Chapter 9
TRADE IN INTERMEDIATE GOODS
AND FACTORS OF PRODUCTION
The models discussed up to this point have presented the particularly simple view that only
consumption goods are produced, and that these consumption goods are traded according to
the principle of comparative advantage. Chapter 9 broadens the analysis to include trade in
intermediate goods and in footloose factors of production.
Many goods are used as inputs into other production processes. Such goods are called
intermediate goods and range from raw materials, metals and oil, to machine tools, computer
chips and supertankers. They are widely traded internationally, and the gains from such trade
are over and beyond those obtained from trade in final goods. The pattern of trade in
intermediate goods is not easily explained by the standard principle of comparative advantage.
The chapter develops a model that combines the concepts of absolute and comparative
advantage, by adding a footloose factor of production to Ricardo’s model of trade.
The movement of factors of production between countries has been of vast significance for the
world economy. Wars have been sparked by the encroachment of immigrants onto foreign soil
or by threats to nationalize foreign-owned capital. Few issues stir as much emotion in
industrialized nations as the question of how much immigration to allow, while in poorer
countries there is concern over a brain drain as many of the the best and brightest individuals
emigrate.
Factors of production respond to international differentials in their returns just as flows of
goods respond to price differences. And, as in the comparison of autarky with free trade, the
important questions are:
(a)
(b)
who gains and who loses; and
can those who gain compensate those who lose?
In general, the competing factors of production will lose from immigration since it implies a
reduction in their returns, and gainers can afford to compensate losers. In the most complete
analysis of these issues it is important to incorporate the effect of factor movements on trade in
commodities, as immigration and capital flows can in turn affect the size of the gains from
commodity trade.
The multinational enterprise (MNE) is a major channel for the flow of intermediate goods and
of capital. Analysis of MNEs is therefore an important (and often controversial) topic in
international economics. MNEs are active in international trade, trading inputs and finished
goods among their own branches as well as with other entities. They are also an important
mechanism for the diffusion of new technologies between countries. The chapter concludes
with an extensive discussion of the policy controversies surrounding MNEs in both host and
source countries.
SHORT-ANSWER QUESTIONS
1.
True or False:
Industrialized countries, which have a relative abundance of natural resources, tend to
export intermediate goods and raw materials to the more labor-abundant developing
countries.
2.
Which of the following are intermediate goods?
(a)
(b)
(c)
(d)
(e)
A stamping machine.
Wheat.
A truck.
A sports sedan.
Soft drinks.
3.
Norway exports the intermediate product, oil, and the final good, cod fillets. It imports
Country and Western CDs from the U.S. and Volvo trucks from Sweden. Define its
terms of trade. (Hint: Construct a price index for its exports and a price index for its
imports.)
4.
Could trade in intermediate goods explain Leontief's findings about the U.S. trade
pattern in 1949?
5.
Evaluate the following statement:
“Poor countries sell raw materials to rich countries in exchange for final goods.
Because final goods command higher prices in the world marketplace, the rich
countries are in effect exploiting the poor countries by converting cheap imported
inputs into high-priced goods.”
6.
If production requires the input of intermediate goods, there are the standard gains
from trade when the final goods are traded. Allowing for trade in intermediate goods
permits further gains to be realized. Assuming that the production of final goods food
and clothing requires intermediate goods fertilizer and cotton respectively, illustrate
these gains for the following cases:
(a)
(b)
The value of imported intermediate products equals the value of exported final
goods.
The value of imported intermediate products and final goods equals the value of
exported intermediate products and final goods.
7.
How does the product cycle help to explain the pattern of trade between high-income
and low-income countries?
8.
True or false:
In the standard Heckscher-Ohlin model, factor flows and commodity flows are
substitutes.
9.
True or false:
When factors of production can move between countries the result is less trade in
commodities.
10.
Recent investments by the Japanese in the United States automobile industry represent
(a)
(b)
(c)
(d)
(e)
(f)
(g)
11.
portfolio investment.
direct foreign investment.
vertical integration.
horizontal integration.
