Trade Flashcards
Please provide a 2 country 2 product example that explains absolute versus comparative advantages
Classical models of trade emphasize that trade is based on differences between countries. Two types of differences.
Technological differences: Ricardian model.
Factor endowment differences: Heckscher-Ohlin model.
Countries trade to take advantage of their differences. If countries were identical, there would be no point in trading. It is differences between countries, whether in terms of their technological capabilities or their factor supplies, that cause trade. The differences that matter for trade are relative differences.
Example: Hours of work necessary to produce one unit
Country Cloth Wine
England 100 120
Portugal 90 80
England use 100 hours of labor to produce one unit of cloth. Alternatively they could produce 100/120 = 5/6 units of wine. Portugal use 90 hours of labor to produce one unit of cloth. Alternatively they could produce 90/80 = 9/8 units of wine. Portugal possess an absolute advantage in producing cloth and wine due to fewer labor hours used producing one unit.
To identify who has the comparative advantage, we compare opportunity costs:
- England's opportunity cost of cloth (5/6 wine) is less than Portugal's opportunity cost of cloth (9/8 wine). This means England gives up less wine to produce cloth than Portugal does, making England's opportunity cost lower. - Conversely, Portugal's opportunity cost of wine (8/9 cloth) is less than England's opportunity cost of wine (6/5 cloth), giving Portugal a comparative advantage in wine.
Hence, England should specialize in producing cloth where it has the comparative advantage, and Portugal should specialize in producing wine where it has the comparative advantage. They can then trade, and both countries will be able to consume more than if they each produced both goods on their own.
Please explain the predictions of traditional trade theory in relation to within country inequality in low income countries and what the empirical evidence suggest
The prediction:
That countries would be able to use their comparative advantages, when their opportunity cost is lower in a specific product.
Changes in a country’s exposure to international trade affect the distribution of resources within the country and can generate substantial distributional conflict. But distributional changes went in the opposite direction from the one suggested by conventional models: Globalization was expected to help the less skilled in the Global South (who are presumed to be the locally relatively abundant factor in developing countries), the evidence showed that they are generally not better off (at least not relative to workers with higher skill or education levels).
Remind me, what is within country inequality?
There are two type of inequality.
Between countries:
Is the inequality between countries.
Within countries:
Is the inequality inside the country, which can grow even if the between country inequality is falling.
Please explain the underlying idea behind the theory of economics complexity
EC is a framework that assesses the level of production sophistication and diversity in a country.
The first leg of Economic Complexity (EC) :
It suggests that the more diverse and sophisticated the products a country can produce, the more likely it is to be on a successful development path.
This concept hinges on the idea that producing different goods is associated with various knowledge externalities. That means when a company or entrepreneur starts producing a new product, it uncovers information about the production costs in the economy (called the “Cost discovery process”). This information is valuable because if the venture is successful, it signals to other producers that this new product can be profitably made, prompting them to enter the market. The cost is then socialized. The first entrepenuers work can be seen as a positive externalities to other producers. However, if the entrepreneur fails, the costs are not shared; the losses are private.
Because of these knowledge externalities, the level of investment in exploring new production possibilities tends to be less than ideal. The theory suggests that industries or governments need to find ways to internalize these externalities, so more potential producers are incentivized to invest in discovering new production avenues.
The second leg:
The concept of Economic Complexity recognizes a strong link between the sophistication of a country’s exports and its economic growth. For a nation to advance rapidly, it’s essential to expand its production into a wider array of sophisticated, or complex, products. This is true even for countries primarily exporting raw materials or simple goods; they aren’t destined to follow a single path but can diversify their economies. DIVERSIFY, DIVERSIFY, DIVERSIFY.
Each country has unique circumstances and industry conditions that influence its economic journey. However, the path to growth isn’t pre-determined by what a country is currently good at producing. Comparative advantage isn’t static; it can be creared/developed. Nations can develop new strengths by building technological capabilities that shift their productive focus.
Thus, policy should encourage the production of high-quality and high-productivity goods, even beyond areas of existing comparative advantage, to foster a dynamic and evolving economy.
EC in graphics (ECI):
The theory uses the product space to illustrate how products are interlinked, with more complex products positioned in a densely connected core and simpler products on the periphery. The ease of moving from producing one product to another depends on these connections. Additionally, the EC framework employs the method of reflection, which takes into account diversity and ubiquity:
* Diversity refers to the number of products that a country can produce competitively. In the picture the Netherlands diversity is 5, Argentina 3 and Ghana 1. * Ubiquity refers to how many countries can produce a particular product competitively. In the picture chees´s ubiquity is 2, medicaments 1, fish 3.
Picture of three countries and 5 capabilities (products). 2
So the diversity and ubiquity terms are used to construct Hausmann and Hidalgo indicator of eceonomic complexity index (ECI).
