14.581 International Trade — Lecture 5: Comparative Advantage and Gains from Trade (Empirics) — 14.581 Week 2 Spring 2013 Spring 2013 14.581 (Week 2) GT and CA in the data Spring 2013 1 / 44
Plan of Today’s Lecture 1 Law of comparative advantage (recap) 2 Does the law of comparative advantage hold in the data? 2 3 A primer on the size of the gains from trade 3 14.581 (Week 2) GT and CA in the data Spring 2013 2 / 44
Law of Comparative Advantage Basic Idea In Lecture 1 we used a revealed preference argument to establish the existence of gains from trade We now demonstrate how the same argument can be used to make positive predictions about the pattern of trade Principle of comparative advantage: Comparative advantage—meaning differences in relative autarky prices—is the basis for trade Why? If two countries have the same autarky prices, then after opening up to trade, the autarky prices remain equilibrium prices. So there will be no trade.... The law of comparative advantage (in words): Countries tend to export goods in which they have a CA, i.e. lower relative autarky prices compared to other countries 14.581 (Week 2) GT and CA in the data Spring 2013 3 / 44 3
Law of Comparative Advantage Dixit-Norman-Deardorff (1980) n − c nh Let t n ≡ nh n y − c , , y denote net exports in country n 1 1 G G an and u n Let u denote the utility level of the representative household in country n under autarky and free trade Let p an denote the vector of autarky prices in country n Without loss of generality, normalize prices such that: an p g = p g = 1, Notations: cov ( x , y ) _ cor ( x , y ) = var ( x ) var ( y ) n cov ( x , y ) = ( x i − x ) ( y i − y ) i =1 1 n x = x i n i =1 14.581 (Week 2) GT and CA in the data Spring 2013 4 / 44
Law of Comparative Advantage Dixit-Norman-Deardorff (1980) Recall from Lecture 1: Proposition 4 In a neoclassical trade model, if there is a representative household in country n, then cor ( p − p a , t n ) ≥ 0 14.581 (Week 2) GT and CA in the data Spring 2013 5 / 44
Plan of Today’s Lecture 1 Law of comparative advantage (recap) 2 Does the law of comparative advantage hold in the data? 2 3 A primer on the size of the gains from trade 3 14.581 (Week 2) GT and CA in the data Spring 2013 6 / 44
Testing for Comparative Advantage Principle of CA is a fundamental theoretical idea in Economics, yet testing it is hard. Why? Problem 1: ‘Principle’ version is too weak to test in real world (where more then 2 countries or goods). Problem 2: Latent variable problem: ‘Law’ version is statement about trading behavior but is based on autarky prices! Problem 3: Periods of autarky rarely observed. How to proceed? Two routes: 1 Put a small amount of structure on the problem, as in Proposition 4. Avoids Problem 1. Downside: Problems 2 and 3 remain, and test lacks power. We will discuss this approach next. 2 Put a large amount of structure on the problem: model determinants of autarky prices and substitute this model in. This is hard to do, but can in principal avoid Problems 1-3. Downside: tests become joint test of CA and structure. Much of the rest of this course can be thought of as attempts to do this. 14.581 (Week 2) GT and CA in the data Spring 2013 7 / 44
Testing the Law of Comparative Advantage Recall Proposition 4: a If p is the vector of prices that prevail in an economy under autarky, And t is the vector of net exports by this same economy in any trading equilibrium, a Then p . t ≤ 0. Comments from empirical perspective: a It is impossible to observe p and t at the same time (ie ‘Problem 2’ can never be overcome). This is a very weak prediction. (Compare with coin toss model.) a But remarkably, p (if you observe it) is a sufficient statistic for all of the supply and demand features of the economy. (Chetty 2009 ARE discusses advantages of settings like this in which ‘sufficient statistics’ exist. Though here dimensions of statistics may be quite high...) 14.581 (Week 2) GT and CA in the data Spring 2013 8 / 44
Bernhofen and Brown (JPE, 2004) Bernhofen and Brown (JPE, 2004) exploit the (nearly) closed economy of Japan in 1858, and its subsequent opening up to trade in 1859, as a natural experiment to test for Law of CA. a Rare example of a closed economy, so p is (almost) observed. This overcomes ‘Problem 3’. Further attractive features of this setting: Relatively simple economy Subsequent opening up was plausibly exogenous to economic change in Japan (non-autarky was forced upon Japan by USA). 14.581 (Week 2) GT and CA in the data Spring 2013 9 / 44
Japan Opening Up Japan Opening Up The Development of Japan's External Trade, 1860_85 50 40 In million silver yen 30 20 10 0 1860 1865 1870 1875 1880 1885 Exports Imports Source: Sugiyama (1988, table 3-4) Image by MIT OpenCourseWare. 14.581 (Week 2) GT and CA in the data Spring 2013 10 / 44