(a) and (c).
(b) and (d).
none of the above.
True or false:
If a firm has a production technology with substantial plant-specific economies of scale
it is likely to engage extensively in horizontal direct foreign investment.
12.
Provide two reasons why a firm might want to vertically integrate "backwards."
13.
Why should a country care whether its tariff barriers attract foreign direct investment?
14.
Define "transfer pricing."
PROBLEMS
1.
Comparative Advantage and Trade in Intermediate Goods:
What is the sense in which “the fundamental Ricardian concept of comparative
advantage needs significant modification” when trade is allowed in intermediate
products?
2.
The Product Cycle Model:
Raymond Vernon proposed that new products tend to emerge in high-income countries
(which also tend to be capital abundant) and suggested that substantial uncertainty
surrounds how a new product will be received by consumers as well as which
technology is the most efficient at producing these new goods.
(a)
(b)
All else equal, what would be the consequence of such uncertainty for the
capital-labor ratio in industries producing new products?
What would happen to the capital-labor ratio used as a product “matures”?
At some point the production of this good may have become so standardized that the
innovating country loses the production of it to a lower-income country.
(c)
(d)
(e)
3.
By which process can this happen, i.e. how might this technology be
transferred?
What will happen over time to the capital-labor ratio used in the production of
this good in the developing country?
Can you reconcile this dynamic theory with the Leontief paradox?
The Pattern of Trade of the United States:
Originally, the United States was abundant in natural resources. Over time, these
resources have been depleted, however, and natural resources have now become a
relatively scarce factor of production.
(a)
(b)
Suppose that natural resources (land, for example) and labor are the two most
important factors of production in the United States. What does the
Heckscher-Ohlin model predict about the United States' pattern of trade?
What evidence is there that the United States' pattern of trade has changed as a
result of its depletion of natural resources?
4.
Value-Added:
(a)
(b)
(c)
(d)
5.
Define value-added per worker.
Which of the following statements is true? An industry's value-added per
worker is high when:
(i)
the industry employs a large number of workers;
(ii)
wages are high;
(iii)
the capital-labor ratio of the industry is low;
(iv)
the cost of hiring capital is high.
Newly industrial countries (NICs) tend to export goods with low value-added
per worker. Why?
Many governments allow firms to export materials for processing abroad and
then re-import the final product, paying a tariff only on the value added abroad.
Discuss why this encourages the transfer of the labor-intensive stages of
production to less developed countries.
Comparative and Absolute Advantage:
Suppose two countries are endowed with labor that is used in the production of both
food and clothing and assume that labor cannot migrate across national borders. In
addition, suppose that the two countries compete for a “footloose” factor A which is
needed to produce clothing. The techniques of production in each country are given
by:
aLC = 3,
aLF = 2,
aAC = 0.5,
(a)
(b)
(c)
(d)
(e)
aC = 2,
aF = 2,
aC = 1.
Write down the competitive profit conditions for food and clothing in each
country.
Which country has a comparative advantage in producing clothing in terms of
labor costs? Which country has an absolute superiority in terms of the cost of
hiring factor A?
Rewrite the competitive profit conditions in the form of equation 9.3 in the
textbook. Plot the two equations in a diagram with pC/pF on the vertical axis
and RA/pF on the horizontal axis.
Suppose world prices are pC/pF=3. Which country will produce clothing and
why? Does comparative advantage in terms of labor productivity or absolute
advantage in the use of factor A determine the pattern of trade?
Now suppose world prices are pC/pF=2. Which country produces clothing at
these prices?
6.
Relaxing Balancedness Constraints:
The figure drawn below is a reproduction of Figure 9.4 in the textbook. Points A and
A* show production if trade in intermediates is unbalanced, B and B* show
consumption if trade in intermediates is unbalanced. Points C and C* show production
if trade in intermediates is balanced.
(a)
(b)
(c)
7.
Which country runs a deficit in intermediate goods trade?