To assess comparative advantages, EC uses the Revealed Comparative Advantage (RCA) index. A country is said to have an RCA in a product if it exports more of that product than the product’s share of global trade. This is a way of identifying what a country is particularly good at producing compared to the rest of the world.
By comparing countries using the EC approach, we can understand how countries like Thailand have been able to diversify their production and increase their sophistication faster than countries like Ghana. This difference in economic complexity is proposed as a key reason for their different growth trajectories.
Please select Ghana and Kenya. based on the country profiles how would you evaluate and compare the two countries:
- Recommended strategic approach?
- Potenital growth opportunities?
- New product opportunities?
Kenya:
Recomended strategic approach:
- Parsimonious Industrial Policy Approach
○ Limited opportunities requires addressing bottlenecks, to help jump short distances, into related products. In other words focus on existing economic activities, and consist of putting mechanisms in place to ensure that roadblocks facing these activities can be identified and removed.
- But they could just as well have vent with a light touch approach, because the they are placed on cero on the complexity axis. It means Kenya is neither low or high on realtive complexity, but placed right in the middle. Therefore we could argue that Kenya could go for the light touch approach as well.
Link til grafer: https://atlas.cid.harvard.edu/countries/116/strategic-approach
Potential growth opportunities
- Countries grow by diversifying into new products of increasing complexity. Strategic new products aim to balance:
○ Distance to existing capabilities: lower distance (close to 0) signifies a product is “nearby” to existing knowhow
○ Complexity: more complex products tend to support higher wages
○ Opportunity gain for future diversification: higher values hold more linkages to other high-complexity products, opening more opportunities for continued diversification.
- This is the bundles of products that Kenya would produce, when their selection criteria is balanced portfolio.
New Product Opportunities: “Parsimonious Industrial Policy Approace”.
- In the case of low-hanging fruits:
Given its current exports, some of the sectors with high potential for new diversification in Kenya are: Diary products and Aluminium.
- In the case of Balanced Portfolio:
○ Given its current exports, some of the sectors with high potential for new diversification in Kenya are: Industrial Machinery and Diary products.
- In the case of long jumps:
Given its current exports, some of the sectors with high potential for new diversification in Kenya are: Industrial Machinery and Articles of iron or steel
Ghana:
Ghana’s Product Space
Recommended Strategic Approach:
- Ghana’s existing knowhow affords a few opportunities to diversify into related products. In diversifying its economy, Ghana may consider a:
Strategic Bets Approach
○ Few nearby opportunities call for coordinated long jumps into strategic areas with future diversification potential. So
Potential growth opportunities:
With the “Stratigic Best Approach” and choosing the product selection criteria balanced portfolio, then the product bundles will look like this.
New Product Opportunities: “Strategic Best Approach”.
In the case of low-hanging fruits:
Given its current exports, some of the sectors with high potential for new diversification in Ghana are: Miscellaneous edible preparations and Preparations of vegetables, fruit, or nuts.
In the case of Balanced Portfolio:
Given its current exports, some of the sectors with high potential for new diversification in Ghana are: Industrial Machinery and Dyes, paints, inks, etc.
In the case of long jumps:
Given its current exports, some of the sectors with high potential for new diversification in Ghana are: Industrial Machinery and Plastics.
Briefly discuss how well these traditional trade theories have explained the patterns of
international trade during the last approximately 40 years, with an emphasis on the evidence in
Hanson (2012) in relation to (i) North-North, (ii) North-South and (iii) South-South trade.
During the 1980s North-North trade dominant – Is that consistent with classical theories of
comparative advantage? NO. But the recent rise in North-South trade led to renewed interest in
the role of comparative advantage in global production. (i) Specialization in primary
commodities was seen as a pathway to economic growth for many low income countries. (ii)
Differences in industrial capabilities the driver of trade. Growth in low- and middle-income
economies led to a recent rise in South-South trade deepening global production networks.
The gravity model of trade expresses exports from one country to another as a function of the
countries’ (i) GDPs, (ii) Bilateral trade costs, (iii) Relative prices. Following the gravity logic,
the share of low- and middle-income countries in global trade should increase in rough
proportion to their share of global income.
Before 2000: Robust success of the gravity model. Country size and trade costs the primary
determinants of trade flows. No significant role for “comparative advantages.
After 2000: Gravity model facing problems. Growth in trade shares for low- and middle-income
countries far exceeds the increase in their relative economic size. Southern trade has grown
much faster than Southern GDP.
What are the implications of EC in relation to traditional trade theory?
