the nation and the world economy - economics - aniket · 2020. 3. 17. · c dr. kumar aniket the...

Introduction Trade Flows Capital Flows Immigration Comparative Advantage Impact of trade

The nation and the world economyECONOMICS

Dr. Kumar Aniket

UCL

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Lecture 18

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http://www.aniket.co.uk/pages/ucl.php


CONTEXT

Exchange between parties can be mutually beneficial but conflictsarise over how these gains are distributed. (Units 5-9)

This lecture explores globalisation and its impact on the nationstate. It answers the following questions.

• What are the cost and benefit from globalisation?

• What affects how gains from trade are distributed within thecountry?

• Can governments influence influence the cost and benefitsfrom trade in its favour?

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Lecture slides with my additional notes.For each slide, first go through the slide onthe left and then read my notes on theright. The notes either explain the lectureslides or provide some extra material tohelp you absorb the course material. If aparticular set of notes are not clear to you,move to the next slide and come back to itlater. Sometimes reading ahead can helpunlock the key concept that is preventingyou from understanding a slide or aconcept.


MOTIVATION

Manufacturing wages relative to the US (1950-2015)

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The graph describes each countriesmanufacturing wages relative to the US.Wages in both Germany and Japan werelower than the US after the second worldwar but they had caught up by the 1980s.South Korea’s has caught up with the USafter the 1980s. China has made significantstrides in the last two decades but still hasa long way to go. Sri Lanka and thePhilippines have stayed where they werewhereas Mexico is the only country thathas lagged. In the last lecture, we saw thatthe period from 1945-1970s was the GoldenAge. This is also the period during whichGermany and Japan caught up with the USin terms of their manufacturing wages.South Korea and China have moved closerto US wages during the Great Moderation.

This lecture will ask the followingquestion.What opportunities does the worldeconomy offer a nation-state to developeconomically?What is the role of the nation-state in aglobalised world?The globalised world economy offersopportunities in terms of trade. Yet, thereare significant costs in terms of nationalsovereignty. The objective of the lecture isto give you a better understanding of thetrade-offs as they exist in the worldeconomy today.


GLOBALISATION

Ford Employees across the world in 2014: a reflection ofopportunities globalisation offers large firms

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The example of Ford illustrates how acompany’s production footprint can bespread all across the world. The size of thelabour force reflects the size of the marketfor cars. Firms are distinctive in the waythey make things, i.e., each firm has itssecret recipe. These are ideas that only areonly the firm knows how to implement.Ford, in this case, represents a distinctiveway of making cars. Ford could havechosen to produce cars in one country. If ithad done so, it would have faced traderestrictions in terms of exporting cars fromthat country. Instead, by producing carsacross the world, it can cater to the localmarket and bypass the trade restrictions. Itis the free flow of capital or the fact thatFord’s property rights are respected acrossthe world that

allows it to set up factories across theworld and employ local workers in thosefactories. The pattern of employeessuggests that Ford is responding to traderestrictions and taking advantage of thefree flow of capital to have a globalproduction footprint. Japan has a large carmarket and Japanese carmakers haveproduction facilities across the world. It isstriking the Ford has no productionfacilities in Japan, while Toyota is one ofthe largest car manufacturers located in theUnited States. There have been severaltrade disputes between America and Japanover this. Americans claim Japan isunfairly protecting its domestic car market.Japanese claim Japanese strictly preferJapanese cars to American cars. Thedispute between the two continues.


GLOBALISATION

Globalisation A process by which the economies ofthe world become more integrated

output (goods & services) and factorinputs (capital & labour) flow freelyacross national boundaries

Trade flow flow of goods across borders

Capital flow flow of capital (investment)across borders

Immigration flow of labour acrossborders

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There are normally three-factor inputs inthe production function. Capital, labourand technology or ideas. Technology orideas are non-rival goods, i.e., they can beused at multiple locations at the same time.Hence, they are free to flow across nationalboundaries. The flow of capital acrossnational boundaries is through investment.When a citizen from one country invests inanother country, then they need to ensurethat their investment is secure. Hence, thefree flow of capital (investment) requires aseries of arrangements that secure

the property rights of the person whoknows the capital, irrespective of theirorigin. Most countries respect the propertyrights of the capital owner. As a result,capital has been mobile for a long time.Labour is the least mobile of the threefactors, even though it has become moremobile over the last few decades. Just theway capital carries ideas across borders,labour carries with it the knowledgehumans in the form of human capitalacross borders. Finally, trade flows are theflow of goods and services produced usingthese three-factor inputs.


