantity or
120
value of merchandise permitted to be imported, subject to the provisions of the following
paragraphs of this Article.
Indeed, a number of conditions are provided in the manner in which this provision is to
be resorted to as we review next. GATT (1994) Art. XVIII (Government Assistance to
Economic Development) exempts LDCs to institute QRs in a flexible manner for
purposes of dealing with BOPs problems in the process of economic development and
promoting particular industries based on the infant industry argument. Articles XII and
XVIII are also governed by the Understanding on Balance-of-Payments Provisions of the
GATT 1994, which provides some operational procedures to be followed when invoking
the Articles. Consultations are handled by the Committee on Balance-of-Payments
Restrictions. As of December 2005 Bangladesh was the only member country of the
WTO that maintained import restrictions for BOPs purposes (WTO, Annual Report 2005,
p. 58).
GATT Art. XIX (Emergency Action on Imports of Particular Products), also known as
an escape clause or safeguards provision, permits member countries to use QRs in order
to get relief from unexpected surges of imports that have potential or are causing serious
injury to specific domestic industry. The operational rules of this Article are provided
for, clarified and reinforced in the UR Agreement on Safeguards (ASG, 1994). The
inclusion of safeguard provisions in the multilateral trading system was influenced by the
United States, which had such mechanisms during the 1930s and Art XIX of GATT was
direct import of the escape clause found in the USA-Mexico Reciprocal Trade Agreement
of 1943. These measures were based on fears that trade liberalization could damage
certain vulnerable or weak industries and therefore these could be given some temporary
relief by invoking contingency measures. In response to concerns about the impending
trade liberalization under GATT (1947), the US legislature (Congress) urged the US
Government to ensure that the escape clause was included in all trade agreements,
including GATT. (Trebilcock and Howse, 1995, p. 163). As we shall see below the
escape clause of the US or Section 201 has been challenged in the WTO Dispute
Settlement mechanism. We now proceed to review the escape clause in terms of its
invocation; determination of serious injury; nature of safeguard measures; application
modalities; duration; surveillance; the Special and Differential Treatment (SDT) status of
developing countries; and dispute resolution.
Invocation of Safeguards
The relevant provision or Escape Clause is paragraph 1(a) of Art. XIX, which states:
If, as a result of unforeseen developments and of the effect of the obligations incurred by a
contracting party under this Agreement, including tariff concessions, any product is being
imported into the territory of that contracting in such increased quantities and under such
conditions as to cause or threaten serious injury to domestic producers in that territory of like or
directly competitive products, the contracting party shall be free, in respect of such product, and
to the extent and for such time as may be necessary to prevent or remedy such injury, to suspend
the obligation in whole or in part or to withdraw or modify the concession. (See also ASG, Art.
2.1).
121
There are two causative factors to invoke the escape clause; namely, unforeseen
developments and the obligations under GATT itself. The latter refers to a countrys
commitments to trade liberalization such as tariff removal or reduction and other trade
barriers, which then lead to sudden or necessarily cause increased influx of imports that
make it difficult for domestic industry to compete during the adjustment period. The
other causative factor of unforeseen developments is not explained and therefore all-
inclusive of any increase in imports, even if through normal changes in international
competitiveness, could therefore be considered actionable under Article XIX.
(Trebilcock and Howse, 1995, p.164).
Definition of Serious Injury or Threat Thereof
A member state has to constitute an investigations authority consisting of competent
authorities who will conduct investigations to establish and determine the extent of
injury. Article 4 of the Safeguards Agreement (SGA) provides for the relevant technical
definitions and guidelines to be followed in the investigations. A serious injury is
defined (in Art 4.1a) as a significant overall impairment in the position of a domestic
industry; and a threat to serious injury is in turn defined (Art 4.1b) as serious injury that
is clearly imminent. A determination of existence of a threat of serious injury must be
based on facts and not merely on allegation, conjecture or remote possibility.
The Locus of Injury. In the determination of injury or threat thereof, a significant
proportion of the domestic industry in question has to be involved. In this context, a
domestic industry is defined to mean the producers as a whole of the like or directly
competitive products operating within the territory of a Member, or those whose
collective output of the like or directly competitive products constitutes a major
proportion of the total domestic production of those products. (Art 4.1 c). The meaning
of the term directly competitive has not yet been settled in the WTO, but countries have
operationalized it in their laws or injury determinations.
Establishment of Injury and Causality Test
The investigations authority has to determine: (1) The extent of injury to the domestic
industry; and (2) The causal link between imports and injury. In order to carry out an
impact assessment on the industry in the determination of injury or threat thereof, the
competent authorities have to evaluate all relevant factors of an objective and quantifiable
nature having a bearing on the situation of that industry, especially including following
non-exclusive set of factors (Art. 4.2a): (a) The extent of import surge as measured by the
rate and amount of the increase in imports of the product concerned in absolute terms and
relative to domestic production. However, the SGA is silent on quantitative thresholds.
In terms of impact assessment of increased imports on the domestic industry, these
factors have to be ascertained: (b) The share of domestic market taken by imports; (c)
Decline in the level of sales by domestic firms and production; (d) Decline in
productivity and capital utilization; (e) Severance in normal profitability and unusual
losses; and (f) Substantial unemployment or job losses and underemployment.
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Causation: For an investigation to be affirmative and an industry to be awarder a remedy,
two criteria have to be fulfilled; that is, the investigation must demonstrate, on the basis
of objective evidence, the existence of a causal link between increased imports of the
product concerned and serious injury or threat thereof. When factors other than increased
imports are causing injury to domestic industry at the same time, such injury shall not be
attributed to increased imports. (Art 4.2b). This is the principle of parallelism, by which
investigators have to establish that no other independent factors other than imports are or
have been responsible for the observed economic and financial stagnation in concerned
domestic industry.
The investigations have to be conducted in a transparent manner such as: (i) Reasonable
public notice to all interested parties and public hearing involving importers, exporters
and other interested parties; (ii) The parties will make presentations in terms of evidence
and views on the matter; (iii) Prompt publication of finding and reasoned conclusions
reached by the authorities on all pertinent issues of fact and law.
Application of Safeguard Measures
A member state may impose safeguard measures as either definitive measures or
provisional measures. Provisional safeguard measures can be imposed before
investigations are concluded based on preliminary determination that, in critical
circumstances...delay would cause damage which it would be difficult to repair,
indicates that there is clear evidence that increased imports have caused or are
threatening to cause serious injury. By preference, the SGA recommends the use of
tariff increases and not to last for more than 200 days, subject to refund should
investigations fail to establish injury. (Art. 6) Once investigations have been concluded
and serious injury has been established to be caused by imports, a member country may
impose definitive safeguard measures, tariffs and/or QRs, in order to bring relief to the
industry concerned but based on certain principles. First, the measures should be applied
to a product being imported non-discriminatively, that is irrespective of its source
(Art.2.2). Second, the measures should be limited only to the extent necessary to prevent
or remedy serious injury. Third, they should facilitate adjustment, meaning that the
measures should assist the injured industry to take structural adjustment such as
technological improvements, rationalizations and/or rationalization of production so as to
enhance its competitive position once the measures expire. Fourth, if a QR is used, such
measure should not reduce imports below the average level of the past three
representative years for which data are available. Fifth, the member imposing the
measures should agree with exporters on the best possible shares or quotas to allocate.
However, in very exceptional circumstance the member may depart from a non-
discriminatory way by selectively targeting restrictions against imports from countries
which have increased in disproportionate percentage in relation to total imports of the
product concerned during a representative period. This, however, has to be implemented
to the satisfaction of the Committee on Safeguards.
Duration and Review of Safeguard Measures. In principle and spirit a safeguard
measure is meant to be applied for temporary periods and the Agreements provisions
regarding duration are meant to prevent abuse and repetitive applications. (Article 7). An
123
initial period of four years is granted and a possible extension, should the case merit, to
give a cumulative maximum of eight years (10 years for DCs). A mid-term review
exercise is to be carried out in order to determine whether measures of over 3 years be
withdrawn or liberalized faster.
Compensations. The Agreement provides for adequate compensation by the country
imposing measures to the exporting countries that have lost market share. Those
countries whose exports have been restricted may take retaliatory action through
suspension of equivalent concessions should an agreement on adequate compensation
fail. But the right of suspension shall not be exercised for the first three years that a
safeguard is in effect, provided that the safeguard measure has been taken as a result of
an absolute increase in imports and that such a measure conforms to the provisions of
the Agreement on Safeguards (Art.8.3).
Developing Country Measures (Art. 9). In the spirit of special and differential treatment
(SDT) status, exports from a developing country Member are exempt from safeguard
measures if its export volume is negligible or de minimis; that is, if it accounts for less
than 3% of the total imports of the imposing country, provided that such countries
collectively account for no more than 9% of the total imports of the product concerned.
Further, instead of a maximum of 8 years for application of safeguard measures DCs are
permitted a maximum of 10 years. In addition, DCs have more flexible latitude to
impose measures than HDCs. (Article 9.2).
Notification and Consultation. A process is established for promptly notifying and
reporting to the Committee on Safeguards at each and every stage a Member state is
pursuing actions related to safeguards. The key stages are: initiating an investigation;
making a finding of serious injury; and taking a decision to apply or extend a safeguard
measure (Art 12.1). Similarly Members are obliged to promptly notify the Committee of
their laws, regulations and administrative procedures relating to safeguard measures as
well as any modifications made on them (Art. 12.7). The Committee on Safeguards
works under the authority of and reports to the Council for Trade in Goods (Art. 13).
Dispute Settlement (Art. 14)
It should be recognized that it is individual governments, through their appointed
domestic authorities, that use their country laws on safeguards to conduct proceedings
leading to the imposition of safeguard measures. These domestic laws should, however,
be compatible or consistent with the WTO multilateral provisions. Consultations and
settlement of disputes arising under the Agreement on Safeguards are governed by and
subject to provisions of Articles XXII and XXIII of GATT (1947) as elaborated and
applied by the WTO Dispute Settlement Understanding (DSU) established in 1994.
Under this multilateral legal framework, member states are first encouraged to engage in
consultations should one member feel that some trade measures or actions taken by
another member are inconsistent with any of the legal provisions of the WTO Agreement.
Should consultations fail to yield amicable solution, then any member may file its
complaint to the Dispute Settlement Body (DSB), which is established under the DSU
(Art. 2) as the administrative authority of the WTO legal system and processes. In trade
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disputes the DSB starts by establishing a panel on the request of a complaining member,
which then reports its findings to the DSB. Any concerned member may file an appeal to
the Appellate Body, which will also make its determination in a report to the DSB.
Thus the initiation of consultations begins when a member feels that its benefits from the
multilateral trading system are being nullified or impaired. This is stated in GATT
Article XXIII (1) as:
If any contracting party should consider that any benefit accruing to it directly or indirectly under this
Agreement is being nullified or impaired or that the attainment of any objective of the Agreement is being
impeded as the result of: (a) the failure of another contracting party to carry out its obligations under this
agreement, or (b) the application by another contracting party of any measure, whether or not it conflicts
with the provisions of this Agreement, or (c) the existence of any other situation, the contracting party may,
with a view to the satisfactory adjustment of the matter, make written representations or proposals to the
other party or parties which it considers to be concerned. Any contracting party thus approached shall give
sympathetic consideration to the representations or proposals made to it.
The consultative process in Articles XXII and XXIII are elaborated in Article 4 of the
DSU where Art. 4.7 provide that:
If the consultations fail to settle a dispute within 60 days after the date of receipt of the request for
consultations, the complaining party may request the establishment of a panel. The complaining party may
request a panel during the 60-day period if the consulting parties jointly consider that consultations have
failed to settle the dispute
We shall use two cases on safeguard disputes in order to gain some useful insights on the
functioning of the WTOs DSU. While in the first case it was a DC that initiated against
another DC, in the second one the battle was among the worlds economic giants, but
including some key DCs.
CASE I: Argentina Definitive safeguard measures on imports of preserved peaches,
complain by Chile (WT/DS238)
This request, dated 6 December 2001, concerned a definitive safeguard measure which
Argentina applied on imports of peaches preserved in water containing added sweetening matter,
including syrup, preserved in any form or in water. According to Chile, Argentinas definitive
safeguard measure was inconsistent with Articles 2, 3, 4, 5, and 12 of the Agreement on
Safeguards, and Article XIX of GATT 1994. At the DSB meeting on 18 January 2002, a panel
was established. Immediately after the establishment, Chile stated that it would not, for the
moment, proceed with the appointment of panelists, as it was still hoping to reach a mutually
satisfactory solution with Argentina. The European Communities, Paraguay and the United
States reserved their third-party rights to participate in the Panels proceedings. On 13 March
2002, Chile informed the Chairman of the DSB that it would like the composition of the panel to
go ahead. On 16April 2002, the parties agreed on the composition of the Panel. On 15 October
2002, the Chair of the Panel informed the DSB that it would not be possible to complete its work
in six months due to the schedule agreed with the parties and that the Panel expected to circulate
its report at the end of January 2003.
On 14 February 2003 the Panel circulated the Report to the Members. The Panel
concluded that the Argentine preserved peaches measure was imposed inconsistently with certain
provisions of the Agreement on Safeguards and GATT 1994. In particular, the Panel concluded
125
that: (a) Argentina acted inconsistently with its obligations under XIX:1(a) of GATT 1994 by
failing to demonstrate the existence of unforeseen developments as required; (b) Argentina acted
inconsistently with its obligations under Article XIX: 1(a) of GATT 1994 and Articles 2.1 and
4.2(a) of the Agreement on Safeguards by failing to a determination of an increase in imports, in
absolute or relative terms, as required; (c) Argentina acted inconsistently with its obligations
under Article XIX:1(a) of GATT 1994 and Articles 2.1, 4.1(b) and 4.2(a) of the Agreement on
Safeguards because the competent authorities, in their determination of the existence of a threat
of serious injury did not: (i) evaluate all factors having a bearing on the situation of the domestic
industry, (ii) did not provide a reasoned and adequate explanation of how the facts supported their
determination; and (iii) did not find that serious injury was clearly imminent. The Panel did not
find that Argentina acted inconsistently with its obligations under Articles 2.1 and 4.1(b) of the
Agreement on Safeguards by basing a finding of existence of a threat of serious injury on an
allegation, conjecture or remote possibility. The Panel exercised judicial economy with respect to
all other claims.
At its meeting of 15 April 2003, the DSB adopted the Panel Report. On 27 June 2003,
Argentina and Chile informed the DSB that they had agreed that the reasonable period of time
would run until 31 December 2003.
At its meeting on 23 January 2004, Argentina announced that the safeguard measure at
issue had been withdrawn on 31 December 2003 in line with the agreement reached between
Argentina and Chile and thus in its view it had implemented the DSBs recommendations. Chile
welcomed the withdrawal of the measure by Argentina. (WTO Annual Reports 2003, pp. 103-
104; 2004, pp. 56-57).
CASE II: United States Definitive safeguard measures on imports of certain steel
products, complaints by the European Communities (WT/DS248), Japan (WT/DS249),
Korea (WT/DS251), China (WT/DS252), Switzerland (WT/DS253), Norway (WT/DS254),
New Zealand (WT/DS258) and Brazil WT/DS259)
In this case there were eight co-complainants and the dispute concerned definitive
safeguard measures imposed by the US, effective 20 March 2002, in the form of duties on various
steel products and a tariff rate quota on steel slabs, making a total of ten such measures. Further
to individual requests for the establishment of a panel submitted by the eight complainants, the
DSB, at its meetings between 3 and 24 June 2002, established a single panel, in accordance with
Article 9.1 of the DSU and pursuant to an agreement between the parties to the dispute. Members
that had reserved their third-party rights before the various Panels, namely Canada, Chinese
Taipei, Cuba, Malaysia, Mexico, Thailand, Turkey and Venezuela, were considered as third
parties before the single Panel.
The Panel circulated its Reports to Members on 11 July 2003 in which it concluded that
all ten of the United States safeguard measures at issue were inconsistent with at least one of the
following WTO prerequisites for the imposition of a safeguard measure: lack of demonstration of
(i) unforeseen developments; (ii) increased imports; (iii) causation; and (iv) parallelism. The
Panel therefore recommended that the DSB request the US to bring the relevant safeguard
measures into conformity with its obligations under the Agreement on Safeguards and GATT
1994.
On 11 August 2003, the US notified its decision to appeal to the Appellate Body certain
issues of law covered in the Panel Report and certain legal interpretations developed by the Panel.
In its Report circulated on 10 November 2003, the Appellate Body upheld all the Panels
126
conclusions on all ten products for unforeseen development, increased imports and parallelism,
but it reversed the Panel on one set of conclusions relating to the decision-making process of the
US International Trade Commission when dealing with tin mill and stainless steel wire. It also
decided that it was not necessary to examine the other claims of causation. Therefore these ten
measures were found to be inconsistent with Article XIX of the GATT 1994 and the Safeguard
Agreement on other grounds. The Appellate Body neither upheld nor reversed the Panels
findings on the causal link between increased imports and serious injury for seven of the ten
safeguard measures, as it was unnecessary to do so to resolve the dispute.
At its meeting on December 2003, the DSB adopted the Appellate Body Report and the Panel
Reports, as modified by the Appellate Body Report. At the same meeting, the US informed
Members that, on 4 December 2003, the President of the United States had issued a proclamation
that terminated all the safeguard measures subject to this dispute, pursuant to section 204 of the
United States Trade Act of 1974. (WTO Annual Report 2004, p.59).






