Traditional models of trade emphasize that trade is based on differences between countries. Two types of
differences: (i) Technological differences: Ricardian model. (ii) Factor endowment differences: Heckscher-
Ohlin model. Countries trade to take advantage of their differences. If countries were identical, there would
be no point in trading. It is differences between countries, whether in terms of their technological
capabilities or their factor supplies, that cause trade. The differences that matter for trade are relative
differences. Relative (or comparative) advantage determines the patterns of trade. You do not need to be
the best in anything to take advantage of trade. Available theories of trade are capable of explaining
specific features of global commerce, such as why trade has a gravity structure, why countries specialize, or
why so few firms export. But not capable of explaining the rich tableaux of trade patterns that we observe
through the growing importance of low and middle-income countries in the world economy. Moreover,
according to traditional theories of trade, globalization was expected to help the less skilled (who are
presumed to be the locally relatively abundant factor in developing countries), but the evidence showed
that they are generally not better off (at least not relative to workers with higher skill or education levels).
If the EC theory is correct, then the policy implications are very different from recommendations coming
out of traditional trade theories:
- Specialization in few products is a bad idea, diversification is key.
- Comparative advantages can be developed, and countries should promote products (with RCA<1)
that meet three criteria: (i) The product should introduce new productive knowledge (high product
complexity), (ii) The product should facilitate further diversification (high opportunity gain) and (iii)
The product should be relatively easy to diversify into given existing knowledge (low distance).
Give me an intuitive thinking on EC theory:
Imagine a country as a large kitchen. In this kitchen, different chefs (entrepreneurs) try to cook a variety of dishes (products). Each dish requires a different set of recipes and ingredients (knowledge, skills, capital, institutions). Some dishes are simple and known worldwide (less sophisticated products), while others are gourmet and require specific know-how and tools (more sophisticated products).
The Economic Complexity idea, according to Ricardo Hausmann and his colleagues, is like a cooking show where chefs share their recipes and cooking techniques. When one chef figures out how to make a gourmet dish successfully, the others learn from this and start making their own versions. This sharing of recipes boosts the overall cooking level of the kitchen, leading to a wider variety of dishes being prepared (product diversity).
The product space is like a recipe book that shows how dishes are connected. Some recipes are central; they share ingredients and techniques with many others (densely connected core), making it easier to learn and adapt. Other recipes are more unique, not sharing much with the rest (periphery), and are harder to learn from.
The kitchen (country) becomes more successful (develops) when it can cook a wide variety of dishes well (product diversity) and when its recipes are sought after by many other kitchens (countries) worldwide (product ubiquity). To figure out which dishes a kitchen excels in, they use a special index (RCA) that compares their dish (product export) to what’s popular globally. If their dish is more popular than the global average, they’re said to have a specialty in it.
Ghana and Thailand can be seen as two kitchens. Over time, Thailand’s chefs have learned to cook many more new and complex dishes than Ghana’s. This means Thailand’s kitchen has become more diverse and capable, helping it grow and become more prosperous faster than Ghana’s.
In essence, the Economic Complexity approach is about the hidden value of learning to cook new and complex dishes and sharing that knowledge, which eventually leads to a richer and more diverse culinary (economic) experience for the entire kitchen (country)
What is the revealed comparative advantage (RCA)
Definition from chatten
A country is considered to have an RCA in a product if that product makes up a bigger portion of its exports than it does in the worldwide market. In simpler terms, if a country exports more of a product relative to its total exports than what is typical on the global stage, it has a Revealed Comparative Advantage. This is quantitatively expressed by an RCA greater than 1. This metric helps to identify the unique strengths of a country’s export economy.
Definition from slides
A country is defined to have an RCA in a given product if its export share is larger or equal to the product’s share of the overall world trade. (RCA > 1).
So if the Elfenbenskysten is exporting chocolate for 10% of its total export and the global export of chocolate is 1% of total global exports, then the RCA would be 10 > 1. Elfenbenskysten have a RCA in producing chocolate.
E.g.
RCA = Export share of chocolate for Elfenbenskystens / Global export share of chocolate
= 10/1
= 10
What is the Product Space?
Our research finds that countries tend to diversify by moving into nearby and related products or into those that require similar knowhow to build on existing capabilities. The Product Space represents the relatedness of over 800 goods using real world data.
For example, countries that produce textiles (green) are highly likely to be able to produce other textiles, but share few links to the knowhow required to produce machinery (blue).
The notes between the dots show which products a given product i related to.
The Product Space helps to define paths to diversify a country’s economy based on the connectedness of its knowhow.
The product space will look the same for all economies. The difference is that some countries export more than others.
- Colored notes
○ Products that the country export
- Greu notes
○ Products the country does not export
- The sizing of the dots changes from country to country. In some contries they export a lot of metals and in others medicaments. That will change the size of the dots.
○ Extra feature: Sizing of dots in the graph, right now I have chosen world trade, but I could also choose country trade, then I get the correct sizing of the dots. A quick way to check for RCAs . Therefore the dots will change in size if I choose country trade.