HYPERGLOBALISATION

Hyperglobalisation: free flow ofgoods, technology, capital andlabour across the nationalboundaries

Examples

European Union’s singlemarket

United States internal market

India internal market

China’s internal market

Autarky: no inflow or outflow ofgoods, technology, capital andlabour across the nationalboundaries.

Example

North Korea

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Hyperglobalisation is a term that describesthe free flow of factor inputs and outputsuch that the location where the goods andservices are produced can be entirelydelinked from the location of theirconsumption.Most countries have a free flow of goodswithin their national boundaries. Theythus mimic the effect of hyper globalisationwithin their national boundaries. Thinkabout California’s trade with either Oregonor North Carolina. There are no obstaclesto trading between these states. Yet, ifCalifornia trades with Japan, there areseveral obstacles.

European Union’s ambition has alwaysbeen to create an remove all internalobstacles to trade and reap the benefits ofhyper globalisation within the Union.While the United States and the EuropeanUnion are hyper globalised within, they actas an economic unit and agree on tradearrangements with other countries in theworld.The other extreme is Autakry, i.e., anentirely closed economy where all factorinputs are used to produce goods andservices that can only be consumed withthe country and there is no trade betweenthe country and the rest of the world.Most countries in the world are somewherein between the two where they trade withthe rest of the world with some restrictionson the free flow of goods, capital andlabour.


INTEGRATION OF GOODS MARKETS

Common measures of globalisation:

• Trade (export or import) as a share of GDP

• Reduction in trade costs (price gaps) between countries

Merchandise trade Tangible products that arephysically shipped acrossborders

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Trade as a share of GDP: Upward trend in worldwide trade (except 1914-1945),with sharp acceleration from 1990s onwards

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Reduction in trade costs (price gaps) between countries

Law of One Price should hold if there are no transport costs orbarriers to trade.

Price gap Difference in the price of a good inthe exporting and importing country

Arbitrage in competitive equilibrium the pricegap should equal the sum of all tradecosts

Price gaps between countries have generally declined over time,while the volume of goods traded has generally increased.

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ANGLO-AMERICAN WHEAT TRADE (1800-1914)

Before 1840 price gap volatile

After 1840 shipping cost ↓, price gap ↓, wheat import ↑

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The wheat price gap started declining wasvolatile before 1840. After 1840 it starteddeclining and the volume of wheat shippedstarted increasing. This is because the costof shipping started falling as a result ofintroduction of steamships.


ANGLO-AMERICAN WHEAT TRADE (1800-1914)

For agricultural commodities British prices were higher

For industrial commodities American prices were higher

Nearly all prices fell over this period.

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TRENDS IN GLOBALISATION

Globalization I before 1870 until 1914

Globalization II the end of the Second World War until now

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TRENDS IN GLOBALISATION

Globalization I before 1870 until 1914

Deglobalization increasing trade costs during TheDepression

partly due to protectionist policiesaimed at protecting domesticemployment (tariffs and quotas onimports)

Globalization II the end of the Second World Waruntil now

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INTEGRATION OF CAPITAL MARKETS

If a country has an export surplus (it exports more than imports), it isleft with foreign currency as a result of its export surplus.

• The foreign currency can either increase the reserves of the centralbank or is invested abroad.

Current Account (CA) exports – imports + net investment

Current Account (CA) deficit Country is borrowing (receiving netcapital flows)

Current Account (CA) surplus Country is lending (net capitaloutflow)

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Foreigners pay for exports in foreigncurrency (e.g. dollars). Domesticconsumers pay for goods in domesticcurrency (e.g. Sterling). An export surplussimply means the country sells moreabroad that it buys from abroad. Thisresults in a surplus of foreign currency (e.g.dollars). The foreign currency can be usedto either increase the reserves held by theCentral bank (in case the domesticcurrency needs to be supported during aperiod of crisis) or can be used to buyforeign assets like foreign stocks and bonds(Portfolio Investment) or foreign physicalassets (Foreign Direct Investment).


