Chapter 5 International Trade and Economic Growth

1
Chapter 5International Trade and Economic
Growth

• The international trading system...has enhanced
  competition and nurtured what Joseph Schumpeter a
  number of decades ago called creative
  destruction, the continuous scrapping of old
  technologies to make way for the new.
• (Alan Greenspan, 2001)

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The Goals of this Chapter

• Extend the analysis of trade beyond the
  traditional static models of international trade
  and analyze the relationship between
  international trade and economic growth.
• Show how the power of compounding makes
  international trades effect on economic growth
  much more important for human welfare than the
  static gains in welfare.
• Familiarize students with the recent statistical
  evidence on the relationship between trade and
  economic growth.
• Introduce the Solow growth model and use it show
  how international trade affects economic growth
  when investment is subject to diminishing returns
  and depreciation.
• Explain the Schumpeterian model of technological
  progress and use it to show how international
  trade affects the determinants of long-run
  technological progress.

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Trade and Growth Achieve Similar Gains in Welfare

• Trade and growth both enable the economy to reach
  a higher indifference curve.
• Trade leads to a new consumption point at C.
• Growth leads to a new consumption point at D.
• Both points lie on the same higher indifference
  curve.

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• An economy with the red production possibilities
  frontier can reach the indifference curve I2 with
  trade.
• However, it takes continued growth (a large shift
  in the indifference curve) to reach the much
  higher level of welfare given by I20.
• Can trade help stimulate such economic growth?

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The Power of Compounding

• If per capita real GDP (PCGDP) grows at an annual
  rate of R, then after T years PCGDP will be
• PCGDPT PCGDPt0(1 R)T (5-1)

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The Power of Compounding

• For a country with a per capita real GDP of
  2,000, a 2.5 percent annual growth rate implies
  that in 10 years per capita real GDP will grow
  to
• PCGDPt10 2000(1 .025)10 2,560

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The Power of Compounding

• Suppose that another country grows a little
  faster at 3.5 percent per year. After ten years,
  this economys per capita real GDP will be
• PCGDPT10 2000(1 .035)10 2,821
• After ten years, a difference of 1 per year
  causes a per capita income difference greater
  than 10.

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The Power of Compounding

• Two countries that grow at 2.5 percent and 3.5
  percent, respectively, for 100 years will find
  their standards of living growing far apart
• PCGDPT100 2000(1 .025)100 23,627
• PCGDPT100 2000(1 .035)100 62,383
• The power of compounding is great.

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The statistical analysis of the relationship
between international trade and economic growth
shows that

• International trade is closely and positively
  related to economic growth.
• The potential size of trades growth effect is
  large.
• Statistical analysis thus suggests that
  international trade is very
  important for future human welfare.

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• Production function Y f(K,L) with diminishing
  returns.
• If labor supply is fixed, then the function can
  be written as Y f(K).
• Diminishing returns implies a decreasing slope
  each additional unit of capital adds less to
  output than the previous unit

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• Solow assumes that the saving rate is constant
  and between 0 and 1.
• The saving function is a reduced image of the
  production (income) function.
• The saving function depends on the production
  function and the saving rate.

s
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• Depreciation is assumed to be a constant fraction
  d of the stock of capital K.
• Thus, depreciation is a straight-line function of
  K.

d
s
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• Saving and investment are equal where the
  depreciation line and the savings function
  intersect.
• In equilibrium, a capital stock of K results in
  output Y f(K).
• K and Y are referred to as the steady state
  levels of capital and output/income.

d
s
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• The steady state level of K is a stable
  equilibrium.
• If K lt K, investment exceeds depreciation and K
  grows.
• If K gt K, depreciation exceeds investment and K
  shrinks.

d
s
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• The Solow model depicts an economy with a stable
  equilibrium.
• Output/income depends on the rate of saving, the
  rate of depreciation, and the shape of the
  production function.

d
s
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d
s
s
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• The static gain from trade raises the production
  function, which raises output to Y g(K).
• Given a constant saving rate, the saving function
  shifts up proportionately to the production
  function.
• Trade therefore leads to transitional growth as
  the economy adjusts to a new steady state
  equilibrium at K and Y g(K).

s
s
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• Technological progress raises the production
  function
• Technological progress neutralizes diminishing
  returns output doubles when the capital stock is
  doubled, as from a to b
• Without technological progress, the increase in
  capital from 1 to 2 would only take the economy
  to point c, where output rises by only 40

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d
s
s
s
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Trade and Growth

• International trade seems to produce only
  temporary growth according to the Solow model.
• Indeed, the Solow model suggests that continued
  economic growth is not possible without
  technological progress.
• Hence, for trade to raise standards of living in
  the long run, it must influence technological
  progress.

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The statistical analysis of the relationship
between international trade and economic growth
shows that

• International trade is closely and positively
  related to economic growth.
• The potential size of trades growth effect is
  large.
• The statistical analysis thus strongly suggests
  that
• international trade is very important for future
• human welfare.

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The statistical evidence on trade and growth is
not entirely convincing, however

• Statistical studies cannot provide definitive
  proof that international trade causes economic
  growth.
• It is difficult for statistical procedures and
  the available data to accurately distinguish
  between the effects of trade and those of the
  other factors.
• Statistical research has not yet distinguished
  why trade and growth are positively related.
• For further insights, we need logical reasoning
  and
• consistent models that can explain the
  statistical
• relationship between trade and growth.