After trade in both intermediates and final goods, the home country consumes
at a point in the interior of its production possibilities set. Why is it optimal for
the country to trade in this way?
With balanced trade in intermediate goods, the foreign country could produce
at C*. As a result of unbalanced trade in intermediate goods, the foreign
country's production possibilities frontier shifts inward. Why does the foreign
country find it beneficial for this to happen?
Factor Endowments and Factor Price Equalization:
The following diagram illustrates the unit isoquants of the two constant returns to scale
industries, clothing and food.
(a)
(b)
(c)
(d)
8.
Assuming that these technologies are shared by two trading countries, what
range of capital-labor endowments will trade in commodities lead to factor
price equalization?
Suppose the home country's capital-labor ratio exceeds this range. How will its
wage-rental ratio compare to the foreign country's wage-rental ratio? (Support
your result by referring to the diagram.)
If labor were allowed to move between countries which country would
experience immigration and which emigration?
Would factor flows and commodity flows be complements or substitutes?
The Gains from Immigration:
Consider the following diagram, which was used in the analysis of the specific factors
model in Chapter 6:
(a)
(b)
(c)
(d)
(e)
Assuming that the country depicted is a small country, how would immigration
of labor change this diagram?
What happens to the returns to capital and land from immigration?
What happens to the wage rate?
Is it possible to devise a scheme of transfers such that all domestic residents
gain from the immigration without taxing the immigrants?
If this country exports clothing and imports food, how would the analysis
change if it is large rather than small?
9.
Migration and the Production Possibilities Frontier in the Heckscher-Ohlin Model:
Suppose that labor migrates to the country with the production possibilities frontier
drawn below. Assume also that clothing uses labor intensively, and that food uses
capital intensively.
(a)
(b)
(c)
(d)
(e)
How does the production possibilities frontier change?
If this is a small country how does production change? Which result from
Heckscher-Ohlin theory did you use in answering this question?
The post-immigration budget line is to the right and parallel to the initial budget
line if this is a small country. Furthermore, the budget line will be tangent to an
indifference curve above the one through point B. Does this imply that the
welfare of this country's pre-immigration residents has increased?
How would your analysis change if this were a large country?
Suppose the new budget line is tangent to a lower-valued indifference curve
than the one at point B. Does this imply that the immigrants have lost from
immigration? Does it imply that the residents have lost from immigration?
What does it imply?
10.
Migration and the Production Possibilities Frontier in the Specific Factors Model:
The analysis of the specific factors model centers around the following two diagrams
where A is the initial production bundle, D is the initial consumption bundle, and WA is
the initial wage rate.
(a)
(b)
(c)
(d)
(e)
(f)
How does the production possibilities frontier change as a result of the
immigration of labor?
What happens to the production of clothing and food?
How does this differ from the Heckscher-Ohlin model?
What is the easiest way to prove your result in (b)? (Hint: Which diagram is
more useful?)
Suppose that instead, capital, which is used intensively in clothing, immigrates.
How do you illustrate this in the upper diagram? In the lower diagram?
What is the effect on the pattern of production?
11.
Employment and the Domestically Owned Multinational:
Consider a specific factors model with two goods, wine and computers, produced by
sector-specific capital and mobile labor.
(a)
(b)
(c)
12.
What is the direct effect on the welfare of domestic labor if some domestic
computer capital emigrated abroad?
Are there other effects that would mitigate this effect? (Hint: What would
likely happen with the returns earned abroad?)
Illustrate your analysis in the diagram below:
Tariffs and Direct Foreign Investment:
Consider an American tobacco manufacturer that exports a significant share of its
production to the Japanese market. Suppose Japan levies a very large tax on imported
cigarettes to protect employment in its domestic tobacco industry.
(a)
(b)
(c)
Using your knowledge about how tariffs affect factor returns, why should the
American producer set up a subsidiary in Japan?
Will this affect the competitive structure of the Japanese market?
Will it affect the competitive structure in the U.S. market for tobacco products?