TRENDS IN GLOBALISATION OF CAPITAL MARKETS

• Historically, increased trade resulted in larger current accountimbalances for countries across the world

• Countries that trade more also tend to borrow and lend more

• International asset holdings increased over the 20th century

c©Dr. Kumar Aniket

The graph on the left shows how aggregatetrade balances have increased duringglobalisation phases and decreased duringthe de-globalisation phases. Simply put,this is graphs reflect the output market, i.e.,the market in traded goods are services.

The right graphs show how the secondphases of globalisation have both resultedin and facilitated the free flow of financialcapital. This graph reflects the free flow ofcapital through the global capital markets.The increasing sophistication of capitalmarkets means that savers from any part ofthe world can invest in entrepreneurialprojects in another part of the world. Inprinciple, it shows allow marginal capitalfrom across the world to be equalised. Inpractice, information problems mean thatpeople invest in herds, i.e., where peoplehave obtained some information becauseothers have invested. It may seemcounter-intuitive but the cost of acquiringreal and useful information can be veryhigh. The cost of transmitting informationhas decreased but the cost of acquiringinformation remains high.


LABOUR MARKETS INTEGRATION

Fewer advances in labour market integration than goods or financialmarket integration due to immigration barriers.

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c©Dr. Kumar Aniket

Immigration population periodicallyincreases, but those increases don’t last forlong.


LABOUR MARKETS INTEGRATION

Wages still differ across countries due to migration costs.

c©Dr. Kumar Aniket

Capital is inanimate and hence its flowonly impeded by the restriction put inplace by nation states. Labour on the otherhand is more complicated. Wagedifferentials are just one of the motivationfor moving from one country to another.People have a strong preference for theirown language and a strong affinity fortheir own community.

There have to be strong push or pull factorsin place to overcome these preferences. Thepull factors are usually wage differentials.A high enough wage differentialovercomes the reluctance to move. Giventhe large wage differentials betweendeveloped and developing countries, thereis flow of labour from the poorest countriesto the richest countries. The push factor isoften some kind of conflict that makes itimpossible for a person or family to stay.They have no option to move. Of all thedimensions of globalisation, immigration isthe most controversial one.


SPECIALISATION

In autarky, the nations are selfsufficient and produce everythingon their own

An open economy has an incentiveto nations specialise

Specialisation: when an entity produces a narrower range of goodsthan it consumes, acquiring the rest through trade

Reasons for specialisation include:

Comparative advantage: in producing particular set of goods

Economies of agglomeration: cost reductions from locating closeto other firms in similar industries

Economies of scale: cost advantages from producing more

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In autarky, the economy has to produceeverything for itself. Naturally, therewould be no specialisation. As we seebelow trade offers an opportunity tospecialise and expand the range of goodsthat a country can consume. Specialisationalso comes as a cost as we see below.


COMPARATIVE ADVANTAGE

A country has an absoluteadvantage in a good if it canproduce the output using fewerinputs than others

A country has a comparativeadvantage in the good where it hasthe greatest absolute advantage

• A country may not have absolute advantage in any goods but itwill always have a comparative advantage in some good

• Trade is mutually beneficial when countries specialise in the goodthey have a comparative advantage in.

c©Dr. Kumar Aniket

The difference between comparativeadvantage and absolute advantage seems abit confusing at first but an example shouldhelp. Let’s imagine a situation with twotasks and two actors. The actors are alawyer and a secretary she hires. The twotasks are typing and “lawyering”, i.e.,practising law. Let’s also imagine that thelawyer has an absolute advantage in bothtasks as compared to the secretary, i.e., thelawyer makes £400 an hour while workingas a lawyer and types at 80 words perminute. The secretary is not trained as alawyer, so can only £0 per hour as a lawyerand types at 60 words per minute. Thelawyer may have an absolute advantage inboth tasks, i.e., lawyering and typing.

The secretary does not have a comparativeadvantage in either task. Yet, the secretaryhas a comparative advantage in typing, i.e.,she is better at typing than she is atlawyering.Should the lawyer and secretary trade. Thetrade, in this case, is Lawyer hiring thesecretary to type for her. The answer is yesif she can hire the secretary for less than£per hour. Let’s say the lawyer hires thesecretary for £100 per hour. They bothbenefit from this arrangement. Every hourthe lawyer is freed up from typing, shemakes a surplus of £300(= 400−100). Thesecretary makes £100 typing instead ofmaking 0 £from lawyering. It is mutuallybeneficial for them to trade. This is exactlythe situation in the world economy. Giventhe prevalence of new technology inproduction, the US has comparativeadvantages is most things. Yet, it isbeneficial for the US to trade with the restof the world.



