Trade Diversion

In a 1996 article, William Milberg surveyed all international trade articles appearing in the AER, JPE, RES, and JIE from 1988 to 1992. He described two notable shortcomings:

Of articles containing no policy conclusions, 55.9 per cent included empirical studies. Of articles with policy relevance, only 16.1 per cent had empirical content. This is precisely the opposite of the expectation that policy-relevant research will tend to be grounded on empirical support, and that when such relevance is not at stake, empirical support will be less important. According to the survey, empirical analysis is often used to explore positive issues, whereas policy-related issues are most often analyzed using purely theoretical arguments…

[I]n a field where writing structure and even methodology are otherwise extremely uniform, the rhetoric of policy relevance is diverse, flexible and unrigorous. Paradigmatic convention seems not to dictate this aspect of the discourse. Norms of systematic and logical analysis break down precisely where the most is at stake in economic analysis – the legitimacy of its policy conclusions.

It’d be fascinating to see such an analysis of the recent literature.

Hat tip: Matthew Eagleton-Pierce.

Krugman, Paul 2009. “The Increasing Returns Revolution in Trade and Geography.” American Economic Review, 99(3): 561–71.

Opp, Sonnenschein, and Tombazos, forthcoming in the JIE:

We demonstrate that Rybczynski’s classic comparative statics can be reversed in a Heckscher-Ohlin world when preferences in each country favor the exported commodity. This taste bias has empirical support. An increase in the endowment of a factor of production can lead to an absolute curtailment in the production of the commodity using that factor intensively, and an absolute expansion of the commodity using relatively little of the same factor. This outcome – which we call “Reverse Rybczynski” – implies immiserizing factor growth. We present a simple analytical example that delivers this result with unique pre- and post-growth equilibria. In this example, production occurs within the cone of diversification, such that factor price equalization holds. We also provide general conditions that determine the sign of Rybczynski’s comparative statics.

Marc Melitz nicely summarizes the empirical and theoretical literature on “international trade and heterogeneous firms” for the New Palgrave Dictionary of Economics, 2nd Edition.

Oxford’s Alberto Behar and Ben Nelson are working to build a really rigorous trade gravity model. They combine Anderson and van Wincoop’s general equilibrium multilateral resistance approach with Helpman, Melitz, and Rubinstein’s emphasis on firm heterogeneity and the extensive margin.

We argue that one needs to take both AvW and HMR’s findings into account, otherwise interpretation of the effects of trade frictions will be misleading. We therefore unite these two strands of the literature. We derive a theoretically grounded gravity equation and then extend a method of approximating MR [multilateral resistance] terms, developed by Baier and Bergstrand (2009), to the case of firm heterogeneity…

For all our observations, traditional linear estimates bias downwards the effect of observable trade barriers on country-level trade flows. This difference, rather than the firm-level bias in the opposite direction highlighted by HMR, is arguably more relevant for policy…

Consistent with AvW’s “Implication 1″, larger countries have larger firm-level elasticities of bilateral trade in response to multilateral changes in trade costs. However we show that, once firm entry into trade is accounted for, this is no longer unambiguously true in theory for overall elasticities at the country level. Moreover, on balance we find a negative correlation in the data between country size and bilateral trade elasticities once changes in the extensive margin are accounted for.

Robert Staiger & Alan Sykes on the the theoretical relationship between exchange rate policy and international trade:

[I]t is often asserted that China’s currency policies have real effects that are equivalent to an export subsidy. In fact, however, if prices are flexible the effect of exchange rate intervention parallels that of a uniform import tariff and export subsidy, which will have no real effect on trade, an implication of Lerner’s symmetry theorem. With sticky prices, the real effects of exchange rate intervention and the translation of that intervention into trade-policy equivalents depend critically on how traded goods and services are priced.

Ian Ayres and Doug Kysar, law profs at Yale, apply The Theory of Moral Sentiments to carbon trading. They include this paragraph:

In addition to his famous arguments in favor of markets and liberalized trade, Smith also had a well-worked-out theory of moral behavior, one that was not so neatly separated from his economic thought as we treat it today. For example, Smith’s arguments in favor of free trade included an assumption that owners of capital would naturally prefer domestic to foreign industry, even if the latter offered higher returns. Smith thought this was a good thing because it reflected the moral sentiments that ultimately help make markets work.

What? Citation, please.