127
CHAPTER 7

TRADE AND POLICY UNDER MONOPOLISTIC MARKETS

7.1 Monopoly Maximization Behaviour
7.2 Trade Policy under Monopoly
7.3 Trade in Differentiated Products
7.4 International Price Discrimination and Dumping in World Markets

Monopolistic markets in the context adopted in this Chapter will refer to the cases of pure
monopoly and monopolistic competition. The single-firm industry of monopoly in
selling, or its counterpart of monopsony in purchasing, is the extreme opposite market
structure to the perfect competitive market model that has been our pre-occupation for the
last six Chapters. Unlike under perfect competition in which each of the numerous
atomist firms is a price taker facing a perfectly elastic market demand curve, a
monopolist is a price-fixer who is endowed with substantial discretion to move along its
downward-sloped demand curve in order to maximize its profits. Monopolistic
competition combines features of both monopoly and perfect competition in terms of
pricing behaviour and the atomist non-interdependent environment characteristic of
competitive firms. However, while under monopoly there is a single firm and a
homogeneous product, under monopolistic competition there are several firms producing
differentiated or groups of products. This Chapter reviews trade policies under the two
market structures, starting with monopoly.

The sources of a monopolist's market power are market entry barriers, which emerge or
are erected because of technological, managerial or locational/strategic advantages that
are buttressed by legal protection. At the technological level, an invention or a new
product a pioneer firm may be impossible to technologically replace by other firms
during some reasonable period. In other situations one firm may have access to a
strategic resource which deters other firms to produce a similar product that uses that
input. Yet at another level a firm may have attained a certain scale of operation by
gaining significant economies of scale which makes new entrants inefficient and
therefore uncompetitive. Managerial acumen is another factor that may allow a firm
which has talented individuals to be continually at the frontier on the market place to the
frustrations of any potential followers. However, as we saw in the case of product cycles
these sources of barriers to entry may not be sustainable in the medium to long term as
other firms or individuals strive to imitate the invention or product of the pioneer firm
and contest the monopoly rents. It for these reasons that pioneers, whether individuals or
firms, seek legal protection against potential competition in order to earn sufficient
compensation from their ingenuity or innovativeness, called intellectual property or
intangible assets. As a result countries have developed a system of intellectual property
rights, which are a set of laws or legal instruments that confer exclusive or monopoly
rights over the use of innovative and creative works. These legal instruments include
patents, copyrights, trademarks, trade secrets, etc. A patent confers exclusive right for
the use of an invention of a new product or a process. Copyright laws grant protection to
authors, artistic and others for their original intellectual creations or works which include
128
literally works, musical works, works of art, maps and technical drawings, photographic
works, motion pictures, computer programmes, and multimedia products. Trademark law
protects the use of a trademark, a distinctive sign or symbol which distinguishes a
product of a given firm from similar products of other firms so that consumers are not
confused. A geographical indication, as discussed in detail in sub-section 7.3.3, is a
special type of a trademark which distinguishes a product by the region of origin.
Intellectual property rights form a substantive presentation in Chapter 14. This Chapter
will discuss GIs as a case study of trade policy in differentiated goods.

7.1 Monopoly Maximization Behaviour

We develop a general model with which to characterize this monopoly behaviour in
product markets. Side by side with the general formulations, we use linear specifications
in order to show some solutions. The industry quantity demanded is a negative function
of its own price; that is:

0 , , 0 ) ( , ) ( ] 1 . 7 [ > < = = P Q P P Q Q a

When converted into its inverse demand function, we get:

0 , , 0 ) ( , ) ( ] 1 . 7 [ > < = = = b a Q P bQ a
Q
Q P P b

This is plotted in Figure 7.1 as downward-sloped curve aD, which has slope:
0 ) ( / < = Q P dQ dP or . / b dQ dP = The total revenue function to be used is specified
as:

bQ a MR bQ aQ P Q P TR 2 ; ) ( ] 2 . 7 [
2
= = =

In panel A of the Figure 7.1 the MR curve is plotted with half the horizontal distance
from the demand curve. The total cost function is stated as:

) ( ), ( ] 3 . 7 [ Q c MC Q c TC = =

Then the total profit function to be maximized is of the form:

) ( ) ( ] 4 . 7 [ Q c Q Q P TC TR = =

The general first order condition (FOC) for profit maximization is:

0 ) ( ] ) ( ) ( [ ] 5 . 7 [ = + = = Q c Q Q P Q Q P MC MR
dQ
d
a



Since Q' = dQ/dQ = 1, we can re-write this FOC as:
129
MC Q dQ dP P MC Q Q P Q P MC MR b = + = ] ) / ( [ ] ) ( ) ( [ ] 5 . 7 [

In order to get the last expression for MR we have used the following substitutions: P' =
dP/ dQ < 0 and P(Q) = P. Further, MR can be expressed in terms of the own-price
elasticity of demand from [7.1b] so that: ). 1 1 ( ) (
d
P Q dQ dP P = We therefore have
an expression for the FOC for profit maximization of MR - MC expressed as:

MC P MR c
d
=
|
|

\
|
=

1
1 ] 5 . 7 [

Under perfect competition each atomistic firm faces a horizontal or a perfectly elastic
demand curve with
d
, so that the FOC in [7.5c] reduces to P = MR = MC; in this
case the MR is equal to the average revenue as TR/Q = a - bQ in [7.2], so that the
competitive equilibrium price can be solved as:

MC bQ a P
c
= = ] 6 . 7 [

The equilibrium output level for a single competitive firm is then solved as:

b
c a
q
ci

= ] 7 . 7 [

For symmetric n competitive firms, the industry total equilibrium output will be Q
c
=
nq
ci
. In Figure 7.1 the competitive solution is at point C with horizontal line Dc as the
demand curve, which intersects the upward-sloped MC curve so that P
c
is the
competitive industry price.
Monopoly Solution: A monopolist is a single producer of a given product and has
complete control over the market, so that it can manipulate price depending on the size
of the demand elasticity coefficient in [7.5c]. If the monopolist is facing the upward-
sloped MC curve, its FOC for maximization will be:

0 ) ( 2 ] 8 . 7 [ = = Q c bQ a MC MR

At point A this yields monopoly optimum output

b
Q c a
Q
n
2
) (
] 9 . 7 [

=

Using this monopoly output and its expression in the price equation of [7.1b], then the
monopoly price will be fixed at point N on the demand curve and it can be easily solved
as:

130
2
) (
2
)] ( [
] 10 . 7 [
Q c a
b
Q c a
b a bQ a P
n n
+
=

= =

Solving for price in [7.5c] we see that the monopoly price is determined by the
coefficient of own-price demand elasticity in:

MC MR P
MC MR
P
n n
d d
= >

=
) 1 ( ) 1 (
] 11 . 7 [
1 1



This outcome is only meaningful for 1 <
d
< . In panel A of Figure 7.1, if the
monopolist is facing a rising MC curve, the relevant optimal point will be at A, which
would lead to price solution on the demand curve at N, so that the monopolist's supply is
Q
n
at price P
n
and the mark-up would be P
n
P
0
. This yields maximum monopoly profit
represented by area P
o
P
n
NA = (P
o
- P
n
)Q
n
=
n
. In panel B of the Figure, some
hypothetical TR and TC curves are drawn together with the total profit curve having an
inverted U-shape and total maximized profit is determined by the equalities of tangent
lines to the TR curve at Y and to TC curve at X, at which MR = MC. Total profits are
maximized at the peak of the profit curve, which is associated with the optimal output
Qn, with the height from the horizontal line measuring maximized profits. The unit mark-
up P
n
- Po can be generally defined in terms of the elasticity coefficient as:

< < =

=
d
d
o n
P
MC P
P P

0 ;
1
] 12 . 7 [

This index, which measures the degree of monopoly power (the so-called Lerner Index)
means that monopoly power increases when the market demand becomes less relatively
sensitive to price variations or as the coefficient becomes smaller in absolute terms.

We can compare monopoly solution with the competitive solution as follows. If the
monopolist is facing a constant MC = c as pegged at P
c
, then monopoly equilibrium at E
will yield optimum output which is half that of the competitive industry output:

c n
Q
b
c a
Q
2
1
2
] 13 . 7 [ =

=

From [7.10] monopoly price will be:

2 2
] 14 . 7 [
c a
b
c a
b a bQ a P
n n
+
=

= =

The monopoly price is greater than the competitive price by
). ( ) ( ) (
2
1
2
1
c c n
P a c a P P = =

131
The limit to monopoly power is when the own-price demand elasticity coefficient tends
to infinity, which will make the vertical distance between the demand curve and the MC
vanish, or toward point C. This would collapse to the case of a horizontal demand curve
faced by a competitive firm.

7.2 Trade Policy under Monopoly

In this section trade policy will be covered involving import tariff under increasing costs,
quota versus tariff, rent extraction from a foreign monopolist and under economies of
scale. Trade policy analyses that we carried out under the competitive market structure
of Chapter 6 relied heavily on the concept of the DWL due to imposition of a fiscal
instrument. In the case of monopoly, it should be recognised that the reference to DWL
due to a trade policy instrument emerges over and above the DWL which is due purely to
unrestricted behaviour of a monopolist even when there is no application of a trade
instrument. In panel A of Figure 7.1 this DWL is represented by area ANC, which
consists of two components, ABC and BNC. This total DWL is the welfare loss
associated with the introduction of monopoly as a departure from the competitive
position C.

7.2.1 Effects of Import Tariff under Monopoly: Increasing Cost case

We start with the case of a home monopolist that does not have competitive advantage
when the country opens up to free trade and then illustrate economic adjustments as the
monopolist is accorded tariff protection. Using Figure 7.2 there are two autarky positions,
one is the competitive autarky position at point A, with price P
a
and output produced and
consumed Q
a
. The other one is the monopoly autarky position at N with monopoly profit
maximization at B yielding monopoly price P
n
and output produced and consumed Q
n
. As
the home monopolist has no comparative advantage in the product in question, upon
opening up to free trade the price will settle at P
m
as the domestic free-trade landed
import (world) price. The production effect is reduction in domestic output from Q
n
to
Q
1
, which is smaller than the competitive reduction from Q
a
to Q
1
. With horizontal
supply curve P
m
S
w
, domestic consumption increases as excess demand, EF, for the
product is created at P
m
and is wholly satisfied by imports Q
1
C
1
. As opposed to
production results, consumption increase of Q
n
C
1
under monopoly exceeds the
competitive increase of Q
a
C
l
. However, note that the proportionate decline in price is
greater under monopoly than under competition: P
n
/P
m
> P
a
/P
m
.

Imposition of a unit tariff say t, will raise domestic price by (P
m
+ t) and, for purposes of
subsequent analyses, we can distinguish three scenarios. Adopting the small country
assumption, the first stage is where the tariff raises the domestic price such that it lies
somewhere between the free trade price and the competitive autarky price. Let t
0
be zero
tariff and t
a
be the tariff which raises P
m
to P
a
, so that P
a
= (P
m
+ t
a
). Then the first phase
for our analysis is one whereby any t lies in the range (t
a
- t
o
). Within this range the
monopolist responds just like a in any firm in the competitive market. That is, the
monopolist behaves by setting the tariff-ridden domestic price to marginal cost (P = MC)
along the MC curve in the segment EA. Within this segment the monopolist increases
132
import substitution production from free trade level Q
1
to competitive autarky level Q
a
.
The remaining domestic excess demand for imports disciplines the monopolist to behave
like a competitive firm. Even at its profit maximization point B, the monopolist is
constrained to accept tariff ridden price P
t1
and not P
n
due to excess demand BG.
Consumption, however, progressively falls along the demand curve from F to
competitive autarky level at point A. Point A is significant in that the tariff t
a
= P
a
- P
m
is
the competitive prohibitive tariff that completely wipes out imports and the monopolist
will supplies the entire home market, Q
a
.

The second phase in the analysis is with reference to segment AN along the demand
curve, which is associated with tariff rates that will result in domestic prices being
determined along the P
a
P
n
range, say tariff t
a
= P
a
- P
m
and t
n
= P
n
- P
m
or (P
n
= P
m
+ t
n
),
or tariff range (t
n
- t
a
). Unit tariffs in this range are so protective that the monopolist,
having assumed the whole market, starts to practice restrictive production and
consumption behaviour, which contract from A to N. The potential threat from imports if
the tariffs were reduced still exists and prevents the monopolist from producing at its
unconstrained optimum Q
n
. Tariff t
n
is the monopoly prohibitive tariff rate which accords
the monopolist to produce at the profit maximization point N, at which it would operate
as if unconstrained. Any tariff in excess of t
n
would therefore be redundant or water-in-
the-tariff rate, because the monopolist's incentive to raise the price any more has been
exhausted. Our last phase for analysis is the segment above N whereby the water-in-the-
tariff policy eradicates completely any possible import threat, which brings greatest
comfort to the monopolist.

In conclusion, it can be stated that under import tariff the monopolist behaves like a
competitive firm up to the output level associated with a competitive prohibitive tariff.
Import substitution is accorded by the tariff. However, while a competitive firm cannot
supply beyond its prohibitive tariff t
a
, a monopolist requires more protection in order to
obtain its profit maximization position and this extra protection is in the tariff range (t
n
-
t
a
).

7.2.2 Quota-Tariff Equivalence and Non-Equivalence: Monopoly

Recall that under the competitive market structure a quota and a tariff that result in the
amount of imports equal to the quota have equivalent domestic price, domestic
production, consumption, efficiency loss, consumption loss and therefore DWL. These
two trade policy instruments produce non-equivalence results under monopoly above
those we identified under the competitive market structure. In order to evaluate these
comparative consequences some common basis has to be a priori specified, and these
are: (1) To achieve the same level of imports; (2) To achieve the same level of domestic
production; and (3) To maintain the same domestic price level. These are taken up in that
order.

Same Import Level
Figure 7.3 sets out how a domestic monopolist adjusts to an import quota vis--vis an
import tariff when equivalence is defined in terms of equal import level permissible. The
133
difference between Figure 7.2 and 7.3 is that in the latter the domestic monopolist faces a
residual demand schedule D
n
D
n
and its marginal revenue MR
n
, which are below or to the
left of the total market demand DD, and marginal revenue MR, respectively. If the
monopolist were facing the total industry demand, the optimal profit maximization
condition would be at point B and price at N. The country is initially a net importer and
the landed free trade import price is P
m
at which total consumption is C
l
or P
m
F, which is
satisfied by domestic production of Q
1
(given MC), leaving excess demand Q
1
C
1
= EF to
be satisfied by imports. Imposition of import quota LF Q
m
= induces the monopolist to
calculate its residual demand as D
n
D
n
at each price level. Given the MC curve, the
monopolist optimises at point B
1
and supplies Q
0
, leaving an excess demand at Pm of
Q
0
C
1
= MF. The quota LF only satisfies ML, leaving net excess demand equivalent to the
quota itself LF, which then bids up domestic price to point K on the market demand
curve, DD. There, the price Po is the one set by the monopolist at point J and the quota
exactly satisfies the excess demand of JK, which is beyond the monopolist's output of Q
o

(or P
o
J).

A tariff which can lead to the same import quantity as the quota, is the one which pushes
the monopolist along the MC curve to point H on D
n
at which the monopolist supplies Q
t

and excess demand is met by the quota HG Q
m
= at domestic price P
tl
. The only
equivalence between quota and tariff is in the same quantity imported, equal to the quota
level, as presumed. Non-equivalence is at various effect levels. A quota makes the
monopolist firm to fully exercise monopoly behaviour while a tariff constrains it to
behave like a competitive firm. Consequently, output and consumption are less and price
is higher under a quota than under a tariff. Under a quota monopoly rent is MJKL which
is greater than the government revenue of tP
m
(C
2
Q
t
) = UHGV. The consequent
comparative welfare losses are as follows:

Quota Tariff
Efficiency loss: EB
1
MEHU > EB
1
M by MB
1
HU
Consumption loss: LKF VGF < LKF by LKGV
DWL = EB
1
M + LKF DWL = EHU + VGF

In order to gauge the net DWL we have to assume the same demand elasticities in the
ranges HJ and GK, so that MU = LV. This would make MJHU = LKGV > MB1HU,
which is the net DWL due to the quota. This is over the uncertainty surrounding the
distribution of the quota rent.