Empirical Methodology Suppose 1858 is autarky and 1859 is not. BB (2004) effectively observe p 1858 and t 1859 . Though in practice they use years prior to 1858 for p 1858 and years post-1859 for t 1859 , to allow for adjustment. They compute p 1858 . t 1859 and check whether it’s negative. Before seeing the answer, what might we be worried about if this is meant to be a test of the Law of Comparative Advantage? 14.581 (Week 2) GT and CA in the data Spring 2013 11 / 44
Assumptions Required by BB (2004) Approach See discussion in Section III Perfect competition under autarky 1 Japan price taker on international markets ⇒ there still is perfect 2 competition in 1859 No export subsidies ⇒ no pattern of trade reversals 3 To overcome ‘Problem 2’: Observed autarky prices under autarky (ie 4 p 1858 ) are same as what post-1858 Japan’s autarky prices would have been if it were in autarky. (That is, the theory really calls for us to a a compute p 1859 . t 1859 , where p 1859 is the counterfactual price of Japan’s 1859 economy if it were in autarky.) (Put another way: Japan’s underlying technology and tastes haven’t changed around 1858.) BB (2004) point out that if the unobserved 1859 autarky price ( p a , 1859 ) is equal to p 1858 plus an error term ( ε ) then the only real worry is that t 1859 .ε > 0. 14.581 (Week 2) GT and CA in the data Spring 2013 12 / 44
Results: Graphical NB: y-axis is p − p a , not p a (but recall that p . t = 0 by balanced trade). = Net Exports and Price Changes for 1869 100 Silk 80 Silkworm eggs Change in price since 1851-1853 60 40 Cotton Copper(Mfc) 20 Rice Legumes Wax Sake 0 Fish -20 Tea White sugar Charcoal Brown sugar Pig iron -40 Cotton cloth Candy -60 Cotton yarn Iron(Mfc) -80 -1.25 -1 -.75 -.5 -.25 0 .25 .5 .75 1 1.25 Net exports in 1869 Image by MIT OpenCourseWare. 14.581 (Week 2) GT and CA in the data Spring 2013 13 / 44 rose substantially, so that the graph expresses price changes adjusted
Results Results - Approximate Inner Product in Various Test Years (Millions of Ryo) Components Year of Net Export Vector 1868 1869 1870 1871 1872 1873 1874 1875 (1) Imports with observed autarky prices -2.24 -4.12 -8.44 -7.00 -5.75 -5.88 -7.15 -7.98 (2) Imports of woolen goods -.98 -.82 -1.29 -1.56 -2.16 -2.50 -1.56 -2.33 (3) Imports with approximated autarky -1.10 -.95 -.70 -.85 -1.51 -2.08 -1.60 -2.65 prices (Shinbo index) (4) Exports with observed autarky prices 4.07 3.40 4.04 5.16 4.99 4.08 5.08 4.80 (5) Exports with approximated autarky .09 .03 .07 .07 .15 .07 .11 .10 prices (Shinbo index) Total inner product (Sum of rows 1_5) -.18 -2.47 -6.31 -4.17 -4.28 -6.31 -5.11 -8.06 - - Note: All values are expressed in terms of millions of ryo. The ryo equaled about $1.00 in 1873 and was equivalent to the ~ ~ a yen when it was introduced in 1871. The estimates are of the approximation of the inner product (p 1 T) valued at autarky prices prevailing in 1851_53. Image by MIT OpenCourseWare. 14.581 (Week 2) GT and CA in the data Spring 2013 14 / 44
Comments Theory says nothing about which goods are ‘up’ and which are ‘down’ in Figure 3, only that the scatter plot should be upward-sloping. Low power test. Harrigan (2003): “I think I can speak for many economists who have taught this theory with great fervor when I say ‘thank goodness’.” a Why is p . t growing in magnitude over time? 14.581 (Week 2) GT and CA in the data Spring 2013 15 / 44
Plan of Today’s Lecture Law of comparative advantage (recap) 1 Does the law of comparative advantage hold in the data? 2 A primer on the size of the gains from trade 3 14.581 (Week 2) GT and CA in the data Spring 2013 16 / 44
How Large Are the Gains from Trade? Many approaches to this question. Today we will discuss some recent answers employing a ‘reduced-form’ approach: Bernhofen and Brown (AER, 2005) Frankel and Romer (AER, 1999) Feyrer (2009a, 2009b) Many other approaches in the literature will come up throughout the course (estimating GT is of fundamental interest throughout). 14.581 (Week 2) GT and CA in the data Spring 2013 17 / 44
Bernhofen and Brown (2005) Measure gains (to a representative Japan consumer) of Japan’s opening up in 1858 Consider Slutsky compensation to consumers in (autarkic) 1858: a f a a ∆ W = e ( p 1858 , c 1858 ) − e ( p 1858 , c 1858 ) f Here, c 1858 is the counterfactual consumption of Japan in 1858 if it were open to trade. f Of course, by WARP, c 1858 was not affordable in 1858 or else it would have been chosen. ∆ W measures the amount of income that would have made f counterfactual c 1858 affordable. 14.581 (Week 2) GT and CA in the data Spring 2013 18 / 44
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