Ghana’s Product Space
Countries are more successful in diversifying when they move into production that requires similar knowhow and builds on existing capabilities.
How to decide a stratgic approach using the graph?
The stretegy tree:
Can the country grow its economy using its existing knowhow?
Yes or no
- Yes, then you are far to the right on the complexity axis, which means the country ecnomy is complex enough for its income to grow. The right strategy for the country would be light touch approach
- No, opposite case.
How easy is it to diversify into new products?
- Many nearby jumps: The country is well connected and will then choose the “parsimonious industrial policy approach”.
- Few nearby jumps: The country is not well connected, which means they do not have many new product opportunities. Meaning that the products they produce allready is not well connected to other products, which would make the transition into new products easier and cheaper.
Is that because the country is at the technological frontier?
- No: The country is not at the technological frontier, where it can be difficult to produce new products, becuase one country would need to invent new ideas to do so. When the country is not at the technological frontier, then they should choose “Stratigic bests approach”.
- Yes: chose the technological frontier
E.g. Germany is complex, but their products are not easy to diversify into new products because they are not well connected with th rest of the world, because they ar completely new. In order to continue growth, Germany must promote innovation and invent new products.
How to read the “Picking Winners graph?
Right now we do not look at products which we allready have a realtive comparative advantage in (RCA>1). We want to look at new ways to diversify our product portfolio, but it can be difficult to indentify feasible prodcuts (RCA<1). To solve that we use to grpahs:
Explain the graphs “picking winners criteria”
- Look only at producs with RCA < 1, ofc
- The product selection criteria is a affected by the following:
- Low hanging fruit: opportunities closer to existing knowhow; lower risk & lower reward.
§ Some sectors with high potential for new diversification: Diary products and aluminium production.
- Balanced Portfolio: context-driven opportunities that balance risk and reward (recommended).
§ Some sectors with high potential for new diversification: Industrial macheniry and diary products
- Long Jumps: opportunities further from existing knowhow; higher risk & higher reward.
§ Some sectors with high potential for new diversification: Industrial
- Conclusion: Going from low hanging fruit to long jumps leads to higher opportunity gain and complexity, but distance … I dont get the procentage. It will also increase the risk of failure.
§ Distance should be higher, but its a smaller procentage, due to the higher relative increase in opportunity gain and complexity.
Complexity/distance graph:
X-asis, the distance to existing knowledge. We eant the product to be relatively easy to produce given existing knowledge (low distance)
y-asis, the complexity of a product. We wnat the product to introduce new productive knowledge (high product complexity).
Now exclude products with lower complexity than Tanzania’s average (marked dark green).
Exclude all products with a distance score above the median (grey).
Exclude all products below the dotted line (marked in light green). (Investing in products below the line is
inefficient, as it will always be possible to invest in an industry at a similar distance but with higher complexity and opportunity gain).
Products above the line are the
feasible products (marked in blue).
Opportunity gain/distance graph
X-asis, the distance to existing knowledge. We want the product to be relatively easy to produce given existing knowledge (low distance)
y-asis, opportunity gain meassure how much a product facilitate further diversification. The product should facilitate further diversification (high opportunity gain)
Same recipe.
Describe what policy advise can be made based on traditional trade theory
You should produce the products you have a comparative advantage in. Specialize in these products, and let other produce the rest.
In contrast will the EC theory argue, that you should not specialize in few products. That is a bad idea.
Traditional trade do not explicitly say that you should specialize in few products, if you have the comparative advantage in several things then a country should produce it. But the EC theory would say that the old theory is not diversifying there products enough. The traditional trade theory globalisation, harms some low income countries, who becomes losers producing only few not very advanced products for exporting.
What is the main take away that make EC theory different from oldschool neoclassical theory?
Diversify instead of specialize.
You should not only specify in few product where you have the compariative advantages, otherwise the world would look alike. Where globalisation have had is torn with specific parts of the world, especially Sub Saharan Africa.
Describe the three areas that are likely to influence the gains from trade.
Be able to give at least one detailed example under each of the three main areas,
- under invoicing
- invoicing in USD
- consequence of high fixed cost of entry to trade
Tariff evasion
- Under invoicing of imports is the main problem. It is a practice where importers deliberately declare a lower value for the goods they are bringing into a country than their actual market value. This can be done for several reasons, primarily to evade taxes and customs duties
- To measure this, the government use difference between reported export and import values (“evasion gap”).
Capital markets
- Invoicing in USD may be a problem if exchange rate shocks transmission. On the other (positive) hand it reduces the risk of using exchange rates.
- Fixed costs: Getting credit and capital is a fixed cost, which can be a problem for small scale firms. E.g. it can be difficult for a small entrepreneur firm to go out and buy a Gaffeltruck. But they could maybe borrow or rent it.
If we fix this, trade would gain growth.