Same Domestic Production Level
By equivalent in production means that a quota and a tariff cause the domestic
monopolist to produce the same level of output. In Figure 7.4 this is at point B
1
with Q
o
=
Q
t
. The quota in this case is JK and monopoly price is Po, which gives a higher price rise
of (P
0
-P
m
) than for the tariff tP
m
= (P
t2
- P
m
). The efficiency loss is the same which is
equal to EB
1
M, while the consumption loss is greater for the quota (LKF) than for the
tariff (XGF), so that the net DWL is due to the quota by LKGX, over and above the quota
net rent by BUKT (net of government revenue MB
1
TL).

134
Same Price Level
In the competitive case a quota that yielded an implicit tariff led to the same DWL as for
the equivalent tariff. In Figure 7.5 we have a quota JK which leads to price P
o
equal to the
one produced by a tariff (1 + t)P
m
= P
t3
. While the efficiency loss for the quota is EB
1
M,
this is less than for the tariff of EYW, by MB
1
YW. The consumption loss of KLF is
equivalent for both instruments so that the net DWL of MB
I
YW is due to the tariff. In
this case the tariff is inferior to a quota on efficiency grounds. Note, however, that a tariff
is more protective as a result. Further, the country could be worse off with a quota if the
quota rent of MJKL were appropriated by foreign suppliers as it is more than the
government revenue WYKL plus the net DWL due to the tariff by BUY.

7.2.3 Tariff Imposition for Extraction of Foreign Rents

Since the proliferation of multinational corporations (MNCs), governments have
considered taxation as a means of increasing the spread of benefits to the rest of the
economy from the domestic business conducted by such foreign enterprises. Since direct
taxation of their profits or dividends may raise complications, a government may take
recourse to indirect taxation of the rents through imposition of an import tax. We analyse
some likely effects of such a policy move in the case of a small and a large country. A
key assumption is that there is a foreign monopoly satisfying the whole of our domestic
market only with imports and that the threat of entry is immaterial. Figure 7.6 will be our
reference for analyses.

In the small country case the world supply is given by S
w
at the landed free trade import
supply cost of P
m
. The monopolist equates this price to MR at A and has the market
power to set the price at the domestic demand point A
1
, with the ruling price of P
n
. With
total sales q
n
, the free trade monopoly profit is
F
= P
m
P
n
A
l
A. Imposition of an import
tariff would raise the landed average cost to P
t
by (P
t
- P
m
) = tP
m
. At profi
t
maximization
point B, total sales decline to Q
l
and the tax ridden total profit is

T
= P
t
P
1
B
1
B, which is a
decline from the free-trade level,
T
<
F
, for two reasons: one, due to decline in
domestic (import) sales by ZA
1
AX, and two, because of government revenue, GR =
P
m
P
t
BX = tP
m
(Q
l
). The ensuing DWL is solely due to consumption loss ZB
1
A
1
, since
YZA
1
is a pure trading loss by the monopolist (and not efficiency loss as there is no
corresponding domestic output loss). Since the monopolist captures a new gain of
P
n
P
1
B
1
Z, the condition for the small country to register a net again is such that GR
P
1
P
1
B
1
Z > 0, and exceed the consumption loss, ZB
1
A
l
. This requires that the tax rate
substantially exceed the consequent rise in domestic consumer prices; that is: tP
m
> (P
1
-
P
n
), so that (P
t
- P
m
)Q
l
> (P
1
- P
n
)Q
l
. Such a condition would be satisfied if the domestic
demand curve were not too convex in the relevant ranges.

A large country would exercise its monopolistic power over the foreign monopolist and
would seek to impose an optimum tariff akin to the one we encountered under perfect
competitive conditions. To do this the government would impose a tariff of CC
1
or (P
2
-
P
3
), which would lead to further contraction of domestic sales to Q
2
and to the following
redistribution effects:

135
Consumer surplus: -(P
n
P
2
C
1
A
1
)
Government revenue: P
3
P
2
C
1
C
Monopoly loss to GR: P
3
P
n
VC (TOT gain shifted in favour of
home taxpayer)
Consumption distortion: -(VC
1
A
1
= (DWL)
Net national maximized gain (if): P3Pn VC - DWL > 0
Reduced monopolist profit left: Pm P
3
CD

A powerful result is the potential for even a small country to have some capacity to
extract some rent from a foreign firm.

7.2.4 Monopoly and Trade Policy under Economies of Scale

The concern here is to analyse two traditional cases of how to assist an uncompetitive
monopolist so that it can stand on its own in the domestic economy or penetrate the
export market using tariffs or subsidies under conditions of economies of scale. An
objective of relevance here would be to create a monopoly for purposes of undertaking an
import substitution (IS) strategy or more specifically, an IS industrialization (ISI)
strategy. The ISI strategy has been advocated and pursued by followers of the British
classical industrial revolution and in contemporary times by DCs since the 1950s. We
start with the case of a tariff using Figure 7.7. Initially domestic demand is FD with its
MR below it, and the structure of production costs for the potential monopolist is given
by decreasing average cost LAC and the MC. The declining LAC curve portrays
economies of scale, which is derived from increasing returns to scale as was
demonstrated in Chapter 3. At the free trade landed cost Pm of imports of the product in
question, domestic production is unviable and domestic demand at A is wholly met by
import volume Q
m
. Cost-benefit analysis, however, indicates that domestic production
can break even at point B, where AC = AR with price P
1
. The right tariff to strike this
break-even position, known as the "made-to-measure tariff (MMT), would be tP
m
= (P
1
-
P
m
). Imposition of this tariff leads to emergence of domestic production of Q
1
as a full
scale IS to meet domestic demand Q
1
at B, with price P
1
.

Key resu1ts from this initiative are henceforth summarized: All imports have been
replaced so that with unit tariff tP
m
there is zero government revenue. Consumer surplus
loss of P
m
P
1
BA has emerged. This is a tax burden on consumers to cover the inefficient
entry of the new domestic producer. To see this, under constant costs, at the free trade
import price, unit fixed cost would be LB at quantity Q
l
, so that TFC would be P
m
P
1
BL
and the bigger the unit fixed cost LB the more inefficient the local producer would need
to be protected (with a higher tariff) at even lower scale of production. Further, a higher
tariff than the MMT, such as (P
2
- P
m
), which takes the monopolist to point N, only
consolidates monopolistic behaviour, thereby leading to higher price, lower output, but at
higher domestic consumer cost (such as GNBH in excess of the MMT). Under economies
of scale, a tariff is antithesis of the popular IS or the infant industry argument.

How about a subsidy? A case may be advanced whereby lump-sum taxes are used to
subsidise the creation of a domestic producer for IS as proposed by Corden (1967). The
full net benefit to a country for opening up to trade before domestic production begins is
136
FAP
m
at the free world supply. A production subsidy per unit of SS
1
at point S expands
demand to Ds and equates MC to MR
s
. This makes the home producer to be competitive
and so output expansion to Q
s
is achieved. With reference to free trade position A, the
cost that emerges when the new domestic producer is supported by the subsidy is under
the MC or CGP
m
, so that the net gain to the venture is adjusted to be: FAP
m
+ GAS -
CGP
m
= FSC. Critically, the subsidy to support domestic production at S is worthwhile if
GAS > CGP
m
. This means that there is some minimum free trade landed unit cost C
m
at
which GAS = CGP
m
and which provides a threshold for subsidization (a made-to-
measure subsidy). One obvious problem with a subsidy under the circumstances is the
question as to when the monopolist will produce at the minimum cost scale in order to
prevent endless drain on public coffers.

7.3 Trade in Differentiated Products

So far we have assumed homogeneous products both under competitive markets and
monopoly.

7.3.1 Monopolistic Competition: Horizontal Differentiates

In this Section we examine a theory of product differentiation or variety that is based on
economies of scale and monopolistic competition. It is therefore imperative that we
review first the behaviour of a firm under monopolistic market structure. As pointed out
in this Chapter's introduction, the market structure of monopolistic competition combines
some features of perfect competition and monopoly. Like a monopolist a firm under
monopolistic competition faces a downward-sloping demand curve for its variety of a
given product and in equilibrium it will also equate MR to MC. In Figure 7.8 this will be
at point A, and the monopolist's price will be fixed at point N on the demand curve D as
P
n
, thereby yielding monopolist's unit rent of AN in accordance with the Lerner index of
market power. According the Chamberline's theory, a firm under monopolistic
competition, just like a competitive firm, also faces competition from other firms but
producing similar products because of free entry and exit, and in the long run profits will
be contested to zero. This means that the price will be determined by the tangency of
demand curve and the long-run average cost curve such as at point N, where LAC = AR.
However, note that with more firms entering the industry with more varieties, demand for
an existing firm becomes more elastic. As shown in the Figure, the demand curve
becomes flatter and the firm's price will decline to P
1
as the demand curve slides along
the LAC curve to point B. This means that the remaining firms tend to exploit economies
of scale for survival in the industry.

The model reviewed here (Krugman, 1979) focuses on horizontal differentiates, and is
based on key symmetry assumptions, namely, that: (a) Consumers value product
differentiation and it is consumers' tastes or love for variety that determine the market
levels of output or demand curves faced by firms producing different varieties; (b) The
technology used to produce each variety is identical; and, (c) Each firm produces a
137
unique but differentiated product and a firm which enters the industry will have to
produce a different variety from those already existing.

Let us start with the demand side of the model. All consumers are assumed to possess
identical utility function for all the varieties. In the consumption of each variety, say C
i
,
the utility function is defined to be well behaved with positive marginal utility and
diminishing marginal utility, such as:

0 ) ( , 0 ) ( ), ( ] 13 . 7 [
1
< > =

=
i i
n
i
i
C U C U C U U

for varieties . , , 1 n i = Given a budget constraint, the first order condition for utility
maximization of a representative consumer is given by:


i i
P C U = ) ( ] 14 . 7 [

where is the Lagrangean multiplier of the constraint. Solving for the optimal price, we
get:

/ ) ( ] 15 . 7 [
i i
C U P =

It is useful to note that differentiation of this gives: . / ) ( / C U dC dP = . Using its
reciprocal and equation [7.14] for P
i
, the own-price elasticity of demand can be expressed
as:

i i
i
i
i
i
i
i
C C U
C U
C
P
dP
dC
) (
) (
] 16 . 7 [

= =

This states that the absolute elasticity of demand coefficient is inversely related to the
level of per capita consumption; thus: 0 / <
i i
C .

On the supply side, an economy is assumed to have a single scarce factor of production,
the labour force, L, to produce a finite number of n unique varieties of product or industry
X. Each firm produces or each variety is produced with identical production function or
identical technology. To produce x
i
units of variety i, requires
i
units of labour, which
in linear form means:

0 , ] 17 . 7 [ > + =
i i
x

This expresses economies of scale in the form of decreasing average cost as:
, / / + =
x i i
x x where
i
x / is decreasing average fixed cost. With total cost function:
138
w x w TC
i i
) ( + = = and revenue function: ,
i i i
x P TR = the total profit function
becomes:

w x x P
i i i i
) ( ] 18 . 7 [ + =

Each firm is a price taker in the labour market so that the monopolistic profit maximizing
FOC of MR = MC can be written, using the expression for the demand elasticity, as:

MC w x P P MR
i i i
= = + = ] 19 . 7 [

The mark-up for each firm in wage units is given by:

< <
|
|

\
|

1 ,
1 1
] 20 . 7 [
1
w
P


This gives an inverse relationship between the elasticity coefficient and the price level,
and since per capita consumption is also inversely related to the elasticity coefficient in
equation [6.16], then price and consumption should be positively related:

0 ) ( ), ( ] 21 . 7 [ > = C g C g
w
P


Market Equilibrium. Under monopolistic competition (by Chamberlinian condition), as in
Figure 7.8, profits are reduced to zero, then by setting the profit function to zero and
solving for the price of each firm or variety we obtain:

x w
P
+ = ] 22 . 7 [

Market clearance for each variety requires that its demand C
i
equal its supply, x
i
. If the
size of the labour force is equal to the number of consumers, then total consumption of
each variety is L.C
i
, so that the market is balanced when:

i i
LC x = ] 23 . 7 [

Substituting this is [7.22], the price equation can be re-written as:

LC w
P
+ = ] 24 . 7 [

This means that there is an inverse relationship between the price and per capita
consumption of a given variety.

139
Autarky Equilibrium. We plot equations [7.21] and [7.24] as done in Figure 7.9. The
curve P
o
P
o
traces the positive relationship between consumption and price of equation
[7.21] while curve Z
o
Z
o
portrays the inverse relationship of equation [7.24]. Autarky
equilibrium is solved simultaneously between these two equations, which is at point A in
the Figure 7.9 yielding wage unit price P
o
/w and per capita consumption C
o
. We can then
solve for the autarky optimal number of firms (varieties) and the size of each firm. The
number of firms is determined at full employment, which is defined in terms of equality
between total industry employment and the labour force. Summing up employment
across all firms using [7.17] and [7.23] for x
i
, we obtain:


= + = + =
i i
i i
L CL n x ) ( ) ( ] 25 . 7 [

Solving for n we have:

L C
L
n
o
o
+
= ] 26 . 7 [

This gives an important result that the number of firms or varieties is positively
associated with the size of the labour force, dn/dL > 0, but negatively related to per capita
consumption, dn/dC < 0. The optimal size of each firm is solved from the profit function
under the zero-profit requirement, so that:

=
) / (
] 27 . 7 [
0
w P
x
o


This yields another important result that the size of each firm (meaning the equilibrium
quantity of each variety supplied) is inversely related to changes in equilibrium price.

Effects of Trade

Suppose now that the world economy consists of two countries whose economies are
identical in utility, production and cost functions that we have developed above.
However, each firm produces a unique variety so that variety groups are different
between the two economies. Opening up to trade means a larger market, which is
determined by a widened number of consumers as measured by a larger labour force.
With foreign labour force of L
f
, then together with home's of L, a total market potential
of L + Lf will be created. The effect of this will be tantamount to growth in the labour
force, and since it enters equation [7.24], the price equation will be:

) (
] 28 . 7 [
1
f
L L C w
P
+
+ =



140
With a constant P
o
P
o
curve, the Z
o
Z
o
curve shifts down and to the left so that the price
level drops for each consumption level. The new equilibrium will be at point B with
lower price level P
l
/w than P
o
/w and reduced per capita consumption level C
1
from C
o
.
(Note that the P
o
P
o
curve is based on a variables own-price demand elasticity. If a
constant coefficient were the case, then the relevant PP curve would have been the
horizontal broken line which passes through points B
1
AA
1
, and although price would not
fall, consumption would fall even deeper). With the decline in price, the size of each firm
(the supply of each variety) increases by equation [6.27]. In the Figure this is the
movement from point B to B
l
, and x
1
> x
0
. However, by gauging from equation [7.26],
the number of firms or varieties produced in each country is smaller with free trade than
in autarky; thus:

) (
;
) (
] 29 . 7 [
1
1 1
f
f
f
f
L L
L
n
L L C
L
n
+ +
=
+ +
=



In the home this is a decline from no to n
l
and in the foreign it must be from nf0 to n
fl
.
The relative extent of decrease in varieties in each country will depend on the country's
population size. For the world, however, the number of varieties supplied with free trade
will be the sum:

) (
] 30 . 7 [
1 1
f
f
f
L L
L L
n n
+ +
+
= +



This states that the number of varieties produced and available to both countries will
increase with free trade. This is because, by equation [7.23], dn/dL > 0, so that the rise in
combined labour force by d(L + L
f
) = L
f
, necessarily means that (n + n
f
) > n. In the home
market, for example, n
1
+ n
f1
> n
0
.

What are the welfare effects? We have seen that the per capita consumption of each
variety declines. However, this is offset by two factors. First, the real wage has risen,
since the decline in the unit wage price P
1
/w is the inverse rise in the real wage, such that
w/P
1
> w/P
0
. This gain is due to economies of scale which have risen with the decline in
unit cost as the size of each remaining in the industry has increased. Second, with the
love of variety, the number of varieties for utility maximization has increased to n + n
f
in
the function:


= = + =
i j
f j i
n j n i C U C U U , , 1 ; , , 1 ), ( ) ( ] 31 . 7 [

The opening up to trade has led to concentration of the industry in each country because
with full employment, labour has been released from closed or taken over firms and re-
deployed into expanded or merged units. This model therefore shows that with identical
tastes, technology and factor endowment, economies of scale give rise to gainful trade of
intra-industry type.

