International_Economics_Tenth_Edition (1)

librium wage ratio rises to 2.5, thus intensifying wage inequality.

• Education and training. As the availability of education and training increases, so does the ratio of skilled workers to unskilled workers, as seen by the increase in the supply curve from So to S1' If the demand curve remains constant, then the equilibrium wage ratio will fall from 2.0 to 1.5. Additional opportunities for education and training thus serve to reduce the wage inequality between skilled and unskilled workers.

Evidence on Wage Inequality

We have seen how trade and immigration can promote wage inequality. However, economists have

found that their effects on the wage distribution have been small. In fact, the vast majority of wage inequality is due to domestic factors, especiallytechnology.

One study, by William Cline, estimated that technological change was about four times more powerful in widening wage inequality in the United States between 1973 and 1993 than trade, and that trade accounted for only 7 percentage points of all the unequalizing forces at work during that period. That's only one study, but it is consistent with many studies. The consensus is that technological change has exerted a far stronger effect on wage inequality than trade.

The results of Cline's study are summarized in Table 3.4 on page 70. It found that between 1973

and 1993, the ratio of skilled to unskilled wages increased by 18 percent. This was the net result of two opposing forces. First, there was an increase in the supply of skilled workers relative to the supply of unskilled workers, made possible by increased opportunities for education and training. The increased relative supply of skilled workers drove down the ratio of skilled to unskilled wages, thus promoting wage equality, But at the same time, a variety of forces promoted wage inequality, and these unequalizing forces overwhelmed the equalizing forces. This resulted in an 18 percent net increase in the ratio of skilled to unskilled wages. Besides trade and technology, these unequalizing forces included immigration, stagnant minimum wage, and decline of unions.

Two things are striking about Cline's data. First, trade has been relatively unimportant in widening wage inequality. Second, trade's impact on wage inequality is overwhelmed not just by technology but also by the main force operating in the opposite direction-education and training. Indeed, the shifts in labor demand, away from less educated workers, are the most important factors

behind the eroding wages of the less educated. Such shifts appear to be the result of economy-wide technological and organizational changes in how work is performed. The use of computers in the workplace has increased significantly in recent years. Not only has computerization led to the replacement of rote jobs (typing letters on an electric typewriter), but workers who use computers are also generally paid higher wages than those who do not.

The relatively small impact of trade on the inequality of skilled and unskilled wages means that skeptics of globalization miss the point if they are concerned mainly about the impact of globalization on adversely affected workers in wealthy countries.

Indeed, some workers in wealthy countries do lose out from a combination of trade and technology. Yet just as a crusade against technology is not the solution to increased inequality resulting from technological progress, most economists argue that increased trade protection will not raise the relative wages of unskilled workers. A better solution involves better education and increased training to allow low-wage workers to take advantage of the technological changes that increase productivity.

Are Actual Trade Patterns

Explained by the Factor-

Endowment Theory?

Following the development of the HeckscherOhlin theory, little empirical evidence was brought to bear about its validity. All that came forth were intuitive examples such as labor-abundant India exporting textiles, rugs, or shoes, or capital-abun- dant Germany and the United States exporting machinery and automobiles, or land-abundant Australia and Canada exporting wheat and meat. For some economists, such examples were sufficient to illustrate the validity of the Heckscher-Ohlin theory. However, others demanded stronger evidence.

The first attempt to investigate the factorendowment theory empirically was undertaken by Wassily Leontief in 1954: It had been widely recognized that in the United States capital was relatively abundant and labor was relatively scarce. According to the factor-endowment theory, the

United States should export capital-intensive goods and its import-competing goods should be labor-intensive.

Leontief tested this proposition by analyzing the capital!labor ratios for some 200 export industries and import-competing industries in the United

'Wassily w. Leontiel, "Domestic Production and Foreign Trade: The American Capital Position Reexamined." Proceedings of the American Philosophical Society 97, September 1953.

TABLE 3.5

States, based on trade data for 1947. As shown in Table 3.5, Leontief found that the capital!labor ratio for U.S. export industries was lower (about $14,000 per worker year) than that of its importcompeting industries (about $18,000 per worker year). Leontief concluded that exports were less capital-intensive than import-competing goods! These findings, which contradicted the predictions of the factor-endowment theory, became known as the Leontief paradox.

