Theory of International Trade

The Theory of International Trade An Alternative Approach

Branko Horvat

THE THEORY OF INTERNATIONAL TRADE

Also by Branko Horvat HISTORY OF THE YUGOSLAV OIL INDUSTRY, 3 Vols. ECONOMICS OF THE YUGOSLAV OIL INDUSTRY TOWARDS A THEORY OF PLANNED ECONOMY INTERINDUSTRY ANALYSIS ECONOMIC MODELS ECONOMIC SCIENCE AND NATIONAL ECONOMY AN ESSAY ON THE YUGOSLAV SOCIETY BUSINESS CYCLES IN YUGOSLAVIA AN INTEGRATED SYSTEM OF SOCIAL ACCOUNTING FOR THE YUGOSLAV ECONOMY (with assistants) THE YUGOSLAV ECONOMIC SYSTEM: The First Labour-Managed Economy in the Making INTRODUCTION IN THE THEORY OF PRODUCTION ECONOMIC ANALYSIS SELF-GOVERNING SOCIALISM (co-edited with R. Supek and M. Markovic), 2 vols. ECONOMIC POLICY OF STABILIZATION THE POLITICAL ECONOMY OF SOCIALISM THE CRISIS OF THE YUGOSLAV SOCIETY THE LABOUR THEORY OF PRICES ABC OF YUGOSLAV SOCIALISM THE KOSOVO QUESTION ENTREPRENEURSHIP AND THE MARKET TRANSFORMATION OF ‘SOCIAL’ OWNERSHIP THE THEORY OF VALUE, CAPITAL AND INTEREST

The Theory of International Trade An Alternative Approach Branko Horvat Director The Institute for Advanced Studies Zagreb Croatia

First published in Great Britain 1999 by

MACMILLAN PRESS LTD Houndmills, Basingstoke, Hampshire RG21 6XS and London Companies and representatives throughout the world A catalogue record for this book is available from the British Library. ISBN 0–333–73409–2 First published in the United States of America 1999 by ST. MARTIN’S PRESS, INC., Scholarly and Reference Division, 175 Fifth Avenue, New York, N.Y. 10010 ISBN 0–312–22003–0 Library of Congress Cataloging-in-Publication Data Horvat, Branko. The theory of international trade : an alternative approach / Branko Horvat. p. cm. Includes bibliographical references and index. ISBN 0–312–22003–0 1. International trade—Econometric models. I. Title. HF1379.H675 1998 382'.01—dc21 98–30661 CIP © Branko Horvat 1999 All rights reserved. No reproduction, copy or transmission of this publication may be made without written permission. No paragraph of this publication may be reproduced, copied or transmitted save with written permission or in accordance with the provisions of the Copyright, Designs and Patents Act 1988, or under the terms of any licence permitting limited copying issued by the Copyright Licensing Agency, 90 Tottenham Court Road, London W1P 9HE. Any person who does any unauthorised act in relation to this publication may be liable to criminal prosecution and civil claims for damages. The author has asserted his right to be identified as the author of this work in accordance with the Copyright, Designs and Patents Act 1988. This book is printed on paper suitable for recycling and made from fully managed and sustained forest sources. 10 08

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Printed and bound in Great Britain by Antony Rowe Ltd, Chippenham, Wiltshire

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Contents viii

List of Figures

ix

Preface List of Symbols

xiv

List of Abbreviations

xvi

1

Introduction PART I

1

THE MAINSTREAM INTERNATIONAL TRADE THEORY

2

The Evolution of International Trade Theory

3

The Heckscher–Ohlin Theory

10

3.1 3.2 3.3 3.4 3.5

10 12 15 21 22

4

Preliminaries The Heckscher–Ohlin Theorem The Factor–Price Equalization Theorem The Stolper–Samuelson Theorem The Rybczynski Theorem

7

Critique

24

4.1 4.2 4.3 4.4

24 27 28 29

The validity of underlying assumptions The validity of neoclassical economic theory Empirical evidence The Evaluation of the Heckscher–Ohlin theory

Appendices to Part I 1 2

32

Empirical evidence Leamer’s attempt at reconciliation of the theory with facts

32 33

PART II THE SYSTEMIC THEORY OF VALUE 5

Diachronic vs Synchronic Labour Input: The Two-Century Old Misunderstanding v

39

vi

Contents

6

The Employment Effect

42

7

The Replacement Effect

45

8

The Interplay of Employment and Replacement Effects

50

9

The Traverse

54

PART III 10

11

THE BASIC THREE-INDUSTRY MODEL

Steady State

59

10.1 10.2 10.3

59 62 63

Integrated world economy Open economy Growing economy

The Wage–Rental Curve

Appendix to the Part III 1 A note on price movements

67 70 70

PART IV AN ALTERNATIVE THEORY 12

Three Models

75

12.1 12.2 12.3

75 77 79

The two received models An alternative model of internationl trade Comparative advantage