Production if all time is spent on one good, per hectare of land

Greta 1,250 apples or 100 tonnes of wheatCarlos 1,000 apples or 40 tonnes of wheat

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Carlos lives on Apple island and Gretalives on Wheat island. Both islands are ofequal size and have 100 hectares that canbe used for agriculture, i.e., either produceapples or wheat.If Carlos spent all his time on producingapples, he would produce 1000 apples perhectare. If he spent all his time on wheat,he would produce 40 tonnes of wheat perhectare. If Greta spent all her time onproducing apples, she would produce 1250apples per hectare If she spent all her timeon wheat, she would produce 100 tonnes ofwheat per hectare.

Following on from the last slide: It frees up itsfactor input to produce things that they arebest at, i.e., they have a comparativeadvantage in. Even though iPhones aredesigned in Silicon Valley, the physicalproduction takes place in China. Freeingup resources from production andspecialising in designing creates a surplusfor the US in principle. In principle, it willbe beneficial for the US if this surplus isshared with the people negatively affectedby the manufacturing of the iPhone tomove to China. The natural way to do sowould be through redistribution (as in theNordic countries) or by fundinghigh-quality public goods likely subsidisededucation and health care. In practice, thebenefits are not shared through eitherchannel and as a result inequality hasincreased over time.



An island has a comparative advantage in producing a good when it isrelatively cheaper in their economy (in the absence of trade).

Island Apple Wheat(Carlos) (Greta)

Land (in hectares) 100 100

Production per hectare per yearTonnes of wheat produced 400 1,000

Number of apples produced 1,000 1,250

Relative pricesRelative price of wheat per apple 1,000

400 = 2.5 1,2501,000 = 1.25

Relative price of apples per tonne wheat 4001,000 = 0.4 1,000

1,250 = 0.8

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Price of wheat in terms of apples is 2.5 forCarlos and 1.25 for Greta.Wheat is cheaper for Greta to produce onthe wheat island.

Price of apples (in terms of wheat) is 0.4for Carlos and 0.8 for Greta.Apples are cheaper for Carlos to produceon apple island.



Island Apple Wheat(Carlos) (Greta)

Total productionTotal tonnes of wheat produced 0 10,000

Total number of apples produced 10,000 0

Apples exported 4,000Wheat exported 2000

Apples consumed 6,000 4,000Wheat consumed 2000 8000

Carlos has a comparative advantage in apples and

Greta has a comparative advantage in wheat

c©Dr. Kumar Aniket

Apples are comparatively cheaper on appleisland and wheat is comparatively cheaperon the wheat island. Hence, Carlos has acomparative advantage in apples and Greta hasa comparative advantage in wheat.



With trade, Carlos specialises in producing apples and Greta specialises inproducing wheat. Both of their consumption frontiers are above theirproduction frontiers, so they are both better off

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The solid red lines are Carlos and Greta’sfeasible production frontier under autarky,i.e., the situation where they areself-sufficient and don’t trade. The dottedlines show how their feasible productionfrontier will move out if they were to tradeat the relative price of wheat (in terms ofapples) of 2.

Carlos will specialise in apples, produce10,000 tonnes, consume 6000 and export4000.Greta will specialise in wheat, produce10,000 tonnes of wheat, consume 8000tonnes and export 2000 tonnes.It should be clear that both Carlos andGreta end up consuming more than theywould have in autarky.


CAPITAL AND LABOUR INTENSITY

Capital intensive good requires a lot of capital and relatively lesslabour to produce, e.g., aircraft

Labour intensive good requires a lot of labour and relatively littlecapital to produce, e.g., consumer electronics

• The principle of comparative advantage is often used to analysewhere capital intensive and labour-intensive goods are produced.