Some economists maintained that 1947 was not a normal year, because the World War II reconstruction of the global economy had not been corrected by that time. To silence his critics, Leontief repeated his investigation in 1956, using 1951 trade data. Leontief again determined that U.S. import-competing goods were more capitalintensive than u.s. exports.

Since Leontief's time, many other studies have tested the predictions of the factor-endowment model. Although the tests conducted thus far are not conclusive, they seem to provide support for a more generalized factor-endowment model that takes into account many subvarieties of capital, land, and human factors and recognizes that factor endowments change over time as a result of investment and technological advances.

The upshot of a generalized factor-endowment model can be seen by looking at some trading statistics of the United States. Table 3.6 on page 72 shows the shares of world resources for various

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countries and regions in 1993. The table shows that the United States had 20.8 percent of the world's capital, 19.4 percent of the world's skilled labor, and 2.6 percent of the world's unskilled labor. Because the United States has a relatively large share of capital, the factor-endowment model predicts that the United States should have a comparative advantage in goods and services that embody more scientific know-how and physical capital. This prediction is consistent with recent trade data for the United States. The United States has been a net exporter for technologically intensive manufactured goods (such as transportation equipment) and services (such as financial services and lending) that reflect U.S. technological know-how and past accumulation of physical capital. The United States is a net importer of standardized and labor-intensive manufactured goods (such as footwear and textiles).

Early versions of the Heckscher-Ohlin model emphasized relative endowments of capital, labor, and natural resources as sources of comparative advantage. More recently, researchers have increasingly focused on the importance of worker skills in the creation of comparative advantage. Investments

in skill, education, and training, which enhance a worker's productivity, create human capital in much the same manner that investments in machinery create physical capital. The United States is abundant in this human capital, including a well-educated and skilled labor force, relative to those of many other nations, as shown in Table 3.7. Therefore, the United States exports goods, such as jetliners and computer software, that use a highly skilled workforce intensively.

Researchers at the World Bank have analyzed the relationship between manufactures and primary products to relative supplies of skills and land, as shown in Figure 3.2 on page 74. Their study included export data for 126 industrial and developing nations in 1985. Values along the horizontal axis of the figure denote the ratio of a nation's average educational attainment to its land area; values along the vertical axis indicate the ratio of manufactured exports to exports of primary products. In the figure, the regression line relates the division of each nation's exports between manufactures and primary products to its relative supplies of skills and land. The regression line suggests that nations endowed with relatively large amounts

of skilled workers tend to emphasize the export of manufactures. Conversely, land-abundant nations tend to emphasize exports of primary products.

Thus far, we have examined the two most popular theories of trade-the Ricardian theory, in which comparative advantage is based on labor productivities, and the Heckscher-Ohlin theory, in which factor endowments underlie comparative advantage. The Ricardian model is easier to empirically test because measuring labor productivity is easier than measuring factor endowments. Thus, it is no wonder that empirical tests of the Ricardian model have been more successful, as discussed in Chapter 2. In general, these tests support the notion that trade patterns between pairs of countries are largely determined by the relative differences in labor productivities.

However, tests of the Heckscher-Ohlin theory of trade have been mixed. Many empirical studies have raised questions about the validity of this theory. The consensus among economists appears to be that factor endowments explain only a portion of trade pat-

terns. Other determinants of comparative advantage include technology, economies of scale, governmental economic policies, and transportation costs, which we will examine throughout this chapter.

Increasing Returns to Scale and Specialization

Although comparative advantage theory has great appeal, it has little abilityto explain why regionswith similar productivity levels trade to the extent they do-why Europe and the United States, for example, trade in such great volume. Nor does it shed light on intraindustry trade: the fact that Germany and Japan will trade automobiles with each other.

In response to these weaknesses, economists developed a new theory of trade in the 1980s.5

'Paul Krugman, "New Theories of Trade Among Industrial Countries," American Economic Review 73, No.2, May 1983, pp. 343-347, and Elhanan Helpman, "The Structure of Foreign Trade," Journal of Economic Perspectives \3, No.2, Spring 1999, pp. 12 I-I 44.

This "new trade theory" is founded on the notion of increasing returns to scale, also known as economies of scale. The increasing-returns explanation for trade does not attempt to replace the comparative advantage explanation; it just supplements it.