13

Intra-Industry Trade

82

14

Four Hypotheses

85

14.1 Comparative advantage hypothesis 14.1.1 Two commodities 14.1.2 Many commodities 14.2 Equalization of factor prices hypothesis 14.3 Hypothesis about the changes due to the opening of trade 14.4 Increased factor supply specific effect

85 85 88 89

PART V 15

90 92

THE GAINS FROM TRADE

The Pattern of Specialization

95

15.1 15.2

95 99

Given autarkic prices Primary and secondary specializations

Contents 16

17

The Gains from Trade

104

16.1 16.2 16.3 16.4

104 106 108 111

Autarky vs. trade Domestic and international prices Import and export gains Wage–rental curve again

Unequal Exchange

116

17.1 17.2 17.2

116 118 120

Marxian values Unequal exchange I Unequal exchange II PART VI

18

19

vii

TARIFFS

Tariffs and Subsidies

125

18.1 18.2 18.3 18.4 18.5 18.6

125 127 127 129 132 133

Effects of a tariff in a single market Prohibitive tariff and subsidy The pattern of specialization with tariff Nominal and effective tariffs Subsidies Infant industry support

Customs Union

136

19.1 19.2 19.3 19.4

136 137 140 144

Degrees of economic integration Trade creation and trade diversion Customs unions in a more realistic setting Dynamic effects

Appendices to Part VI 1 2

Empirical evidence Economic integration of Eastern Europe: The Project Bridge I Introduction II The Organization III The Customs Union IV The Monetary Union

150 150 155 155 160 162 172

Notes

190

References

192

Name Index

197

Subject Index

199

List of Figures 2.1 3.1 3.2 4.1 7.1 7.2 8.1 11.1 15.1 15.2 16.1 16.2 16.3 18.1 18.2 19.1 19.2 19.3 19.4 A-1 A-2 A-3

International and domestic prices of goods X and Y Factor prices, commodity prices and factor proportions Isoquants, factor-proportion rays and isocost line Factor-intensity reversal Replacement effect Replacement and rental curves The growth rates of labour and capital and capital cost saved Two wage curves α and β The pattern of specialization for Δw*  0 The regions of primary and secondary specialization The gain from trade (1) Wage lines for P*3 and αP*3 given The gains from trade (2) Imposition of a tariff t No-trade regions The effects of a customs union Increased elasticity of the customs union supply curve Reduced costs of customs union Economics of scale The profitability distribution of firms General equilibrium with internal and external balances Demand and supply of reserve currency

viii

8 12 19 26 48 48 53 68 96 101 105 110 113 125 129 139 143 145 148 164 167 181

Preface The theoretical foundation for the present study was established in my book on Value, Capital and Interest. The book dealt exclusively with a closed economy. Now, the same theory is applied to an open economy, becoming thus the The Theory of International Trade. The two books are intended to establish an alternative theoretical paradigm. There is also a difference between the two books. While the first book is more or less definitive, the second one is the first attempt to apply the same theory to international trade. Joseph Schumpeter noticed that different theoretical systems in economics are determined by different value theories. Classical economics was based on the labour theory of value and neoclassical economics on the utility or scarcity theory of value. To avoid a frequent misunderstanding, it stands to repeat that utility theory and marginalism are two different things. The former is a theory, the latter is a technique of analysis. Ricardo was a marginalist (when developing the theory of land rent) but not a subjectivist utilitarian. Marginalism is compatible with any theory. The theory I am trying to develop is based on the theory of value which differs from the other two paradigms in that its starting point is the operation of the economic system rather than the behaviour of individual economic agents. It may, therefore, be called systemic economics. Consequently, macroeconomics cannot be based on micro foundations, but rather the other way round. Technically, the systemic theory differs from the classical labour theory in that it does not aggregate labour inputs diachronically but synchronically. What that means will be explained in Chapter 5. Perhaps a note of clarification is necessary. This systemic approach is not identical to sociological functionalism which ends up in functional determinism. On the contrary, individual economic agents are free to follow their separate interests and their individual choices are not predetermined. But the mechanical aggregation of individual actions does not and cannot explain the functioning of the system. A system is a whole of interdependent parts and therefore more than a mere summation of individual actions. I was led to begin thinking about an alternative theory of value by my experience as a chief methodologist of the Yugoslav Federal ix