Countries Capital Labour Comparative advantage

Developed cheap expensive Capital-intensive goods

Developing expensive cheap Labour-intensive goods

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As we have discussed in earlier lectures,developed countries are relativelyabundant in capital and developingcountries are relatively abundant in labour.Put another way, in developed countries,workers have plenty of capital to workwith. This means that capital is relativelycheaper in developed countries. The logicis simply that if capital is used moreintensively in developed countries, itsmarginal product drops relative to themarginal product of labour. In developingcountries, workers lack sufficient capital.This implies that labour is relativelyabundant and used more intensively indeveloping countries. Thus, labour has arelatively lower marginal product ascompared to capital and is thus relativelycheaper.

The assumption in the discussion above isthat each factor earns its marginal product,something we discussed early on in thecourse.A good can be produced in either a capitalintensive way or labour-intensive way. Forexample, if a shirt is produced withcapital-intensive technology, it is producedusing plenty of machines. If it is producedusing labour-intensive technology, it isproduced mainly by hand.Given their different endowments andresulting prices, developed countries tendto specialise in capital intensive goods anddeveloping countries specialise inlabour-intensive goods.


IMPACT OF TRADE: EXAMPLE

Let’s assume there are only 2 goods in the world:

• passenger aircraft (capital-intensive) and

• consumer electronics (labour-intensive).

The US is relatively capital abundant, whereas China is relativelylabour abundant

• specialisation according to factor endowments.

If US export capital intensive good to China and China exportslabour intensive goods to US

• Returns to capital increase in US

• Wage increases in China

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Trade has allowed the US to specialise incapital intensive goods and China tospecialise in the labour-intensive goods.This means that without trade andspecialisation, the US would have been lesscapital intensive and China less labourintensive.Without trade, the US’s marginal productof capital (and the price of capital) wouldhigher than China’s. Conversely, withouttrade, China’s marginal product of labour(and price of labour, i.e., wage) would belower than rest of the world.

It follows that with trade US’s price ofcapital falls as it productions processbecomes more capital intensive. Similarly,China’s wage increases as it becomes morelabour intensive due to trade.

In the next slide, we construct a simpleexample which would help us understandthe impact trade on the US and Chinesesociety. The size of the circle represents thesize of the economy. The pie on the left ofthe economy represents the size of theeconomies before-trade and the pie on theright represents the size of the economyafter-trade. To help the comparison, we setthe size of both economies at 1before-trade.


IMPACT OF TRADE

Winners in the US Owners of capital inequality should riseWinners in China Workers (higher wages) inequality should fall

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With limited trade, labour share is 75% inthe US and 50% in China with the rest ofthe share going to capital. With trade, twothings occur simultaneously. First, theprice of the relatively abundant factorincreases with trade. Thus, the relativeprice of capital increases in US and relativewages increase in China. Second, botheconomies grow as a result of tradeopportunities, hence there is an additionalsize-effect. In this case, China starting witha smaller base grows by more, i.e., 40% andthe US starting with a larger base grows byless, i.e., 30%. As wages increase, trade hasreduced the relative share of capital andincreased the relative share of labour inChina. The labour share has increased from50% before trade to 60% after trade. Yet,since the total size of the economy has by40%, both labour and capital earn more inabsolute terms.

Total labour earnings have increased from0.5 to 0.84. Total capital earning hasincreased from 0.5 to 0.56. The US story isdifferent. US worker’s share has gonedown both relatively and in absoluteterms. In relative terms, it was 75% beforetrade and is 55% percent after trade. Inabsolute term, it was 0.75 before trade andis 0.72 after trade. Not only has the capitalshare increased due to trade, but the labourhas also lost out in absolute terms becausethe size of the economy has not grownsufficiently to maintain its share. A little bitof calculation should show you that if theUS economy had grown by 6.4% more thanit has currently, the workers would not beworse off. That is, if the size of the circle onthe right-hand side was 1.364, the workerswould have got 0.75 after trade.


WINNERS AND LOSERS: LONG RUN

Trade leads to specialisation, which leads to increased productivity inthe goods the country specialises in.

• Specialisation shifts the price-setting curve upward:

• In the short run, jobs are destroyed.

• In the medium run, growth in export industries creates newjobs.

• Long-run adjustment process depends on how much wage-settingcurve shifts as a result of trade.

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As a country specialises, it starts producinga smaller range of goods. It is moreproductive in the goods it does specialisein. High productivity essentially meanshigh output per worker. If the firm owners’mark up remains constant, this would leadto the price-setting curve shifting up.