141
Trade Policy in the Krugman Model

The effects of commercial policy in this model are not very obvious. Take the case of an
import tariff. A prohibitive home-imposed import tariff will lead to zero quantity
imported of the product affected. However, a non-prohibitive tariff will lead to higher
prices of the imported varieties, reduced consumption of them, but increased
consumption of home varieties. This will, however, leave total consumption unaffected.
The number of varieties in each country will be unaffected. The quantity of variety
produced will remain constant in each country, which is made possible by reduction in
consumption levels of the same available varieties in the export markets while increasing
their consumption in their domestic markets. That is, the reduction in home consumption
of foreign varieties affected by the tariff will be exactly matched by an increase in
consumption of home varieties. The reduction in consumption of foreign taxed varieties
will create excess supply in the foreign country, which will be cleared by reduction in
foreign consumption of home varieties there as reduced by their higher demand at home.
However, consumers in each country will be worse off as their free-trade optimal variety
bundle combinations will have been distorted. In the tariff-imposing economy the
revenue effect may outweigh the consumption loss, while the exporting country of the
taxed varieties will experience an absolute net welfare loss (see Gros, 1987).

7.3.2 The Falvey Model: Vertical Differentiates

Falvey (19) proposed a model of intra-industry trade based on product differentiation
using the standard HO assumptions of two countries, CRTS, competitive markets, factor
availability and factor intensity. However, the model departs from the HO model in that
it presupposes some specific factors and some mobile factors, and is applied to
differentiated products of a vertical differentiation type, such as shoes of different
quality, ranging from low to high quality; or from plastic shoes to genuine leather shoes.
But a critical hurdle to deal with is to define quality.

In the model quality is defined in terms of the degree of factor content of the specific
factor, here capital - hence the factor-content-quality (FCQ) model, or the neo-HO model.
Each quality of a variety is distinguished by the number of units of capital per unit of
labour, = K/L, so that the higher the relative capital content the more sophisticated or
the higher the quality of a given variety. The quality continuum has a defined range [
min
,

max
]. The demand for a variety is a function of its price and a consumer's income, so that
the more expensive a variety is the less it will be consumed, dx
i
/dP
i
< 0; but the higher
quality variety will be consumed by high income bracket people, and vice versa, dx
i
/dY >
0. The supply side is premised on some simplifying assumptions that lead to defining
comparative cost advantage in quality production. While the mobile factor, L, is in
perfect supply, the specific factor, K, is in fixed quantities in each country. Countries
which are capital rich will specialize in production of superior brands closer to max,
while capital scarce or labour rich countries will be supplying low quality brands closer
to min.

142
Production costs are expressed in terms of the unit cost of producing a given variety.
Given a wage rate, w, and capital rental charge, r, and if one unit of a variety is produced
by one unit of labour and units of capital, then the unit cost of the variety in the Home
and Foreign countries will be:



f f f
h h h
r w c b
r w c a
+ =
+ =
) ( ] 32 . 7 [
) ( ] 32 . 7 [


Let us assume Foreign is capital endowed and Home is labour endowed. Then under
perfect competition, we shall observe that: w
h
< w
f
and r
h
> r
f
, and the unit costs will be
reflected in unit prices of a given variety, such that Home will be a lower cost producer at
low quality ranges while Foreign will be a lower cost producer of top range quality
products. The differential unit costs between the two countries for a given variety will be:

) ( ) ( ) ( ) ( ) ( ) ( ] 33 . 7 [
h f f h f f h h f h
w w r r r w r w c c = + + =

We need to discriminate or demarcate low from high quality ranges. To achieve this let
us assume that there is a special variety of quality
s
, to be known as the marginal variety,
at which the unit costs of the two countries are equalized; that is:

s f f s h h s f h
r w r w c c + = + = ) ( ) ( ] 34 . 7 [

Using [6.32] and solving for the special variety, we obtain:

s
h f
f h h f f h s
w w
r r w w r r a

= = ) ( ) ( ] 35 . 7 [
or:

f h
h f
s
r r
w w
b

= ] 35 . 7 [

We now restate the cost differential by using [7.35a] to substitute for the interest
differential in [6.33] to get:

) ( ) (
) (
) ( ) ( ] 36 . 7 [
h f
s
s
h f
s
h f
f h
w w w w
w w
c c

This expression enables us to classify the ranges of comparative quality specialization
between the two countries as follows:
(i) For any equal to s, c
h
() = c
f
(), the unit costs are equal and therefore
Home and Foreign are equally competitive.
(ii) For any <
s
, ( -
s
) < 0, and the left side of [7.36] will be negative, so that
Home is a lower cost producer in the quality range [
min
,
s
].
143
(iii) For any >
s
, ( -
s
) > 0, the left side of [7.36] will be positive and Foreign
will have comparative advantage in higher quality range [
s
,
max
].

This characterization of comparative advantage is shown in Figure 7.10. Since the
interest rates are the coefficients of the unit cost functions in [7.32], the slopes of the
curves reflect the inequality r
h
> r
f
, so that the Home curve is steeper than the Foreign
curve.

For intra-industry trade to take place there should exist demand for all the qualities in
each country so that when trade begins Home exports less than marginal brands to
Foreign while importing higher than marginal brands from Foreign. The gains derived
from such free intra-industry trade are of the comparative advantage type of increased
consumer welfare from consuming the varieties of consumers choices at lower prices
from cheaper sources.

Theoretically, the FCQ model is important in that by using the HO assumptions, it
explains intra-industry trade when the HO model is intended to explain inter-industry
trade. It also attempts to rescue the HO theory from (or resolves) the Leontief paradox as
the FCQ can be extended to incorporate such other factors as human capital or skills in
explaining why countries over time can move from low-skilled products to high-skilled
products in the same industry. Further, the FCQ model, unlike other product
differentiation models, does not depend on economies of scale and imperfect competition
to explain intra-industry trade. The niche is that the FCQ model explains a trade
phenomenon that the HO was not intended to deal with and explains it without the
assumptions of the new theories of trade, such as the Krugman's that we dealt with above.

Trade Policy in the Falvey Model

Let us assume that Home government imposes a tariff on imports of high quality varieties
from Foreign in a bid to protect its domestic producers of such top quality brands. The
target is to raise the quality range beyond the special quality. The immediate effect will
be to raise the domestic price of the foreign brands at each quality level. Using equations
[7.32b] and [7.35b], we shall have:


f f f ft
r t w t c t c a ) 1 ( ) 1 ( ) ( ) 1 ( ) ( ] 37 . 7 [ + + + = + =

so that:

s
f h
h f
t
r t r
w w t
b >
+
+
=
) 1 (
) 1 (
] 37 . 7 [

Equation [7.37a] leads to an upward shift of the Foreign cost curve as shown in Figure
7.11 and by [7.37b] we see that the post-tax quality level which equates unit costs has
risen above the free-trade marginal quality,
t
>
s
. This means that the products in the
Foreign's quality sub-range [
s
,
t
] are no longer competitive in the Home market, leaving
144
a smaller range [
t
,
max
], beyond point E
1
, which can enter Home market relatively
cheaply. It should be noted that Home consumers are facing higher prices for both Home
and Foreign varieties beyond the marginal variety. This implies that consumers will be
worse off in the Home country in favour of local producers.

Measurement of Intra-Industry Trade

Calculations of intra-industry trade (intra-IT) are based on variants of the Grubel-Lyoyd
indices and a popularly used version is presented, for product j and country h, as follows:

( )
1 0 , 1 1 ] 14 . 5 [ =
+

=
+
+
= GL A
M X
M X
M X
M X M X
LG
jh
jh jh
jh jh
jh jh
jh jh jh jh
jh


The fraction A
jh
= |X - M|/ (X + M) turns out to be a measure of intra-IT first suggested
by Balassa (1966), which, as can be verified, is inversely related to the GL index. The
GL index will be zero if either X or M assumes a minimum value of zero, because in that
case the A
jh
term will be unity, which will be the case of no existence of intra-IT. The
extreme case of perfect intra-IT will be when the GL index equals unity, which will be as
a result of equality between X and M, or if |X - M| = 0, so that A
jh
equals zero. This
means that, the smaller the absolute trade balance on a product is, the greater the extent of
intra-IT will be. Table 5.3 reports for a given calculated Balasa and LG indexes for
textiles and clothing, respectively, for the period 1990-2004. It can be observed that the
trade positions were both in surplus, but more balanced in textiles than in clothing. As a
result the country recorded substantially more intra-IT in textiles than in clothing. In
addition, there was marked shift away from intra-IT especially from mid-1990s,
indicating for this country an aggressive move to export orientation.

Table 5.3 : Measurement of Intra-Industry Trade
year xhj mhj xhj-mhj

Xhj+mhj Balasa (Aij) GL
1990 7219 5292 1927 12511 0.1540245 0.8459755
1995 13918 10914 3004 24832 0.1209729 0.8790271
2000 16135 12832 3303 28967 0.1140263 0.8859737
2004 33428 15304 18124 48732 0.3719117 0.6280883
1990 9669 48 9621 9717 0.9901204 0.0098796
1995 24049 969 23080 25018 0.9225358 0.0774642
2000 36071 1192 34879 37263 0.9360223 0.0639777
2004 61856 1542 60314 63398 0.9513549 0.0486451
Note: Calculated from: WTO, International Trade Statistics (various
issues)






145
7.3.3 Asymmetric Information and Quality Protection: The Case of Geographical
Indications

In ordinary commerce we are familiar with brand names and trademarks which are used
by producers to ensure that their products are readily and easily recognisable and
identified by consumers. These brand names and trademarks are designed to prove
information or market signals about the particular characteristics or attributes of the
goods concerned. Geographical Indications (GIs) are a special type of branding or
trademark in that the identity of a product characteristic is derived from the geographic
origin of that product, which seeks to provide a market signal or correct information
about the quality of the product. While legal protection is accorded such products at the
domestic level, international agreements have been sought in order to protect such goods
from international free riders that might profiteer by using a GI when the original users
have invested heavily in establishing a distinctive quality of their product in the market
place. We here now review the economics of vertically differentiated goods as regards
the need for legal protection with special reference to GIs.

This is the theory of imperfect information as it reveals itself in a phenomenon known as
asymmetric information. Perfect information on both sides of the market ensures that
both producers and consumers have access to identical information about a given product
as they enter into a transaction. This double coincidence of equal information guarantees
that the product is supplied with the right quantities and leads to the achievement of
efficiency as it reduces transactions or search costs. While this is not a problem under
trade in homogeneous goods, imperfect information tends to be a significant feature in
transactions involving vertically differentiated goods. In particular, asymmetric
information arises when two parties to a transaction possess information about a product
in different degrees, and a case in point is when producers have more accurate
information about the characteristics or quality of their product than consumers. For
instance, in the market for used cars, the owner of the car definitely has better
information about the status of the car than a prospective buyer or the next user of the
vehicle. Imperfect information on the part of the consumer may result in two problems
known by economists as adverse selection and moral hazard. Adverse selection is a
problem, which occurs before a transaction is made when a potential consumer is most
likely to purchase a product with an undesirable quality (adverse choice) from risky or
wrong supplier whose product is most likely to be (selected or) purchased. This could be
because producers of low quality goods are more aggressive in persuading potential
buyers than producers of high quality goods in the same product group. A result of
adverse selection may be that if a buyer cannot distinguish a high quality variety from a
low quality variety, then it is as well to purchase a low priced variety. The producer of a
high quality variety has to invest in supplying correct information into the market so that
consumers are able to appreciate its variety.

Moral hazard is a result of asymmetric information which occurs after a transaction has
been effected. This is that the consumer is subjected to the risk or hazard that the seller
of the product bought may be in the habit of being involved in cheating on quality or
reneging on its promises (immoral practice as if it were!) of supplying a good quality
146
product to the expectations of the consumer. Due to moral hazard there is high
probability that consumers may decide not to purchase any more from the supplier who is
engaged in reneging his promises of supplying quality goods. A solution to the problem
of moral hazard in product differentiation is for the producer to invest in building
reputation that guarantees the quality of its product variety in the market place.

In the economic literature, the degree of imperfect information has been distinguished
under three categories of vertically differentiated goods; namely, search goods,
experience goods, and credence goods. For search goods, such as shirts, dresses or the
size of a loaf of bread can be ascertained by consumers before a transaction is made. In
the case of experience goods, such as the taste of a loaf of bread, quality is learned only
after the good is purchased and actually consumed. For credence goods some quality
aspects of the good, such as quantity of iodine in salt or calorific content in bread, are not
often learned even after consumption. Information asymmetry, and therefore market
distortion, is associated only with experience and credence goods, and economists have
identified credence goods to have more serious or acute market distortions than in the
market for experience goods. A solution to the information problem in the case of
credence goods is government intervention to establish and enforce certain minimum
standards, as done variously through publicly funded food and drug agencies or bureaux
of standards.

Of relevance here are solutions to information problem posed by experience goods and
these hinge on the incentives for producers to maintain quality. In this regard there are
both market and public solutions. At the market level producers have to invest in dealing
with the twin problems of adverse selection and moral hazard, by investing respectively
in information which leads to consumers to distinguish between qualities of different
goods before they can purchase and investing in reputation building. This, however, has
to be complemented by repeat purchases and consumption so that buyers gain confidence
over time in distinguishing products by degrees of quality. Since for high quality
varieties this involves extra costs especially in the initial product promotion stages during
which consumers are gaining experience and confidence, producers have to be
compensated with a higher mark up or premium for higher quality goods that for lower
quality goods. A producer who takes the mark up as an incentive to sustain quality will
be rewarded as consumers come to be associated with the product variety. However, a
producer that wants to make windfall profits from the high mark up and cheats
subsequently by reducing quality will be punished as its reputation is ruined in the long
run.

Free-Riding and Legal Protection
In real or practical business it has, over history, been realised that repeat purchases and
reputation building alone are not sufficient to guarantee that asymmetric information on
part of consumers is eradicated and that producers will be able to reap the mark ups as
incentives to maintain quality over time. Two further actions are required. First,
producers have to ensure that their consumers identify products through guaranteed
marks that signal product quality. This is the role that trademarks and brand names play
as information transmitters to consumers to easily identify products and quality. As
147
Landes and Posner (2003) have aptly put it, the information conveyed by a trademark or
brand name should allow a consumer to remind herself: I need not investigate the
attributes of the brand I am about to purchase because the trademark is a shorthand way
of telling me that the attributes are the same as those of the brand I enjoyed earlier. In
this way the special attributes of a product need not be repeatedly experienced; these are
instead identified with the trademark, thereby significantly reducing transactions costs,
increasing efficiency and increasing varieties and consumer welfare.

The second problem to deal with is that of free riding by third parties, which can only be
dealt with through state protection. Free riders in this context are producers who, if
allowed to use the same trademark, need not invest in reputation building but who could
produce the same high quality product more cheaply and drive those that initially
invested in the same product out of business. Free riding could be realised also if third
parties could use the trademark to produce products of inferior quality and make
substantial short-term rents as consumers are duped to buy the inferior quality product at
the high price associated with high quality product. This would tend to destroy the
reputation of the original producers as consumers return to the market and create
disincentive in further investing in reputation building information. Producers have
therefore sought legal protection to prevent free riding and ensure that they earn a
guaranteed premium on information capital embodied in a trademark.

GIs have mostly been associated with wines and spirits. Instead of one producer
enjoying a trademark, GIs involve producers of a product variety with certain
characteristic or appellation that is associated with a particular geographical region. In
this case producers from a homogeneous area have over time invested in developing a
certain attribute in a product which gives it a distinctive characteristic from other
varieties from other regions or countries. A GI is meant to ward off potential free riders
within the region and a producers association has to ensure that the value the GI is
protected and individuals who only have short-term interests do not ruin the long-term of
the product reputation.