According to increasing-returns trade theory, nations with similar factor endowments, and thus negligible comparative-advantage differences, may nonetheless find it beneficial to trade because they can take advantage of massiveeconomies of scale, a phenomenon prevalent in a number of industries. In the automobile and pharmaceutical industries, for example, the first unit is very expensive to produce, but each subsequent unit costs much less than the one before because the large setup costs can be spread across all units. Companies such as Toyota and Honda reduce costs by specializing in machin-

ery and labor and obtaining quantity discounts in the purchase of inputs.

Increasing-returns trade theory asserts that a nation can develop an industry that has economies of scale, produce that good in great quantity at low average costs, and then trade those low-cost goods to other nations. By doing the same for other increasing-returns goods, all trading partners can take advantage of economies of scale through specialization and exchange.

Figure 3.3 illustrates the effect of economies of scale on trade. Assume that a u.s. auto firm and a Mexican auto firm are each able to sell 100,000 vehicles in their respective countries. Also assume that identical cost conditions result in the same long-run average cost curve for the two firms, AC. Note that scale economies result in decreasing unit costs over the first 275,000 autos produced.

c

Initially, there is no basis for trade, because each firm realizes a production cost of $10,000 per auto. Suppose that rising income in the United States results in demand for 200,000 autos, while the Mexican auto demand remains constant. The larger demand allows the u.s. firm to produce more output and take advantage of economies of scale. The firm's cost curve slides downward until its cost equals $8,000 per auto. Compared to the Mexican firm, the u.s. firm can produce autos at a lower cost. With free trade, the United States will now export autos to Mexico.

Economies of scale thus provide additional cost incentives for specialization in production. Instead of manufacturing only a few units of each and every product that domestic consumers desire to purchase, a country specializes in the manufacture of large amounts of a limited number of goods and trades for the remaining goods. Specialization in a

few products allows a manufacturer to benefit from longer production runs, which lead to decreasing average costs.

A key aspect of increasing-returns trade theory is the home market effect: Countries will specialize in products for which there is large domestic demand. Why? By locating close to its largest market, an increasing-scale industry can minimize the cost of shipping its products to its customers while still taking advantage of economies of scale. That is, auto companies will locate in Germany rather than France if it's clear that Germans are likely to buy more cars. That way the company can produce low-cost cars and not have to pay much to ship them to its largest market.

But the home market effect also has a disturbing implication. If increasing-scale industries tend to locate near their largest markets, what happens to small market areas? Other things equal, they're

Wiley, 1961). Chapter 3.

tastes. Nations with high per capita incomes will demand high-quality manufactured goods (luxuries), while nations with low per capita incomes will demand lower-quality goods (necessities).

The Linder hypothesis explains which types of nations will most likely trade with each other. Nations with similar per capita incomes will have overlapping demand structures and will likely consume similar types of manufactured goods. Wealthy (industrial) nations will likely trade with other wealthy nations, and poor (developing) nations will likely trade with other poor nations.

Linder does not rule out all trade in manufactured goods between wealthy and poor nations. Because of unequal income distribution within nations, there will always be some overlapping of demand structures; some people in poor nations are wealthy, and some people in wealthy nations are poor. However, the potential for trade in manufactured goods is small when the extent of demand overlap is small.

Linder's theory is in rough accord with the facts. A high proportion of international trade in manufactured goods takes place among the relatively high-income (industrial) nations: Japan, Canada, the United States, and the European nations. Moreover, much of this trade involves the exchange of similar products: Each nation exports products that are much like the products it imports. However, Linder's theory is not borne out by developing country trade. The bulk of lower-income, developing countries tend to have more trade with high-income countries than with other lower-income countries.

IIntraindustry Trade

The trade models considered so far have dealt with interindustry trade-the exchange between nations of products of different industries; examples include computers and aircraft traded for textiles and shoes, or finished manufactured items traded for primary materials. Interindustry trade involves the exchange of goods with different factor requirements. Nations having large supplies of skilled labor tend to export sophisticated manufactured products, while nations with large supplies of nat-

ural resources export resource-intensive goods. Much of interindustry trade is between nations having vastly different resource endowments (such as developing countries and industrial countries) and can be explained by the principle of comparative advantage (the Heckscher-Ohlin model).