IMPACT OF TRADE

Trade shifts up the price-setting curve. US is producing less consumerelectronics now (A→ B) and more aircrafts (B→ C). Increased demand forlabour leads to higher wages (C→D).

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With trade and specialisation, some jobsare destroyed moving the economy from Ato B and another set of jobs are createdmoving the economy from B to C. If thenew jobs created are greater than the oldjobs that are destroyed, then the economymoves from A to C.New jobs are more productive in theeconomy because they have resulted fromtrade led specialisation. The higherproductivity from its definition meanshigher output per workers. If the firmowners’ markup remains constant, theprice-setting curve shifts up. If thewage-setting curve remains unchanged,the economy moves from A to D inlong-run. This higher wages increase andlower unemployment in the economy.

This is the case when the trade isunambiguously beneficial for the economy.The benefits from trade critically dependon the increase in productivity and nochange in the wage-setting curve. As wesee below, under certain conditionsworkers and unions that represent themmay ask for higher wages as a result oftrade.


IMPACT OF TRADE

Increased job turnover leads to workers asking for more generousunemployment benefits, leading to wage-setting curve shifting left andleading to higher unemployment (D→ E).

c©Dr. Kumar Aniket

This is the case where even though somejobs are destroyed and others that arecreated, the workers and Unions ask forhigher real wages, shifting up the wagessetting curve in the process.


IMPACT OF TRADE

A more modest shift in wage-setting curve would lead to lowerunemployment (D→ F).

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If the wage-setting curve shifts up by amodest amount, then the increase inunemployment due to trade would belimited. Whether the demands for wageincreases are modest of more stridentdepends on the institutions that thecountry puts in to support the people wholose their jobs and help them retrain andtransition to the new jobs that are createdin the economy as a result of trade. A coalminer may not be retrained as a softwareengineer but she or he can be retrained as acall-centre worker or someone working inthe Amazon warehouse. Hence, how farthe wage-setting curve moves up dependson the internal policies that are in place inthe country.


IMPACT OF TRADE

Manufacturing wages relative to the US (1950-2015)

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The striking things about this graph is thatdespite its high inequality, themanufacturing wages in the US remainrelatively high. While Germany and Japanhas closed up the gap, other countries stillhave a long way to go. The opportunity oftrade based on comparative advantageremains high in a world economy wherethere is a huge variation in manufacturingwages.


GLOBALISATION AND ECONOMIC PERFORMANCE

• Some countries have benefitted more from globalisation thanothers.

• Economic success depends on how well policies have managedgrowth due to economic integration.

• During industrialisation, Germany and the US achieved higheconomic growth despite high manufacturing tariffs.

• Scandinavian countries prospered through openness, withpolicies that help displaced workers.

c©Dr. Kumar Aniket

With globalisation, the world is tradingmore than ever before. Capital is flowacross the world more freely than everbefore, leading to expansion of capitalmarkets. The flow of labour across theworld ebbs and flow. We are closer tohyper-globalisation than we are to autarky.A nation state can advantage of tradeopportunities offered by world economy.Trade allows a country opportunity tospecialise. Concomitantly, some jobs arecreated and others destroyed. The countrywould naturally specialise in goods andservices where its productivity (or outputper worker) is high. These are the new highproductivity jobs that are created to replacethe lower productive jobs. This pushes upthe price-setting curve (if the firms’markup does not change).


SUMMARY

• Economies have become more integrated over time

• Specialisation and trade can be mutually beneficial

• Winners and losers in the short run, both within and betweencountries, depending on relative factor abundance

• All parties can benefit in the long-run with good policymaking

c©Dr. Kumar Aniket

Whether it results in lower or higherunemployment depends on the Unionsand workers wage demands (Wage settingcurve). Countries that facilitate thetransition of labour forces from jobs thatare destroyed to the new jobs that arecreated are the ones that are likely to fullyreap the benefits of the trade. Countriesthat do not facilitate this churn wouldexperience high unemployment and greatdeal of resentment towards the forces ofchange. Trade can be force for good if its anation state puts appropriate guardrailsthat prevent it from running aground.

the nation and the world economy - economics - aniket · 2020. 3. 17. · c dr. kumar aniket the...

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