Geographical Indications and Impact on Prices
A question arises as to whether GIs influence product prices and a key working
hypothesis would be that products that are protected by a GI would be expected to be
valued at a premium over non-protected ones. The rationale being that a GI reduces
uncertainty which is related to the origin and quality of the product and that it guarantees
consumers that such a product genuinely comes from the right area and therefore possess
the desired long-standing quality. In this way consumers should be willing to pay extra
premium for such a product over non-GI protected products.
Some empirical work has been done to establish the impact of GI protection on the
formation of prices. Both anecdotal and rigorous econometric-based evidence especially
in Europe, Australia and the USA are affirmative on the influence of regional
appellations on prices. For instance, the EU (2003) found that 40% of European
consumers surveyed in 1999 were willing to pay a 10% premium for guaranteed
products, especially of French cheese and chicken, and Toscano oil (See also Torelli,
2003). Ranganekan (2003) has also found that Jamaican blue mountain coffee can
148
receive a premium of up to US$14.50 per kilo over benchmark prices for Colombian
milds. Results from the following econometric studies, which have been based
overwhelmingly on wines, have supported these survey-based findings: Combris, Lecocq
and Visser (1997) and Landon and Smith (1998) on Bordeaux win; Schamel (2000) on
Cabenet Cauvignon in the US market; Bombrun and Sumner (2003) on California wines;
Schamel and Anderson (2003) on Australian wines; and Gil and Sanchez (19997) on
Spanish wines. All these studies, except the last one, used the hedonic pricing model due
to Rosen (1974).

The microeconomic foundation of the hedonic model is that the market for a given
product consists of sub-markets for its attributes. Consumers have a utility function for
each attribute and maximise utility for each one, so that there is sub-market demand for
each attribute. Correspondingly, firms have cost and sub-supply functions for each
attribute. Market equilibrium is established for each attribute which then yield the overall
market equilibrium for the product. We can imagine that a given product j is the sum of
its various attributes i = 1 to n, and that each of these attributes has a sub-price, p
ij
.
Therefore, the price of the whole product group, p
j
, is some average index of these sub-
prices, such that:

=
= + + + =
n
i
ij i nj n j j j
p p p p p a
1
2 2 1 1
] 38 . 7 [

where
i
is the weight or marginal contribution of the attribute i to a unit of product j. In
the study by Landon and Smith (1998), these marginal contributions of different regional
Bordeaux wines were found to be as follows:


Julien St Estephe St
Emilion St Pomerol Pauillac ux M Graves PAB b
. 43 . 9 . 86 . 11
. 04 . 8 15 . 15 84 . 11 arg 48 . 5 08 . 10 ] 38 . 7 [
+ +
+ + + + =

All the estimated coefficients were significant at the 5% level. Based on regional
classification, this means that while a Margau would fetch only US$5.48, a Pomerol wine
would instead fetch US$15.15 more per bottle as premium over the price of an average
Bordeaux (PAB). The study by Schamel and Anderson (2003) used Shiraz wine bottle
produced in Barossa Valley as the benchmark from which to measure deviations of prices
(premiums) of wines of different grape varieties and from other regions. The coefficients
for wines of different grape varieties were negative, indicating that these were cheaper
compared to a Shiraz from the Barossa Valley. For example, a Riesling was 42%
cheaper than a Shiraz from Barossa Valley. However, the results overwhelmingly
revealed that wines with other regional classifications were more expensive than a Shiraz
from the Barossa Valley. In this regard the wines from Southern Tasmania were, with a
premium of about 40%, the most valuable regional wines over a Shiraz from the Barossa
Valley.

149
An interesting question is whether registration of a GI is important in the determination
prices. Schamel and Anderson show that the introduction of legislation in 1993 for GIs
in the case of wines was an important factor in increasing the returns to regional wines in
Australia. A WTO (2004) study extended this approach to the case of tea in India and
found and failed to confirm the conclusion by Schamel and Anderson. The WTO study
used the case of Darjeeling tea which is a specialty tea grown in the West Bengal of
India, whose logo was created in 1983 and was registered as a certification mark in 1986
in India and in export markets in 1988 in the US and in 1997 in the UK. The study sets
out to investigate three effects that should occur with the introduction of the legal
protection for the name Darjeeling. First, is the timing effect, as measured by the
improvement in price following the introduction of protection. Second, is the price
premium effect in the sense that the price of this brand should be seen to rise relative to
other closely related varieties. Third, is the quality effect, which should be revealed in
quality improvement. The premise therefore is that These three elements should allow
us to distinguish the effects of legal protection from other factors which could shift
demand and supply and change prices. (WTO, World Trade Report 2004, p. 86)

The WTO study, while confirming the price premium and quality effects, found that GI
protection seemed to have hardly improved Darjeeling tea in India. The price difference
during the study period (1972-2002) increased in favour of Darjeeling tea and its quality
improved as shown by decreasing trend in the proportion of dust Darjeeling (the inferior
component) to leaf Darjeeling sold from mid-1980s to 2002. To establish that GI had
negligible impact on the price for Darjeeling tea, the study estimated an inverse demand
equation using instrumental variable regression technique using a dummy variable with a
1 for the period 1986-2002 and zeros for the previous period. The coefficient on the
dummy was found to be 0.086 and statically significant at 10% level. This was
interpreted as representing price premium of protection, which amounts to about 1.08
rupees per kg. in 1995 prices. But this represents less that 1 percent of the price of
Darjeeling during the 1986-2002 period, suggesting that GI protection hardly added a
price premium. (WTO, World Trade Report 2004, p. 88). A major reason alluded to this
result was the lack of enforcement of the legal protection of the GI as it was observed that
since 1976 about 40,000 tons of tea is sold annually in the world market as Darjeeling tea
while production of the same in West Bengal did not exceed 10,000 tons.

International Agreements on GIs

7.4 International Price Discrimination and Dumping in World Markets
Key conditions have to be satisfied for monopolistic discrimination to be successful;
namely, first, that markets have to be tightly separated to avoid commodity arbitrage or
resale by third parties. This means existence of imperfect information on the part of the
third parties about conditions in other markets. Second, own price demand elasticities
facing the monopolist should be different across consumer markets; that is, the sole firm
should possess substantial market power. Let us assume that our monopolist has
production plant located in the Home market; that the cost of supplying both markets is
equal, MC = MC
h
= MC
f
; and that the firm is a monopolist in the Home market but faces
150
some competition in the Foreign market, so that the own-price elasticity of demand is
relatively higher in the Foreign market than in the Home market; that is,
f
>
h
. Using
the maximization condition in the two markets we shall have the following inequality:

( ) ( )
< < =

>

=

1 ,
1 1 1 1
] 39 . 7 [
f
f h
h
P
MC MC
P

In order to maximize profits given these different markets, the monopolist will be
induced to fix a lower price in the foreign market with a higher demand elasticity
coefficient than in the home market with a lower elasticity coefficient. For example,
given MC = 30,
h
= -4, and
f
= -10, then prices will be: P
h
= 40 > P
f
= 33.33 (Recall
that the elasticity coefficients in our case enter in their absolute values).

The graphical solution to this international price discrimination problem is set out in
Figure 7.12. Horizontal summation of home and foreign sales yields total demand and
marginal revenue facing the monopolist in panel 3. Given the same marginal cost to
supply both markets, the profit maximization condition becomes: MC = MR
h
= MR
f
=
MR
(h+f)
. To reflect the condition in [7.38], the home demand curve is steeper than the
foreign curve and the monopolist's solutions are at points E
h
, E
f
and E in the respective
markets. Consequently, P
h
> P
f
at points H and F, respectively, in home and foreign
markets. The monopolist's total sales will be: Q
h
+ Q
f
= Q
(h+f)
.

This discriminatory pricing behaviour has important implications in trade theory and
policy. A theoretical implication of it is in relation to the HOS prediction of international
price equalization and factoral income distribution. If indeed trade leads to divergent
commodity prices, then this will run counter to the commodity price equalization theorem
of the HOS model, a result which will also violate the factor price equalization (FPE)
theorem. Under competitive markets factors of production are paid the value of marginal
product which is the product of the market commodity price and the MP of a given
factor; for labour this would be: VMPL = Pc.MPL. Since competitive price is equal to
MR, this means that the VMPL will be equal to the value of marginal revenue product of
a factor; that is: VMPL
c
= P
c
.MPL = MR.MPL = MRPL. But since under monopoly price
is greater than marginal revenue, then factors will be paid the MRP which is less than the
VMP at the monopoly price. That is: VMPL
n
= P
n
.MPL > MRPL. Under constant MC
then MRPL = VMPL
c
< VM PL
n
. However, with rising MC function then factors will be
paid at MR which is less than the competitive price, so that: VMPL
n
> VMPL
c
> MRPL.
A price-taker monopolist in the factor markets will pay factors at the competitive factor
reward prevailing in each market. Factor price equalization will be determined by the
degree of factor market integration between the different countries the monopolist is
trading. The possibility for factor price divergence will be in the case of an international
monopsonist who will pay a given factor a lower price in a source market with a lower
elasticity of supply than in a more elastic source of supply of that input (See Chapter 8,
Section 8).

151
International price discrimination will endure as long as the factors that support it persist.
It can be contended that while in the short to medium term this may be sustainable, in the
long term monopoly rents stand to be contested away so as to restore the possibility of or
tendency to commodity and factor price equalization as postulated by the HOS theorem.

Types of Dumping in International Trade

A practical implication of discriminatory pricing is the phenomenon of dumping in
international markets, which is one of the most vexing problems in international trade
relations and especially within the WTO/GATT framework. Although free-trade
monopoly pricing is not the only source of dumping, three types of this business practice
may be identified. Sporadic or distress dumping is associated with disposition of excess
inventories by a firm into foreign markets at lower prices than those charged in the home
market. This would be due to seasonal influences or to threats of perishability of
products. Predatory dumping occurs when a firm reduces price in foreign markets in
order to ward off foreign competition or increase market access. But once it establishes
substantial market power in those markets, it will tend to raise price in accordance with
market conditions. Lastly, there is persistent dumping, which involves continuous setting
of lower prices in foreign markets than in the home market and, as the term suggests, this
can go on indefinitely.

Reciprocal Dumping

The price discrimination we have described is of a unilateral form by which there is a
one-way trade conducted by the home monopolist exporting abroad without competition
from foreign firms or from a foreign monopolist also dumping in the home market. Free
trade reciprocal dumping would take place if there were a two-way bilateral trade (or
cross-hauling) in a product, whereby firms compete in each other's home market through
price discrimination. In order to illustrate reciprocal dumping, let us take the following
steps. Before cross-hauling trade begins, each monopolist faces the same domestic
marginal cost or unit cost and charges the same price, P
n
, in their respective markets. As
shown in Figure 7.13, the monopoly mark-up of (P
n
- MC) is net of transport costs.
Define a prohibitive unit transport cost, T
p
, which when added to the domestic unit cost
makes cross-hauling prohibitive, so that P
n
= MC + T
p
or (P
n
- MC) =
T
p
, and [P
n
- (MC - T
p
)] = 0. With this scenario, a potential foreign firm cannot dump in
each other's market and the home firm will enjoy the full monopoly rent. To allow fo
dumping, there has to be some unit transport cost, T
b
< T
p
, which makes a monopolist
just break even in another's market so that the break-even price is: P
b
= MC + T
b
. The
foreign firm can dump in our market by setting a price such as P
nf
which falls within the
range P
b
< P
nf
< P
n
and earn a unit profit of (P
n
- P
nf
). In Figure 7.13 this is somewhere in
the range N-N
f
along the demand curve. This is price discrimination because the foreign
firm earns a lower mark-up in our home market than it earns in its domestic market, net
of transport costs; thus: (P
n
- P
nf
) < (P
n
- MC). The home monopoly can retaliate with a
raid in the foreign market by fixing a price there somewhere below P
nf
in the range (P
nf
-
P
b
), and so in this fashion reciprocal dumping would have occurred. Equilibrium would
occur if each monopolist charged a price equal to the break-even price, P
b
, which is
152
inclusive of non-prohibitive unit transport cost. On a more aggressive marketing stance,
each monopolist can drive the foreign firm off the home market by fixing its price, P
nh
,
below the breakeven price P
b
, which is in the range: P
b
> P
nh
> MC. In this fashion each
monopolist would capture the whole domestic market, which is greater than or equal to
Q
nf
without foreign invasion. [James Brander, "Intra-Industry Trade in Identical
Products". Jol. of International Economics. 11 (1981), pp 1-14.]

What are the costs and benefits of this type of trade? A potential advantage of such trade
would be tendency for prices in home markets to decline as home monopoly rents are
reciprocally contested due to competition from foreign suppliers.

Reverse dumping

A pricing practice has been observed by which, instead of charging a lower export price
than in the home markets, prices instead have been observed to be higher with premiums
in export markets than in domestic markets. Alexander Yeats ["Do African Countries
Pay More for Imports? Yes?" Finance and Development, 1990, Vol. 27, No.2, pp 38-40]
investigated the possibility of this reverse dumping using the trade between former
colonizers -- France, Belgium, Portugal and the United Kingdom -- and their respective
former colonies. Yeats calculated f.o.b. unit values for major steel and iron export
products into the former sub-Saharan African colonies and compared them with prices on
the same products from those former colonizers to non-African developing countries.
Using World Bank data from the Trade Analysis and Reporting System (TARS) for the
period 1962 - 87, Yeats reported his findings, which are henceforth surmised.

Over the full period, the average premiums paid by the former Belgian and French
colonies were quite close (23.7 and 23.2 percent, respectively), while the former UK
colonies paid a slightly lower premium of 20 percent. The same price pattern emerged
during 1962-75 for Portugal's exports its former colonies, but form 1976 on, the
premiums more than tripled, averaging over 120 percent. This dramatic rise may in large
part be explained by the hostilities in Angola, which undoubtedly increased the risk factor
associated with delivery and payment. Even so, the results are important, as they show
the widespread nature of the problem of apparent "over-pricing" of imports in Africa.
Given the large sums involved, a key question for policy purposes is why such major
differences between f.o.b export unit values for different countries exist. Since these
items are generally homogenous, variations in product characteristics should have a fairly
limited influence. In an attempt to account for existing price discrepancies, French
relative export prices (i.e, the unit value for the individual importing country relative to
the average unit value for the product group) were correlated with various market
structure and other performance variables that might influence relative prices. In order to
see how the relationships had evolved over time, the periods chosen were 1968-69 and
1986-87. The results demonstrate that adverse prices for the former colonies were
primarily associated with three factors.

153
(i) Market structure: The number of sellers operating in these countries' import market
appeared to exert a key influence, meaning that those nations that are highly dependent
on a relatively few suppliers may pay for this concentrated reliance through higher import
prices.

(ii) Number of trading partner (country) contacts. Importing countries maintaining trade
relations with a larger number of exporters and theoretically benefiting from greater
competition and information on comparative prices, pay less for their exports. A
combination of (i) and (ii) vindicate price discrimination according to degree of demand
elasticity. In this case sellers face higher elasticity in their home markets than in the
export markets, thereby charging a lower price at home than abroad.

(iii) Size of country. Unfortunately, from the development policy viewpoint, the
correlations showed that smaller, poorer countries may not be able to sustain a larger
number of trading contracts, as this variable was significantly and positively associated
with GNP per capita, market size and relative quantities purchased. Thus LDCs acting in
isolation (i.e. not resorting to practices such as combined bulk purchasing) stand to
benefit little under such conditions.

7.4.1 Anti-Dumping Practices

In the practical world, dumping is not only a private agents' concern as has been
discussed so far, but those that feel hurt seek the intervention of their respective
governments for determination and possible remedy. In addition, dumping may be
practiced by many exporters from one country of origin instead of a single firm or
monopolistic firm. Countries have put in place anti-dumping legal instruments which are
designed to address concerns of dumping of products into their territorial markets, and in
bilateral, regional and multilateral trade agreements, the question of dumping is
recognized and provisions are laid down as to how to deal with the practice. This Section
reviews the anti-dumping provisions of the WTO in terms of the determination of
dumping, injury and some salient procedural matters. The WTOs legal sources on
dumping are Article VI of GATT 1994 and the Agreement on Implementation of Article
VI of the GATT (or Agreement on Anti-Dumping, 1994).

Definition of Dumping. The WTO legal framework does not seek to outlaw the practice
of dumping, but it only conditionally recognizes and condemns its existence and
therefore only provides regulations for its determination, proof and remedial actions.
Thus, Art. VI (Para.1) states: "The contracting parties recognize that dumping, by which
products of one country are introduced into the commerce of another country at less than
the normal value of the products, is to be condemned if it causes or threatens material
injury to an established industry in the territory of a contracting party or materially
retards the establishment of a domestic industry."

Determination of Dumping.
At stake in the investigations by the authorities is to compare the normal price in the
exporting country, or the country of origin of the export product, with the export price at
154
which the product is being sold in the importing country. In Figure 7, the home or
domestic price would be Ph and the export price P
x
. The process for determining
dumping involves establishment of the normal value, the export price, and the dumping
margin, dm, which is the gap between the normal value and the export price, d
m
= P
h
- P
x
.
The UR Agreement on Antidumping (AAD) lays down methods for establishing the
normal and the export price. There are three possible methods for determining the normal
value: (i) The domestic or home price in the exporting country or country of export
origin; (ii) The constructed value; and (iii) The export price in a third country. As will be
shown later, the latter two methods are resorted to when the first method is considered to
be infeasible to apply.