I can find no such suggestion in chapter seven of Doug Irwin’s Against the Tide, “Adam Smith’s Case for Free Trade.” I do find this quotation, which seems at odds with Ayres and Kysar’s suggestion:

Every individual is continually exerting himself to find to the most advantageous employment for whatever capital he can command. It is his own advantage, indeed, and not that of society, which he has in view. But the study of his own advantage naturally, or rather necessarily leads him to prefer that employment which is most advantageous to the society.” [Irwin p.76; Smith IV.ii.4]

Moreover, how does not pursuing the profit-maximising returns in allocating productive resources across industries or countries “help make markets work”? Smith wrote:

The value of its annual produce is certainly more or less diminished when it is thus turned away from producing commodities evidently of more value than the commodity which it is directed to produce. According to the supposition, that commodity could be purchased from foreign countries cheaper than it can be made at home. It could, therefore, have been purchased with a part only of the commodities, or, what is the same thing, with a part only of the price of the commodities, which the industry employed by an equal capital would have produced at home, had it been left to follow its natural course. [Irwin, p.79; Smith IV.ii.12]

If Ayres and Kysar are right about Smith, then I’d like to learn how capital’s home bias provides a public good necessary to the system of natural liberty or otherwise enhances simple-minded profit-seeking in the market. Synthesizing such a bias with Smith’s more familiar work quoted above doesn’t strike me as obvious.

Are you starting a (graduate) course in international trade this fall? If so, you’ll soon be encountering the so-called Dixit-Stiglitz CES function, a demand system that underlies trade economists’ work on everything from the gravity equation to the organization of multinational enterprises.

Because the specification is so popular, economists frequently skip to its well-known results, like consumers’ Marshallian demand functions and firms’ pricing strategies, without deriving them. And professors introducing the topic sometimes ask students to derive the results without giving them much guidance.

Here’s my introductory guide to the Dixit-Stiglitz demand system. It walks through the most basic derivations step-by-step, in hopes of helping those students so frustrated with wading through tedious algebra and integrals that they’ve turned to Google searching for a very basic introduction to Dixit-Stiglitz lite.

Comments and corrections (!) are most welcome; my email address is on the first page of the pdf.

In a short two-page note, Yale’s Costas Arkolakis shows that you can introduce non-standard transport costs into the Dixit-Stiglitz monopolistic competition set-up and get clean results. You might call the transport costs “variable icebergs”:

t(q) = Τq^a

where a < 0 so that the unit cost of shipping the good is decreasing with the size of the shipment.

Arkolakis shows that consumers’ demands and firms’ mark-ups come out cleanly in the usual CES fashion, so that this formulation is tractable and isomorphic with the usual iceberg approach in some respects. In the Melitz (2003) formulation, you preserve Pareto distributed outcomes, they just have a different coefficient.

Mary Amiti & Donald R. Davis – “Trade, Firms, and Wages: Theory and Evidence” NBER WP 14106

We develop a general equilibrium model which features firm heterogeneity, trade in final and intermediate products, and firm-specific wages. In doing so, it builds on the work on heterogeneous firms of Marc J. Melitz (2003) as amended to allow trade in intermediate goods by Hiroyuki Kasahara and Beverly J. Lapham (2007). Both of these models maintain the assumption of homogeneous labor and a perfect labor market, so that the wages paid by a firm are disconnected from that firm’s performance. We continue to focus on homogeneous labor, but introduce a novel variant of fair wages which links the wages at a firm to the profitability of the firm…

A decline in output tariffs reduces the wages of workers at firms that sell only in the domestic market, but raises the wages of workers at firms that export. A decline in input tariffs raises the wages of workers at firms using imported inputs, but reduces wages at firms that do not import inputs…

We test our model’s hypotheses with a rich data set covering the Indonesian trade liberalization of 1991-2000. The trade liberalization provides us with over 500 price changes per period, covering both input and output tariffs. A distinctive feature of the Indonesian data set is the availability of firm level data on individual inputs, making it possible to construct highly disaggregated input tariffs. This, in turn, enables us to disentangle the effects of output and input tariffs…

A 10 percentage point fall in output tariffs decreases wages by 3 percent in firms oriented exclusively toward the domestic economy. But the same fall in the output tariff increases wages by up to 3 percent in firms that export. A 10 percentage point fall in input tariffs has an insignificant effect on firms that don’t import, but increases wages by up to 12 percent in firms that do import. In short, liberalization along each dimension raises wages for workers at firms which are most globalized and lowers wages at firms oriented to the domestic economy or which are marginal globalizers. Ours is the first paper to show an empirical link between input tariffs and wages, and the first to show differential effects from reducing output tariffs on exporters and non-exporters.