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The Solow Model and Technological Progress

• The Solow growth model shows that for a given
  production function economic growth will
  eventually stop when the economy reaches its
  steady state.
• Continued economic growth is only possible if
  the production function continually shifts up,
  which requires continued technological progress.
• The Solow model highlights the importance of
  technological progress, but it does not explain
  what determines technological change.
• Several insightful models of models of
  technological progress have been developed to
  complement the Solow growth model.

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• Many studies of industrial productivity have
  noted that unit costs tend to decline in
  proportion to accumulated experience.
• This process is often referred to as learning by
  doing.
• The learning curve depicts the learning process,
  but it does not explain its causes.

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The Schumpeterian Model of Technological Progress

• In Schumpeterian innovation models RD activity
  depends on
• The productivity with which RD activity
  generates innovations.
• The costs of acquiring the resources to carry out
  RD activities.
• The benefits that entrepreneurs expect to reap
  from an innovation.
• The first two items above determine the costs of
  innovation. The latter item reflects the gains
  from innovation. The equilibrium level of RD
  activity is found by maximizing benefits subject
  to the costs of innovation.

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• The quantity of innovations depends on the
  quantity of resources applied to RD activity and
  the productivity of RD activity.
• Defining q as the quantity of innovations, ß as
  the quantity of resources per innovation, and
  RRD as the resources applied to innovation,
  then q 1/ß(RRD).

ß
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• The cost of innovation (CoI) depends on the cost
  of resources and the productivity of RD activity
• The cost of resources depends on total resources
  R and the demand by innovators RRD
• Therefore CoI h(RRD, R,
  ß).

ß
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• The present value of innovation (PVI) depends on
  the size of the profit box p and on how long a
  successful innovator enjoys its monopoly
  position.
• The life of a monopoly is the inverse of the
  number of innovations per year, q.
• Expected profit from an innovation is equal to
• p/q p/RRD / ß pß / RRD.

p
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• PVI is a negative function of the rate of
  interest with which future profit is discounted,
  r, and the amount of resources employed in RD
  activity RRD..
• PVI is a positive function of the profit markup p
  and the resource requirements in RD activity, ß.
• The present value of innovation is
  PVI f( p, r, RRD, ß ).

(p, r, ß)
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• The intersection of the CoI and PVI curves
  determines the amount of resources devoted to RD
  activity, RRD.
• The curve 1/ ß in the bottom half of the figure
  relates the amount of resources to the expected
  number of actual innovations.

ß
(p, r, ß)
1/ß
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• An increase in p shifts the PVI curve upward to
  PVI1, and, all other things equal, the number of
  resources devoted to innovative activity
  increases.
• The increase in RRD in turn raises the number of
  innovations per year from q to q1.

1/ß
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• An increase in R lowers the cost of resources.
• The lowering of resource costs imply a downward
  shift in the CoI curve, say to CoI1.
• This causes profit-motivated entrepreneurs to
  employ more resources in RD, which increases the
  number of innovations q.

1/ß
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• A change in ß is complex because it affects all
  curves.
• An increase in ß rotates the 1/ ß line
  counterclockwise.
• An increase in ß implies that RD activity
  requires more costly resources, which shifts the
  CoI curve up.
• The PVI curve also shifts up because creative
  destruction slows when it becomes harder to
  innovate, which makes each innovation that does
  occur more profitable.

1/ ß
1/ß
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The number of innovations per year is determined
by the function ? q
f( p, r, R, ß )

• All other things equal, innovation in the economy
  will be greater
• The larger is the potential profit for the
  successful innovator
• The more innovators value future gains relative
  to current costs
• The greater is the supply of resources available
  to innovators
• The more efficiently innovators use resources in
  RD activity.

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How Trade Influences Technological Progress

• For example, integrating two identical economies
  through trade doubles the market, effectively
  shifting the demand curve from D to Dt.
• The marginal revenue curve also shifts, doubling
  the equilibrium quantity.
• This doubles the potential profit accruing to
  innovators from p to 2p.

p
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How Trade Influences Technological Progress

• The doubling of the profit area, all other things
  equal, shifts the PVI curve up.
• The amount of resources that profit-seeking
  innovators apply to RD activity expands, and the
  number of innovations rises.

1/ß
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How Trade Influences Technological Progress

• The supply of resources in the combined economy
  is doubled, making more resources available to
  innovators.
• The CoI curve slopes up less steeply because the
  price of resources rises less rapidly.
• This expands RD activity and innovation further.

1/ß
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How Trade Influences Technological Progress

• Trade and specialization furthermore improves the
  allocation of resources, thus increasing the
  effective stock of resources.
• An effective increase in R lowers the CoI curve.
• This efficiency of resource use is in addition to
  profit and resource effects already described.

1/ß
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How Trade Influences Technological Progress

• Finally, comparative advantage also applies to
  innovative activity.
• The improvement in the overall productivity of
  innovation decreases ß
• A decrease in ß shifts all three curves.
• Shifts in CoI and PVI are likely to cancel each
  other out, but 1/ ß also shifts out, likely
  causing an overall increase in innovation.

1/ß