Domestic Price Method or Normal Value

According to this method, a normal value refers to "the comparable price, in the ordinary
course of trade, for the like product when destined for consumption in the exporting
country." (GATT Art. VI (a) and AAD Art.2.1). A like product (produit similaire in
French) is defined as a product which is identical, i.e. alike in all respects to the product
under consideration, or in the absence of such a product, another product which, although
not alike in all respects, has characteristics closely resembling those of the product under
consideration" (AAD, Art. 2.6). This price should net out taxes, discounts and rebates. In
case of intra-firm transactions, the domestic price will be the resale price of the related
sales company and not the price at which the parent or manufacturer charge its sales
company. This is the single economic unit doctrine. Where the product is re-exported
from another country, the normal value will be the price in the country of the re-export.

Disregarding the Domestic Price: The domestic price may be disregarded in the
determination of the dumping margin: (a) Where there are no sales of the like product in
the ordinary course of trade in the domestic market of the exporting country; and (b)
Where there is low or insufficient volume of sales in the domestic market of the
exporting country, which is determined by the representative test of 5%. (Art 2.2,
footnote 2). That is, sales of the like product for consumption in the domestic market of
the exporting country, Q
h
, are considered to constitute a sufficient quantity for the
determination of the normal value if they account for 5% or more of the export sales, Q
x
,
into the importing country; i.e. if (Q
h
/Q
x
)100 5%. Domestic sales are not made in the
ordinary course of trade if the investigating authorities determine that such sales are
made within an extended period of time (six months and one year) in substantial
quantities and at prices which do not provide for cost recovery within a reasonable period
of time; that is, if selling prices are below the weighted average per unit costs, or that the
volume of sales below per unit costs represents not less than 20% of the volume sold in
transactions under consideration for the determination of the normal value. (Art 2.2.1
and footnote 5). This means that when the volume of unprofitable sales is 20% or more in
total transactions then the domestic price should be disregarded. In the EU if profitable
sales are greater than 80%, then the normal value would be based on all sales inclusive of
the unprofitable ones; if profitable sales are less than 80% but equal to or greater than
10%, then normal value would be based only on profitable sales; if, however, profitable
sales are less than 10%, the domestic price method would be disregarded (ITC, EU, p.
155
27) in favour of the constructed normal value or comparable price in a representative
third country. The constructed normal value includes manufacturing or production costs,
and general, selling and administrative (GSA) expenses and a reasonable profit margin
that are apportioned only to the domestic sales of the product.

The Export Price: The export price used in the determination of the dumping margin is
either the actual export price paid by the import(s) or the constructed export value. The
actual export price may be unreliable due to intra-firm, transfer pricing, and
compensatory arrangements between the exporter(s) and the importer(s). In such cases
the export price will constructed based on the resale price to an independent buyer; if not,
then the authorities are empowered to use other reasonable determination methods.
Fair Price Comparisons: The AAD (Art. 2.4) requires a fair comparison to be made
between the export price and the normal value in terms of the same level of trade, product
characteristics, same period of time, trade policy adjustments, exchange rate treatments,
and weighting procedures. In terms of establishment of the dumping margin, the AAD
(Art. 2.4.2) prefers comparison of a weighted average normal value with a weighted
average of prices of all comparable export transactions or by a comparison of normal
value and export prices on a transaction-to-transaction basis. If this method is not
feasible, and an explanation has to be provided as to why the first method cannot be used,
then comparison can be made between a weighted average normal value to individual
export prices.

Determination of Injury and Conduct of Investigations
There are certain conditions that have to be met for the commencement of an
investigation to determine the existence, degree and alleged injury of dumping. The
application should be written by or on behalf of the domestic industry including
evidence of (a) dumping, (b) injury, and (c) a causal link between dumped imports and
the alleged injury. The petition should be supported by domestic producers whose
collective output is greater than 50% of total production by those who are expressing
either support for or opposition to the application. The application should also be
supported by producers whose output is at least 20% of the industry total. An
investigation shall proceed if the dumping margin passes the de minimis level; that is, if it
is equal to or greater than 2% of the export price. The volume of dumped imports should
be substantial in that: (i) the imports from a particular exporting country should account
for 3% or more of the total imports of the like product into the importing country; or (ii)
countries which individually account for less than 3% collectively account more than 7%
of imports into the importing country.

Determination of Material Injury
Investigation of injury seeks to establish that: (a) There has been a significant increase in
dumped imports, either in absolute terms or relative to production or consumption in the
importing country. (b) There has been a significant price undercutting by the dumped
imports compared with the price of a like product of the importing country, or the effect
of such imports is otherwise to depress prices to a significant degree or prevent price to
increases, which otherwise would have occurred, to a significant degree. The relevant
economic factors and indices to be taken into account in the investigation include actual
156
and potential decline in sales, profits, output, market share, productivity, return on
investments, or utilization of capacity; factors affecting domestic prices; the magnitude of
the margin of dumping; actual and potential negative effects on cash flow, inventories,
employment, wages, growth, ability to raise capital, or investments; etc.

The causal effect between dumping and injury
The authorities must be satisfied that there is a causal relationship between the dumped
imports and the injury. Furthermore, they must also examine any known other than the
dumped imports which are simultaneously injuring the domestic industry, and the injuries
caused by these other factors must not be attributed to the dumped imports. Such other
factors include: the volume and prices of imports not sold at dumping prices, contraction
in demand or changes in consumption patterns, trade-restrictive practices of and
competition between foreign and domestic producers, developments in technology and
export performance and productivity of the domestic industry.

Imposition of Anti-Dumping Measures
Anti-dumping measures can be imposed as Provisional Measures, Price Undertakings, or
as Definitive Duties. Provisional measures may be imposed when a preliminary
affirmative determination has been made of the dumping and consequent injury to a
domestic industry; and, the authorities concerned judge such measures necessary to
prevent injury being caused during the investigations. These are in the form of
provisional duty, or preferably, a security such as a cash deposit or bank guarantee or a
bond, equal to the amount of the anti-dumping duty provisionally estimated but not
greater than the provisionally estimated dumping margin. A price undertaking is a
voluntary decision by an exporter to revise its prices or to cease exports of the product in
question at dumped prices so that the authorities are satisfied that the injurious effect of
the dumping is eliminated. The respective price increases should not be greater than
those necessary to eliminate the margin of dumping. Although exporters can avoid anti-
dumping duties by price undertakings, the authorities in the importing country consider
their acceptance impractical, for example, if the number of actual or potential exporters is
too great and the exporters will be furnished with reasons for rejecting their price
undertakings.

Imposition of definitive anti-dumping duty is the sole responsibility of the authorities of
the importing country and is decided upon after all the procedures have been fulfilled and
whether or not the anti-dumping duty should be the full margin of dumping or less. The
AAD advises that the duty be less than the margin if such duty would be adequate to
remove the injury to the domestic industry (Art 9). Anti-dumping measures are subject to
review initiated either by the authorities on their own or by the industry or on tits behalf.
A definitive anti-dumping duty shall not exceed five years in duration, unless the
authorities determine, in a review initiated before the expiry date that the termination of
the duty would be likely to lead to continuation or recurrence of dumping and injury, in
which case the duty may remain in force pending the outcome of such review. (Art 11).



157

The Role of the WTO Dispute Settlement Mechanism
Governments of member countries are expected to initially hold consultations at the
request of one of them designed to resolve the matter to their mutual benefit. This is at
the level of imposition of anti-dumping measures. Should this fail any government can
refer the matter to the DSB, which will make determination(s) based on Panel or
Appellate Body reports.

The issue of fair price comparison has been one of the subjects of determination by the
DSB, especially as regards the practice of zeroing in the calculation of weighted
averages. Zeroing refers to the practice of changing negative margins of dumping, i.e. no
dumping cases, for some individual product varieties, into zero margins in the process of
calculating the overall anti-dumping duty. This procedure leads to higher overall
dumping margin than when the negative margins themselves are used to offset the
positive margins. Zeroing was disputed during the Uruguay Round negotiations and the
new language added to Article 2, which was supposed to outlaw it, has been interpreted
by the EU and the USA as requiring them only to consider average prices within a
particular model type, and not as eliminating the zeroing practice. This interpretation has
been found by the WTO Panel and the Appellate Body to be inconsistent with Article 2 in
the following disputes: EC Anti-dumping duties on imports of cotton-type bed linen
from India; EU Anti-dumping duties on malleable cast iron tube or pipe fittings from
Brazil, complaint by Brazil (WT/DS219)[WTO Annual Report 2003, 2004]; and in
United States Final dumping determination on softwood lumber from Canada,
complaint by Canada (WT/DS264)[WTO Annual Report 2005]. As an example, in the
US-Canada dispute, the Panel Report was circulated to Members on 13 April 2004 in
which the

Panel found that, in its final determination, the US Department of Commerce (DOC) failed to comply with
the requirements of Article 2.4.2 of the AD Agreement because it did not take into account all export
transactions by applying zeroing methodology when calculating the margin of dumping. (One Panel
member issued a dissenting opinion regarding the finding on zeroing.)
On 13 May 2004, the United States notified its decision to appeal certain issues of law covered in the Panel
Report and certain legal interpretations developed by the Panel. On 11 August 2004, the Appellate Body
Report was circulated to Members. The Appellate Body upheld the Panels finding that the United States
acted inconsistently with Article 2.4.2 of the Anti-Dumping Agreement in determining the existence of
margins of dumping on the basis of a methodology incorporating the practice of zeroing. The Appellate
Body furthermore reversed the Panels finding that the United States did not act inconsistently with Articles
2.2, 2.2.1, 2.2.1.1, and 2.4 of the Anti-Dumping Agreement in its calculation of the amount for financial
expense for softwood lumber for Abitibi Company one of the Canadian companies under investigation
At its meeting of 31 August 2004, the DSB adopted the Appellate Body report and the Panel report, as
modified by the Appellate Body report. On 18 October 2004, Canada requested that the reasonable period
of time be determined through binding arbitration pursuant to Article 21.3c of the DSU. On 6 December
2004, Canada and the United States informed the DSB that pursuant to Article 21.3c of the DSU they had
mutually agreed that the reasonable period of time to implement the recommendations and rulings of the
DSB would be seven and one-half months, that is from 31 August 2004 to 15 April 2005. In addition, they
informed that, in light of the agreement, the proceeding under Article 21.3c of the DSU should be
terminated. On 13 December 2004, the Report of Arbitrator was circulated, noting that in light of the
above agreement between the parties, it would not be necessary for him to issue an award. (WTO, Annual
Report 2005, p. 49).

158

[Check conclusion in the case: US Laws, regulations and methodology for calculating
dumping margins (zeroing), complaint by the EU (WT/DS294) Panel formed on 27
October 2004]

Anti-Dumping, Safeguards and the Special and Differential Treatment
It has been argued that the ADA contains legal standards that are less stringent and that it
is more politically appealing for application than the Safeguards Agreement and this
explains its popularity in seeking remedies. In the US companies prefer anti-dumping
remedies to safeguards. For example, the determination of serious injury under the
safeguards is tougher than the determination of material injury under the ADA. Again,
unlike anti-dumping measures, safeguard measures are subject to the normal review
process of the DSU, which demands an objective examination of the facts and WTO
Panels have often reviewed safeguard measures carefully. Panels have found the
measures to be inconsistent with WTO provisions if authorities have not submitted
sufficiently logical or detailed explanations. (International Trade Centre, Business Guide
to Trade Remedies in the United States, Geneva 2003, p. 212). In the US, safeguard
measures are covered under Section 201, and even if the tough legal standards were met,
the President has often used discretion to deny relief to domestic firms. For example,
during the period 1974-2000, of about 70 safeguard investigations were conducted half of
them were found to be non-injurious by the US International Trade Commission and
about half of the injurious ones were not granted relief by the President, meaning that
only 20% of the cases attracted import restrictions. (ITC, US, p. 10) Furthermore, while
the Safeguards Agreement prohibits application to developing countries (with some
conditions), the ADA does not provide for SDT status, except to remind developed
countries to recognize the special situation of developing country members when
considering the application of anti-dumping measures. Thus Art. 15 of ADA states:
Possibilities of constructive remedies provided for by this Agreement shall be explored
before applying anti-dumping duties where they would affect the essential interests of
developing country Members. Although the imposition of a lesser duty or a price
undertaking may constitute a constructive remedy, there is no binding commitment by
developed countries to extend or accept any constructive remedy. Instead, this has been
interpreted as a requirement to actively consider, with an open mind, the possibility of
such a remedy before the imposition of definitive measures. (ITC, Business Guide to
Trade Remedies in the European Community, Geneva, 2004, p.6)












159
CHAPTER 8

OLIGOPOLISTIC MARKETS, STRATEGIC TRADE AND COUNTERVAILING
ACTIONS

The market structure of oligopoly is the last one with which to explore trade policy
consequences, having reviewed counterpart trade effects under perfect competition,
monopoly and monopolist competition. Oligopoly is characterized by a welldefined
number of firms, from two firms or duopoly to sizable few ones. What is important is
that, unlike in other market structures that are characterized by impersonal touch,
oligopolistic firms are conscious of the reactions of other firms and therefore form
guesses or conjectures about such reactions. It is from this type of strategic
interdependence among oligopolists that government intervention to support their firms
so that they can extract gains in domestic markets, in their rivals markets or in third
markets has come to be known as strategic trade policy.

The oligopolistic structure, like the monopolistic competition structure, is about intra-
industry trade, although under oligopoly trade takes place in more similar products than
the more differentiated varieties traded under monopolistic competition. While
economies of scale matter also under oligopoly, strategic behaviour is of great
importance even under increasing costs through precommitments. The analysis of trade
and policy under oligopoly has grown tremendously since the late 1970s and game
theoretic formalism has also been deepened to rival if not to surpass that applied in other
market structures. But the bottom line as stated by Eaton and Grossman (1986), is that the
primary implications of oligopoly for the design of trade policy are: (1) that economic
profits are not driven to zero, and (2) that a price equal to marginal cost dues not
generally obtain. The implications of these conditions are that public policies which
shift industry advantages to domestic firms may have social gains on a national scale and
that policies enhance oligopolistic competition may be a substitute for anti-trust or anti-
monopoly policy when they are directed at reducing distortions introduced by market
concentrations.
However, Dixit (1983) provides a warning on the practical plane of potential misuse of
some of the strategic trade policies, as he states, vested interests want protection, and
relaxation of anti-trust activity, for their own selfish reasons. They will seize upon any
theoretical arguments that advance such policies in the general interest. Distortions and
misuse of the arguments is likely, and may result in emergency of policies that cause
aggregate welfare loss while providing private gains to powerful special groups.
(Bhagwati, SRTT, P, 190).
In this Chapter we are interested, firstly, in researching on the welfare and distributional
effects of fiscal instruments that are designed to enhance domestic market advantage and
export promotion under the oligopoly theories based on Cournot-Nash and Bertrand
strategies. Secondly, we explore the non-cooperative behaviour of retaliation and
160
countervailing actions. Lastly, applications are extended to international cartellization
and commodity agreements. But prior to that we develop the basic oligopoly model.

8.1 General Oligopoly Behaviour

An oligopoly market structure consists of two or more firms producing a highly
homogenous product whose actions and decisions on their prices and output quantities
are strategically interdependent in a number of forms. Firms act as players in a game who
seek to achieve their goals or payoffs in the form of profit, market share, etc. a number of
strategic interactions may emerge. In sequential, market behaviour a firm may become a
price leader or a quantity leader who sets its price or quantity ahead of other firms who
become price or quantity followers. A key strategic advantage of a leader firm is to
possess knowledge about the possible choices the followers will make once it has acted.
In a simultaneous game, firms may act simultaneously based on guesses about each
others decisions or reactions regarding prices or quantities. When firms negotiate on
prices or quantities, they are involved in a market collusion or cooperative game such as
cartels. International agreements are forms of cooperative games with pre-set rules and
disciplines by which parties bind their commitments. Otherwise, if they act
independently, then they are involved in non-cooperative strategic market behaviour.

Strategic equilibrium in oligopoly is widely defined by the concept of Nash equilibrium.
This states that if each firm has chosen its most preferred strategy which yields the best
payoff or profit, while holding constant the strategies of rival firms, no participating firm
can earn a better payoff or higher profit by choosing an alternative strategy. In Nash
equilibrium each participating firm is unwilling to alter its optimal strategy.