Interindustry trade is based on interindustry specialization: Each nation specializes in a particular industry (say, steel) in which it enjoys a comparative advantage. As resources shift to the industry with a comparative advantage, certain other industries having comparative disadvantages (say, electronics) contract. Resources thus move geographically to the industry where comparative costs are lowest. As a result of specialization, a nation experiences a p

mg dissimilarity between the products that it exports and the products that it imports.

Although some interindustry specialization occurs, this generally has not been the type of specialization that industrialized nations have undertaken in the post-World War II era. Rather than emphasizing entire industries, industrial countries have adopted a narrower form of specialization. They have practiced intraindustry specialization, focusing on the production of particular products or groups of products within a given industry (for example, subcompact autos rather than autos). With intraindustry specialization, the opening up

of trade does not generally result in the elimination or wholesale contraction of entire industries within a nation; however, the range of products produced and sold by each nation changes.

Advanced industrial nations have increasingly emphasized intraindustry trade-two-way trade in a similar commodity. For example, computers manufactured by IBM are sold abroad, while the United States imports computers produced by Hitachi of Japan. Table 3.8 provides examples of intraindustry trade for the United States. As the table indicates, the United States is involved in two-way trade in many manufactured goods such as chemicals and motor vehicles.

The existence of intraindustry trade appears to be incompatible with the models of comparative advantage previously discussed. In the Ricardian and Heckscher-Ohlin models, a country would not simultaneously export and import the same product. However, California is a major importer of French wines as well as a large exporter of its own wines; the Netherlands imports Lowenbrau beer while exporting Heineken. Intraindustry trade involves flows of goods with similar factor requirements. Nations that are net exporters of manufactured goods embodying sophisticated technology also purchase such goods from other nations. Much of intraindustry trade is conducted among industrial

Huffy/bicycles

Wal-Martlhandbags

Kathie Lee/handbags

Stride Rite/footwear

Keds/sneakers

New Balance/shoes

15-hour shifts, 7 days a week. No overtime pay. Guards beat workers for being late.

Excessive charges for food and lodging mean some workers earn less than 1 cent an hour

16-year-old girls apply toxic glues with bare hands and toothbrushes. Workers locked in factories behind 15-foot walls.

Lax safety standards, no overtime pay as required by Chinese law.

Prodded by controversy over exploitation in foreign factories that make much of America's clothes and shoes, Nike, Reebok, and other u.s. corporations have pushed for sweatshop reforms. A sweatshop is characterized by the systematic violation of workers'rights that have been certified in law. These rights include the right to organize and bargain collectively, and the prohibition of child labor. Also, employers must pay wages that allow workers to feed, clothe, and shelter themselves and their families. The table provides examples of sweatshop conditions in Chinese factories producing for u.S. companies.

For example, a 1997 audit by the firm of Ernst & Young, commissioned by Nike, was leaked to reporters. The audit found that employees in a large Vietnam factory were exposed to the fumes of cancer-causing toluene and had a high incidence of respiratory problems. The audit also

found that employees were required to work as long as 65-hour weeks, sometimes in unsafe conditions. Also, in 1999 Reebok released a study of two large Indonesian factories. The study uncovered substandard working conditions, sex bias, and health problems among workers.

Pressured by sweatshop critics, in 1999 Nike and Reebok initiated improvements in the wages and working conditions of its foreign workers. Nike and Reebok increased wages and benefits in their Indonesian footwear factories, which employed more than 100,000 workers, making base compensation 43 percent higher than the minimum wage. Also, Nike agreed to end health and safety problems at its 37 factories in Vietnam and other nations. Moreover, Reebok and Nike took unprecedented steps to defend labor rights activists, who have long been their adversaries. However, critics argued that these reforms left

countries, especially those in Western Europe, whose resource endowments are similar. The firms that produce these goods tend to be oligopolies, with a few large firms constituting each industry.

Intraindustry trade includes trade in homogeneous goods as well as in differentiated products. For homogeneous goods, the reasons for intra industry trade are easy to grasp. A nation may export and import the same product because of transportation costs. Canada and the United

States, for example, share a border whose length is several thousand miles. To minimize transportation costs (and thus total costs), a buyer in Albany, New York, may import cement from a firm in Montreal, Quebec, while a manufacturer in Seattle, Washington, sells cement to a buyer in Vancouver, British Columbia. Such trade can be explained by the fact that it is less expensive to transport cement from Montreal to Albany than to ship cement from Seattle to Albany.