In non-cooperative oligopoly, there are two basic types of strategic behaviour and
equilibrium, namely the quantity equilibrium and the price equilibrium. Two quantity
equilibrium models are the Cournot and Stackleberg types, with the former leading to a
quantity simultaneous equilibrium and the latter based on quantity leadership-followers
strategy. Price-based oligopoly models are built on the Bertrand market behaviour with a
leadershipfollower strategy.

At the core of oligopoly is interdependent or strategic thinking about reactions among
firms known as conjectural variations, which may be about outputs or prices. We next
use a generalized oligopoly profit maximization model to demonstrate this choice
behaviour in which there are i = 1, 2, ,n firms, producing a homogenous product Q, of
which each firm producers q
i
, so that total industry output is given by:

( )
n i
q q q q Q + + + =
2 1
] 1 . 8 [

Firms are facing the same market demand and price, which in inverse form is:

[ ] n i q Q P Q P P
i
, , 1 , ) ( ) ( ] 2 . 8 [ = = =

The differential of this is defined by [ ] ), ( ) ( ) (
i i
q Q Q P q Q P = where
161
( )
( )
( )
(

+ =

+ +

+ +

+ +

=
n
j i
j
n
i
i
i
i
n i
q
q
q
q
q
q
q
q
q Q b
and
q
P
q
P
q
P
q
Q P
Q P a
2
1
2 1
1 ...... ....... ] 3 . 5 [
..... ] 3 . 5 [

For 1 = =
i i i
q q q and j i

Before developing the profit functions we define first the TR and TC functions as
follows.

( ) [ ]
i i i
q Q P q TR = ] 4 . 5 [

The corresponding MR function is derived as

( ) ( ) ( ) ( ) ( ) [ ] ( )
(
(

|
|

\
|

+ + = + = + =

=

=
n
j i
j
n i i n i
i
i
i
q
q
Q P q Q P q Q Q P q Q P Q P q Q P q
q
TR
MR
2
1 ) ( . ] 5 . 5 [

The TC function is given by

( )
i i i
q TC TC = ] 6 . 5 [

From which the MC becomes

( ) ( )
i i i i
q C T q MC = ] 7 . 5 [

Then the profit function for firm is written as follows:

( ) ( )
i i i i i i
q TC Q P q TC TR = = ] 8 . 5 [

The first order profit maximization condition with respect to firm i = 1 becomes.

( ) ( ) ( ) 0 1 ] 9 . 5 [
1
1
=
(
(

|
|

\
|

+ + + = =

i i
j
j
i i i
i
i
q MC
q
q
Q P q Q P MC MR
q

There are n such conditions from which the solution requires to express each q
i
in term of
the other n 1 firms quantities as follows:

j i q q q q
q q q q
n n n
n
=
=

), , , ( ] 10 . 5 [
) , , ( ] 510 [
1 1
2 1 1

162
These FOCs are known as reaction functions or best response functions, which are
sometimes denoted by ( )
j i i
q R q = , for j = 1, , n-1. These functions define the response
of sales of firm j to changes or variations in the output (sales) of some other firm i.
Conjectural variation (CV) turns out to be the term
i j
q q / ,whose restriction is given
by: 1 1 =
i j
q q CV . Various conjectures can be modeled. Cournot conjecture is
when CV = 0. A Cournot firms strategic guess is that when it acts to vary its output its
opponents will not react to vary their output levels. This means that the first order profit
maximization condition for a Cournot firm reduces to:

( ) ( ) ( ) 0 ] 11 . 8 [ = +
i i i
q MC Q P q Q P

Under Cournot conjectures, equilibrium n output levels are solved simultaneously using
the n-equation system of reaction functions. Such equilibrium is the Cournot Nash or
Nash in quantity equilibrium. However, under the Stackelberg conjecture, a leader firm
chooses its level of output with the full knowledge of the quantity the follower will
supply. Starting from Cournot-Nash equilibrium, a Stackelberg equilibrium or solution
(for a fixed market) means that when the leader raises sales, the rivals sales will
definitely fall, so that the CV = -1. The opposite obtains under a BertrandStackelberg
conjecture, by which the leader knows that when it raises the price of its output, the
rivals output will also rise, so that CV = 1 (when the choice variable is the price, instead
of output). Other conjectural specifications can be modeled and this is what makes
oligopoly a richly complicated market structure from where results are highly sensitive to
assumptions made about the strategic behaviour of the agents. We move next to develop
the duopoly model to be applied in subsequent policy analyses.

8.2 Duopoly Behaviour and Equilibrium

The basic model used to understand oligopolistic strategic behaviour followed here is that
of two firms that form an oligopolistic market structure, hence a duopolistic structure,
and each participating firm is a duopolist. More specifically we start with the Cournot
duopoly with the following assumptions.

(i) No entry. There are only two firms, 1 and 2, in an industry (market) without entry to
other firms.
(ii) Product homogeneity. The two firms produce a homogenous, Q, to satisfy the
industry and this product is distributed as:
2 1
q q Q + =
(iii) Firms face the same market demand as given by:

( ) ) ( ) ( ] 12 . 8 [
2 1 2 1
q q b a q q P Q P P + = + = =

(iv) Firms face identical cost functions of the form , ) (
i i i i
cq q TC TC = = where c is a
constant.
(v) Each firm seeks to choose an output level which maximizes it profits.

163
With these assumptions and general introduction we proceed to specify the profit
functions, reaction functions, isoprofits and Cournot equilibrium. The profit
maximization problem can be stated for firm i as

( ) ( )
i i i j i i i i
q TC q q q P TC TR + = = ] 13 . 8 [

Using the specific functions we get the two profit functions as follows:

( ) [ ]
( ) [ ]
2
2
2 2 1 2 2 2 2 1 2 2 2
1 2 1
2
1 1 1 1 2 1 1 1 1
] 13 . 8 [
] 13 . 8 [
cq bq q bq aq cq q q q b a TC TR b
cq q bq bq aq cq q q q b a TC TR a
= + = =
= + = =

Under Cournot conjectures each firm chooses its output while thinking the opponents
output will remain constant. This is tantamount to stating that so that 0 /
1 2
= q q . Let
us assume firm 1 conjectures first that the rival duopolist will not make a move given its
output choice. Then firm 1 will gauge its residual demand schedule to be the industry
demand net of a given level so that:

2 1
) ( ) ( ] 14 . 8 [ q Q P q P =

In Figure 8.1A, given the industry demand curve aD, the residual demand curve facing
firm 1 will be AD
U
. Then profit maximization condition of MR = MC leads firm 1 to
optimize at point B, which leads to price P
u
at point U on the residual demand curve. In
order to solve for the equilibrium output we differentiate the profit functions and get the
following respective first order maximization conditions

) ( 2 0 2 ] 15 . 8 [
) ( 2 0 2 ] 15 . 8 [
2 1 2 1
2
2
2 1 2 1
1
1
c a bq bq c bq bq a
q
b
c a bq bq c bq bq a
q
a
= + = =

= + = =

Solving for q
1
and q
2
in 8.15a and 8.15b, respectively, yields the following expressions
for the respective reaction functions:

( )
( )
1
1
1 2 2 1 2
2
2
2 1 1 2 1
2
1
2 2
) ( ] 15 . 8 [
2
1
2 2
) ( ] 16 . 8 [
q Q
q
b
c a
q q q q R b
q Q
q
b
c a
q q q q R a
n
n
=

= = =
=

= = =


164
The familiar quantity Q
n
is the monopoly market output. These reaction functions are
plotted in Figure 8.1B. If duopoly 2 produces zero output, duopolistic 1 will produce a
maximum of ( ) , 2 / b c a q
n
= and as recorded along the horizontal axis this would mean
that firm 1 is a monopolist. However, if duopoly 1 produces nothing, then using 8.16a,
duopolist 2 will produce ( ) , /
2
b c a q = as measured on the vertical axis, which turns out
to be the competitive equilibrium output level, Q
c
. This procedure yields a reaction curve
( )
2 1
q R for duopoly 1 and the reaction curve for duopoly 2 is given by curve ( )
1 2
q R . Note
that the absolute slope of ( )
2 1
q R is greater than that of ( )
1 2
q R , a property which gives a
stable Cournot equilibrium.

Cournot-Nash Equilibrium occurs at the intersection of the two reactions curves, U1, at
which each duopolist maximizes profits given its belief that the other duopolist does not
change its output. In this symmetric solution, duopolists share the market equally and the
optimal output levels can be solved simultaneously from [8.15] (or by substitutions using
8.16) to obtain:

.
3
] 17 . 8 [
2 1
b
c a
q q
u u

= =

The combined market output for the Cournot duopolist is , / ) (
3
2
2 1
b c a q q Q
u u u
= + =
which turns out to be or of the competitive industry output, while each produces a third of
that. It can be verified also that Cournot industry output is greater than the monopoly
output, and that the duopoly price is less than the monopoly price, P
u
< P
m
.

The Stackelberg Solution
The Stackelberg strategy is based on leader-follower behaviour by which the duopolist
leader acts first on the basis of full knowledge of the followers reaction function. The
leader duopolist then uses the followers reaction function into its profit maximizing
function. Let us assume duopolist 1 to be the leader and duopolist 2 to be the follower or
the competitive fringe. Duopolist 1 then has full knowledge of duopolist 2s reaction
function of equation 8.16b. Figure 8.1 will be used initially to experiment graphically on
how the leader develops its residual demand schedule from the reaction function of the
follower. For instance, if firm 1 produces zero output, Equation 8.16a tells us that the
follower will be a monopolist supplying Q
n
. In Figure 8.1A, this will be at the monopoly
price P
n
, with output P
n
N = Q
n
. If, instead, the follower produces zero output, this will be
at the competitive price level, Pc, and the leader will produce the competitive output level
Q
c
= P
c
C in Figure 8.1A, and will earn zero profit. Connecting points P
n
and C in Figure
8.1A results in the residual demand curve facing the leader, which is explicitly drawn in
Figure 8.2a as tracing P
n
KC with its MR as P
n
V. The leaders profits are maximized at
point V where MR = MC, thereby yielding optimal output q1k at price P
k
as determined
at the residual demand curve. In Figure 8.2B the decision point is K1 on the followers
reaction curve. It can, therefore, be seen that at price P1k the follower will supply q
2k
=
KL. Total industry sales would be q
1k
+ q
2k
= P
k
K + KL = Q
k
as shown on the industry
165
demand schedule. The locus P
c
NS
f
is the followers supply schedule, which is derived
from the procedure we have just described.
Algebraically, in order to maximize its profits, duopolist 1 will substitute R
2
(q
1
) for q
2
in
its profit function (8.1a) as follows:

1
2
1 1
2
1 1 1 1
1
1 1
2 2 2 2
] 18 . 8 [ cq q
b
b
c a
bq bq aq cq q
q
b
c a
q b a + |

\
|
=
)
`

\
|

+ =
In order to maximize profits the leader has to figure out its demand and MR curves. To
accomplish this the leader chooses the output on the followers reaction function which
maximizes its profit. By moving along reaction curve R
2
(q
1
) in Figure 8.1B, the leader
derives its residual demand curve drawn as P
n
UKC in Figure 8.12A. With the associated
MR curve that passes through point V on the constant MC curve, firm 1 chooses its
equilibrium output level q
1k
at point K on the followers reaction function and the
followers output as q
2k
. To solve for these equilibrium output levels get first order
condition of the leaders profit function and obtain:
b
c a
q a
k
2
] 19 . 8 [
1

=

Substitution for q
1
in R
2
(q
1
) yields, with simplifications, the output level for duopolist 2
as:

b
c a
q b
k
4
] 19 . 8 [
2

=

It can be seen that the leaders output is equal to monopoly output and half of the
competitive industrys output, while that of the follower is of competitive industry
output. The total industry Stackelberg output is:

c k k k
Q
b
c a
q q Q
4
3
4
3
] 20 . 8 [
2 1
=

= + =

This means that the Stackelberg industry output is greater than the monopoly output, Q
c

> Q
c
, and it is also larger than the Cournot industry output .
3
2
4
3
c c
Q Q > Since output
ordering is Q
c
> Q
k
> Q
u
> Q
n
, then price ordering would be P
c
< P
k
< P
u
< P
n
.

Isoprofit Map and Duopoly Equilibrium

An important concept in oligopolistic strategic behaviour is the isoprofit map, which is a
space of infinite number of isoprofit curves. An isoprofit curve for a given duopolist
traces unique combination or pairs of its sales and its rivals sales which yield a constant
level of its profit. With reference to Figure 8.3, a family or contour map of isoprofit
curves exists as represented by a sample of
10
,
11
and
12
for duopolist 1, which are
166
drawn to be convex to its sales axis due to the following reasoning. Using profit level

12
, for instance, you can see that as sales for duopolist 1 increase from point D to U
1,
q1o
to q
2
, its profits will tend to rise, which has to be offset by an increase in sales of
duopolist 2 so as to keep profit at its original level,
12
. However, from point F to point
U
1
, a decline q
2
requires also a decline in q
1
so as to maintain profit level at
12.
Profit
levels for a duopolist are higher the closer the isoprofit curves are to its axis, and the
highest profit level for firm 1 is
19.
The logic here is that a move from E to U, for
example, boosts sales of q1 while decreasing those of q
2
, thereby increasing firm ls
profits. At Q
n
along the horizontal axis, firm reaps monopoly profit level as q2 is reduced
to zero. Applying the same logic, isoprofit contours for duopolist 2 can been similarly
constructed in Figure 8.4 with increasing profitability from
21
,
22
to
25.


In this model, Cournot-Nash equilibrium is at point U
1
while Stackelberg equilibrium,
with duopolist 1 as the leader, is at point K
1
where its isoprofit curve is tangent to the
reaction function for duopolist 2. Technically therefore, a Stackelberg quantity leader
maximizes profits by moving to its highest isoprofit curve which is tangent to the
followers reaction curve. If duopolist 2 were to be the leader then point K
2
would have
been to the Stackelberg equilibrium.
A pertinent point to record at this juncture is that although the Stackelberg equilibrium
generates more industry output than the Cournot equilibrium, certainly it is the leader
who benefits more, while the follower would be better off with a Cournot position. This
is because position K
1
is better for duopolist 1 but worse for duopolist 2 than Cournot
position U
1
. Diametrically the opposite case is true for position K
2
. Only practical
reality and other considerations would persuade participants to settle initially for such
positions. Another potential Nash equilibrium position is the tangency at point C of
isoprofit curves
25
and
12.
Since both duopolists are off their respective reaction curves,
some other mutual fundamentals arrived at through cooperation must prevail for such
equilibrium to be sustainable.

Imperfect Markets and Inefficiency

Monopoly behaviour, when viewed from the position of competitive equilibrium, is
associated with DWL. This is represented by triangle NVC in Figure 8.2A where the
monopolists profit level is at a maximum of P
c
PnNV. What is notable is that this DWL
is progressively reduced as market structures depart from monopoly and they approach
the competitive structure. The DWLs are WEC and LMC for Cournot and Stackelberg
market solutions, respectively.

The durability of oligopolistic equilibrium can be undermined by a number of factors,
which include:
i) The threats to credibility of strategies that rival firms choose;
ii) The perception of lasting benefits; and
iii) Mistrust especially weaker players hold against large participants.
Due to various country objectives, governments intervene to enhance pre-commitments
of their firms if they feel threatened or cannot withstand competition from foreign rivals.
167
In the next sections, we investigate the effects of both internal and external fiscal
instruments under quantity-based duopoly and extend the analysis to price-based
Bertrand duopoly. In addition to other goals, strategic trade policy, as in the competitive
and monopoly models, pays great attention to its effects on DWL.

8.3 Trade Policy under Quantity Rivalry

In order to analyze the strategic role of fiscal policy under oligopoly we integrate in a
simple fashion a tax and a subsidy into the profit functions of the duopolists. We assume
that a subsidy (s) is a unit revenue on duopolist 1, modeled sq1, while a tax is a unit cost
on duopolist 2, or as tq2, so that their respective profit functions becoms:

2 2 2 1
2
2 2 2 2 2 2 2 1 1 2 1 2
1 1 2 1
2
1 1 1 1 1 1 2 1 1 1 1 1
) ( )] ( [ ) ( ] 21 . 8 [
) ( )] ( [ ) ( ] 21 . 8 [
q t c q bq bq aq tq q c q q q b a q c Pq b
q c s q bq bq aq q c sq q q q b a q c Pq a
t
s
+ = + = =
+ = + + = =

The associated first order conditions are:

) ( 2 ] 22 . 8 [
) ( 2 ] 22 . 8 [
2 2 1
1 2 1
t c a bq bq b
c s a bq bq a
+ = +
+ + = +


Simultaneous solution yields:
)] 2 ( ) 2 ( [
3
1
] 23 . 8 [
)] 2 ( ) 2 ( [
3
1
] 23 . 8 [
2 1
*
2
1 2
*
1
t s c c a
b
q b
t s c c a
b
q a
+ + =
+ + + =


It should be observed that the case of identical MC, c1 = c2 = c, and no fiscal
intervention, s = t = 0, is just the free-trade Cournot equilibrium solution of Equation
[8.17].

Trade Policy for Domestic Market Enhancement

Let us now assume that in a duopoly context, output q
1
is produced by our Home firm
while q
2
by the foreign firm and that they are initially at Cournot-Nash free-trade
equilibrium at point U on Foreign and Home reaction curves F and H, respectively. The
Home firm has achieved a profit level
1
from q
10
sales volume, while Foreign firms
export q
20
into the Home market. The Homes target profit level is the higher
t
. But to
achieve that profitability level it lacks individual resources to make its strategic move to
point T as a credible threat to the Foreign duopolist.

168
To provide credibility, a willing Home government can undertake a commitment to
guarantee the Home firm so that it can achieve its target profit level by imposing an
import tariff on imports. This will have the effect of raising the unit cost of supplying into
the Home market. At the same level of its exports, its profit declines as shown in
equation [8.21b] by tq
2
. The consequent rise in the Foreign firms cost reduces its export
volume in favour of the now relatively cheaper Home product. This leads to a downward
shift of foreign reaction function to F
t
F
t
until it intersects Homes curve at point T,
showing that foreign export volume into Home market has declined to q
2t
while Homes
sales volume has rise to q
1t.


Assuming that the tax rate, t, is an increase from zero rate, we note that from equations
[8.23a] and [8.23b], foreign sales contract by b t q q q
t
3 / 2 (
) 20 2 2
= = (for s =0),
while Home duopolists market gain is by . 3 / ) (
10 1 1
b t q q q
t
= = In this linear
specification, the fall in foreign sales is twice the gain by the home firm. The gains to the
home economy include the shift in profits from the foreign duopolist to the home one.
Using the respective profit equations, the loss in foreign profit is by
) 3 / 2 (
2
b t = and the home firm gains by ). 3 / (
1 1
b t = The other gain is in Home
government revenue of tP
m
q
2
. However, there is an efficiency loss associated with
increased import substitution by the home firm of q1. In addition consumer loss has
been incurred due to contraction in domestic supply of the product. This has arisen
because the decline in imports consumed is greeter than the increase in domestic
production, so that total availability of the product has declined, thereby generating an
overall domestic excess demand of . 0
2 1
< = q q q Since the domestic price must
have risen due to import tariff and also on account of the ensuing excess demand,
consumers are worse off with the tariff than under free trade. (The duopolists may have
shared a windfall in this domestic price rise). However, the foreign country will register a
net welfare loss due to efficiency loss with respect to the loss of export market share and
the shift of profits to the Home firm.
A subsidy to the Home firm is another instrument a Home duopolist may benefit from. In
this case the Home government is a Stackelberg leader to guarantee credibility to its
duopolists desired strategic move. Suppose, as shown in Figure 8.6, the target is higher
profit level
s
to earned in the domestic market. For point D to be a credible threat to the
Foreign duopolist, an adequate subsidy would induce the Home firm to increase domestic
supply to meet its profit objective. A subsidy is a revenue incentive as it enters the profit
function of the Home firm. The Home firm will increase domestic supply shown as a
rightward shift in its reaction curve at each level of Foreigns supply to H
s
or point S. The
gain to the Home firm in market share using equation [8.23b] is , 3 / 2
10 1 1
b s q q q
s
= =
which is greater than the absolute contraction in Foreigns domestic sales of
. 3 / ) (
20 2 2
b s q q q
s
= = If the tariff and subsidy are equivalent in achieving the same
target profit levels, t = t, then the subsidy is superior as the Home firms market share
rises for the same rise in profitability. Given the higher domestic production and supply
levels this would mean that the subsidy will lead to higher consumption levels at lower
inflationary conditions than under a profit-tariff equivalent. However, gains from the
subsidy, since there is no government revenue extracted from the foreign duopolist
169
(coupled with subsidy financing), the tariff may emerge as a more favourable instrument
to the domestic economy. The foreign economy is worse off with the subsidy than under
free trade even though the loss in output and rent is less under the subsidy than under an
equivalent tariff.

8.4 Export Promotion under Oligopoly

We have so far assumed that the battleground for strategic trade policy is the domestic
market of one economy. We move away from this inwardlooking strategy to explore
how a government may assist its home duopolist to compete for profits and extraction of
rents in foreign markets. We start with the use of subsidies and then examine the case of
export tariffs thereafter.

Export Subsidy under Duopoly

For purposes of demonstrating export competition using subsidy, we start by using Figure
8.6 which was used for analysis of effects of domestic production subsidy. In this case q
1

and q
2
are levels of export volume for Home and Foreign duopolists, respectively. The
export market is assumed to be in a third country and that firms are CournotNash
equilibrium there at point U
1,
where they are exporting q
10
and q
20
, respectively. If the
Home firm lacks credibility of a Stackelberg leadership to increase its export market
share and increase its profits, its Home government can act on its behalf with a credible
pre-commitment to provide an export subsidy which can take the Home duopoly to point
S
.
The mechanics of the market adjustment to the export subsidy are shown in Figure 7.6
(which is an extract from Figure 8.1A). Initially, under Cournot conjectures, the Home
firm set the Foreign firms export sales at q
20
with demand curve D(q
20
) and its
corresponding MR of MR
u
. Under constant cost conditions, profit maximization rule is
met at point A where MC = c = MR
u
. Under the symmetry assumption, then both
duopolists in Nash equilibrium export each q
10
(= q
20
) at price P
u
in the rest of the world
market. Given Home governments pre-commitment to support a target profit level of
s
and export sales q
20
, then with a subsidy, the Home firm as a credible leader will now set
the followers export sales at q
2s
, which gives Stackelberg export demand curve D(q
2s
).
The subsidy advantage is to reduce Homes marginal cost to (c-s) which equates MR
s
at
point B and is able to export at a lower price, P
s
, than the Cournot price P
u
. The Home
firms export market share has risen and its profits increased from
1
= cP
u
U
1
A to
1s
=
P
s
S
1
B(c-s). The Foreign firms profits have been squeezed to less than cP
u
U
1
A due to
export sales, which have been cut by . 0
20 2 2
< = q q q
s

A cost-benefit evaluation of this export strategy can be attempted. If we assume that the
product under analysis is not consumed in the domestic economies of the duopolists, then
the ROW consumers would be better off with Home subsidy than under free Cournot
trade. The foreign country is a net loser due to efficient output loss and the profits
extracted Home firm. The home country incurs an efficiency loss due to increased
production over free trade and by subsidizing ROW consumption to the tune of (Ps Pu)
170
per unit or at total subsidy cost of P
s
P
u
DS
1
. An optimal subsidy would be the one that
maximizes home welfare between these costs and the profits extracted from the foreign
duopoly.
Import Tariff for Export Promotion
Since domestic governments do not normally have jurisdiction to exercise fiscal policy in
foreign countries, the subsidy is a logically appropriate intervention instrument for
enhancing export drive. This explains why subsidies have been used systematically by
developed countries to assist agriculture and why subsidies form the core of WTO
wrangles. However, the potential for using an import tariff to promote exports has been
suggested for example by Krugman (1984) under duopolistic economies of scale and by
Eaton and Grossman (1986) under BertrandStackelberg conjectures. The Krugman
proposition, which is reviewed next, is known as strategy of import protection is export
promotion.
In the Krugman (1984) example, economies of scale provide a driving link between a
domestic import tariff and export competitiveness. In the oligopolistic models examined
so far constant costs have been assumed so that the models are exogenously driven by a
tariff or a subsidy as shown in the profit functions. Economies of scale mean that unit
costs move inversely with scale of production, which is represented by the declining
portion of marginal cost as shown in panel B of Figure 8.8. Both home and foreign firms
are assumed to exhibit scale economies. It is further assumed that domestic and foreign
markets are intergraded into one space, so that the struggle for profit or rent shifting is
both in home and foreign markets rather than segmented as we have so far implicitly
assumed under oligopoly. This may be construed as a continuation from the monopolistic
competition model after opening up to a unified world market as was the case in Chapter
7. This model here starts from where we left, though initially under free trade.
With these preliminary observations the Cournot-Nash equilibrium position for the Home
and Foreign firms are initially at point U with respective sales q
10
and q
20
in both panels
of Figure 8.8. Let the Home government impose a tariff against foreign sales. The
adjustment effect of this policy initiative can be identified under two stages. The first one
is the reduction in the volume of foreign sales in the home market from q
20
to q
2t
, which
is associated with the leftward shift of the foreign reaction curve F
1
F
1
. Consequently, the
Home firm sales rise from q
10
to q
1t
. This is precisely the effect we encountered under
the import tariff of Figure 8.5. The second adjustment is due to scale economies. The
reduction in Foreign firms sales means that its marginal cost is rising which further
reduces its competitiveness and shifts its reaction curve further to the left such as to
F2F2. However, the loss in Foreign firms market share has expansionary effect on the
Home firms sales, which are induced by the endogenous decline in unit costs represented
by a rightward shift of its reaction curve to H
1
H
1
. This results in a new equilibrium at
point S1, indicating an overall rise in Home firms sales by q
1n
q
10
> 0 and a loss in
Foreign firms sales by q
2n
q
20
< 0. In the process, the MC for the Home firm has
decreased from MC
0
to MC
1
, while that for the Foreign firm has increased from MC
0
to
MC
2
, which has caused the loss in export market competitiveness for the Foreign firm.
171
From the point of view of rent extraction, point S
4
is to the home economy superior to all
the strategic moves discussed above, but the worst to the foreign economy. The tariff has
made home sales increase in both domestic and in the foreign markets with profit
extraction equivalent to those associated with: (i) import tariff under constant costs at
point S1; (ii) domestic export subsidy at point S2; and then (iii) economies of scale at
point S4.
8.5 Trade Policy under Price Rivalry
We need to review briefly Bertrands duopoly model before applying it to strategic trade
policy. While in Cournot conjectures a duopolist acts on the belief that the other firms
output will not change, a Bertrand duopolists conjecture takes the rivals price as given.
Under Bertrand duopoly leadership behaviour by a firm to cut the price of its product can
not only be counterproductive to the firms business viability, but also, to the extent that
it might ignite a brutal price war, it can destabilize the whole industry. The possibility of
such unstable imperfect competitive market equilibrium is known as the Bertrand
Paradox, which occurs when the products of the rivals are perfect substitutes.
The paradox can be circumvented if duopolists produce or sell slightly imperfect
substitutes so that even when the price of one product is set at some critical low levels,
the demand for the other product would be positive. Take the extreme case of linear
demand curves and two duopolists, 1 and 2 whose behaviour in depicted in Figure 8.9. If
firm 1 sets the price for its product at zero, demand for firm 2s output would be positive
and priced at A
2
and, vice versa, if firm 2 charges zero price, firm 1 would sell at price
A
1
. If duopolist 1 charges at A1 the rival firm will charge above zero, such as at C
2
and,
vice versa, if duopolist 2 sells at A
2
, the other one would charge above zero such as at C
1
.
Connecting points A
2
C
2
and extrapolating gives the reaction function for firm 2, R
2
(P
1
),
while points A
1
C
1
and beyond yield R
1
(P
2
) as the reaction curve for firm 1.
The demand for a firms product depends negatively with respect to its own price but
positively to the price of the rivals substitute. That is

) , ( ) , ( ] 24 . 8 [
2 1 2 2 2 1 1 1
P P q q P P q q = =
Given constant costs, the profit functions can be written as
) , ( ) ( ) , ( ) ( ] 25 . 8 [
2 1 2 2 2 2 2 1 1 1 1 1
P P q c P P P q c P = =
For
0 ) ( 0 ) ( 0 ) (
1 2 2 1 1 1
> > < P q P q P q and 0 ) (
2 2
< P q
The reaction functions are positively sloped because of the following reasoning. Take the
reaction function for firm 2. a rise in the price of output of firm 1 from C
2
to D (or from
A
1
to P
10
) tends to create excess demand for output of duopolist 2 and raises its price P
2
,
172
thereby also raising its profit. If one firm raises it price, it is strategically safe for the rival
also to raise his. For stability condition, the reaction curve for duopolist is steeper than
for the opponents curve.
As in the Cournot case there are also Bertrand isoprofit contours, which however tend to
bend with their trough crossing their respective reaction curves horizontally. The trough
is associated with the profit maximizing price level. Take isoprofit contour
12
for firm 1
with profit maximizing price P
10
. To the left, any P
1
is less than P
10
and a rise in P
1
towards P
10
or point B1, tends to increase profits beyond
12
, which requires a decline in
P
2
so that profitability of good 1 is reduced to restore the profit level
12
and so the
contour slopes downwards. The curve rises to the right of B because a rise in P
2
raises
profits for firm 1 which has to be offset by an increase in P
1
to remain at
12
level.
Higher contours are associated with higher profit levels and there is an infinite number of
them in the P
2
-P
1
plane. Bertrand- Nash equilibrium is obtained at point B, with price P
10

and P
20
and profit levels
12
and
22
for duopolists 1 and 2, respectively. With this
review of the Bertrand framework, we turn next to trade analysis.
Let duopoly 1 again be our Home firm and duopoly 2 be the Foreign rival firm, which are
involved in export trade in a third country market. Their initial free trade Bertrand-Nash
equilibrium is shown in Figure 8.10 at point B on their initial reaction curves F and H for
foreign and home firms, respectively. Profit maximization objective under Bertrand
conjecture renders the use of a price cut by a would be leader irrelevant because both
firms move to lower profit level positions. This leaves the option of raising own product
price as the only strategic instrument. If the Home firm desires to earn higher profits from
export markets, an attractive move would be to point S
1
where its isoprofit curve
11
is
tangent to the Foreign firms reaction curve F, which also turns out to be higher than the
current profit level of
10
. As a leader, it chooses to raise its export price from P
10
to P
11,
a move which raises the opponents price to S
1
. Each firms profit from export business
rises. As for firm 2, there is a higher profit curve (drawn imaginary) than
20
that
crosses its reaction curve H at S1. However, point S
1
is not on Homes reaction curve
which is still H, and therefore its Stackelberg move wont be credible to the follower firm
2. If, alternatively, Foreign rival took leadership initiative to raise its price, point S
2

would also have risen profits for both firms. Such strategic moves can create
disequilibrium in export markets. This is due to the observation that at point S
2
the Home
firm is better off as a follower than as a leader at point S
1
(because there is a higher profit
curve crossing point S
2
than profit level
11
). Similarly, the Foreign firm is better off as
a follower at S
1
than as a leader at S
2
. This Stackelberg instability or disequilibrium arises
in this instance because both doupolists cannot be followers and (it can be shown that)
neither both can be leaders. (One way out would be to redraw Foreign firms isoprofit
map so that its
1 2
is tangent to Homes reaction curve HH between points B and A).
Even if the impasse were resolved so that our Home duopoly emerged as the leader,
position S
1
may not be durable from rivals viewpoint upon suspicion that Home firms
move lacked credibility. Since it is profitable to remain at point S1, our home government
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can intervene by imposing an export tax which raises the price of home product in the
export market to P
11
= P
10
(1+ t). This policy move would shift Home firms reaction
curve to H
1
H
1
so that it crosses the Foreign firms stationary curve FF. Suppose,
however, the Foreign firm also secures its governments support to tax exports so as to
move to a higher profit level than at point S
1
. This would shift its reaction curve of F
1
F1,
which would intersect Home firms curve at the new BertrandNash equilibrium point B
1,

where both firms maximize higher profit from exports.
The result from the Bertrand oligopoly conjectures whereby an export tax rather than a
subsidy is the optimum instrument, yields important lessons. First, to the extent that both
firms mutually move to higher profit maximization position, means that, unlike in the
cases we have reviewed, profit shifting or the begger-thy-neighbour strategy is not viable.
Second, although we have assumed a third export market, the result of mutual gain in
profitability is not altered even when the market is either home or foreign or whether
quantitative restrictions (import quota or VER) are used. Whichever exogenously
precommits to a rise in the price of one product leads to mutually higher profit levels.
Finally, policy under Bertrand conjectures in this case is a substitute for voluntary
collusion among potential competitors or rivals using their governments as guarantor of
the agreement or to the durability of the mutual gains. However, due to inherent pro-
inflationary bias, sustained government intervention in this model has the potential of
generating substantial inefficiency and consumer losses.
8.6 Export Subsidies and Countervailing Measures in World Trade























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