x

Preface

Planning Bureau. As is well known, the classical labour theory cannot explain the formation of prices. Values and prices differ, both theoretically and at the market place, and for that reason the theory is not of a great use. But neither could I make much use of the neoclassical theory because it is largely ideological, tautological and/or subjective. A revealing episode is the neoclassical theory of the firm when applied to the labour-managed firm. It produced predictions of the perverse behaviour on the market which has never been observed in reality. The conclusion drawn was not that the neoclassical theory – at least as practised by its adherents – was a poor theory, but that the theory was correct and the labour-managed firms do not conform to it because they do not behave rationally (Horvat, 1986)! Similar is the episode known as ‘Leontief Paradox’ which will be treated in Chapter 4. For my planning business, I needed an objective standard. And also, I needed explanations and not tautologies, science and not ideology. Thus, a systemic approach was a natural course to take. At that time I was unaware that it will take an entire professional life to formulate the first version of a coherent theory. However, once formulated, it turned out to be very simple. And simplicity is usually considered to be one of the characteristics of good theory. The present book is intended to be short, simple and empirically relevant. As for the first aim, I covered only essential problems. The possible numerous extensions and formalizations are obvious. I resisted the temptation to lengthen the text whenever it was not necessary to complete the argument. In relation to the second target, I used mathematics only as much as it seemed necessary to provide rigorous argument. Finally, the aim of every good theory is to be empirically relevant in order to improve our prediction capabilities. The reader will judge to what degree the three aims were achieved. Since I do not find neoclassical theory of great use, not much of it will be found in this book. But I made every effort not to neglect any good scholarly work as the list of references demonstrates. On the other hand, Neo-Ricardian theory naturally fits into my theoretical framework much better and I did not hesitate to use the research results of Neo-Ricardians. At the time of writing, I was not aware how dangerous that was. Later I observed that NeoRicardians are mostly ignored and rarely if ever quoted in the mainstream literature. The reason for this neglect was explained to me in a letter by Christopher Bliss after he had negatively reviewed

Preface

xi

my book on value and capital – without having given himself the trouble of reading it! Professor Bliss advises me of the fact that ‘in this field there is a large divide between the broadly “Neo-Ricardian” writers and those of a more “Neoclassical” inclination,’ classifies me among unpleasant Neo-Ricardians (which I am not) and states that he does not belong to the ‘same school (sic!),’ adds that ‘reviews ought to be entertaining’ and observes that ‘ultimately such issues are matters of opinion,’ leaving no doubt that his opinion is negative. A nice set of ‘scientific’ criteria. Professor Bliss is one of the editors of Economic Journal and a former editor of Oxford Economic Papers. Neo-Ricardians, however, do themselves a dis-service in constantly attacking the labour theory of value trying to show how Sraffa demolished it. It seems to me that they believe that only one labour theory imaginable is that of Ricardo and Marx. In Chapter 17, I showed what motivated Marx to use the value theory that was at hand, namely that of Ricardo. If Neo-Ricardians drop the assumption of one possible labour theory, they will realize that a poor labour theory may be replaced by a better one and that Sraffa could have written a simpler book free of artificial constructs. Perhaps, some day Sraffians may attempt to accomplish that. But that will not endear them to the dominant academic coterie. My two pure theory books on closed and open economies were intended to be two parts of a tetralogy. The other two parts are an institutional book and a book on macroeconomics. The former was published in 1982 as The Political Economy of Socialism. It was inspired by the institutions of a labour managed economy. At that time the only labour-managed economy in the world was that of Yugoslavia. As I was living in that country and participated in shaping its institutions, I could use my first-hand experience. The other planned book was to be on macroeconomics based on labour management. This book has not yet been written and probably will not be written by myself. The only labour-managed economy has recently been destroyed and no other (on the national scale) has evolved so far. It might be thought that the economy that failed is not worth while studying. For surely, it failed because it was not efficient and economics is about efficiency. That seems to be prevailing opinion, but it is contrary to facts. For four decades, the Yugoslav economy was developing at the fastest rate in Europe. The transfer of population from agriculture to urban occupations – transforming peasants

xii

Preface

into citizens – was probably the fastest in the world (one to one and a half per cent of total population annually). Technological progress, as conventionally measured, was also probably the highest in the world for the period for which the measurement exists (in 1954–67 at the rate of 4.4 per cent annually, Horvat, 1969). The quality of life – measured by the life-expectancy at birth, medical care and education, relative to the level of development – was unambiguously the highest in the world. Income distribution was among the most egalitarian in the world. Clearly, the Yugoslav historical experiment did not fail because of economic reasons. It failed because of political and cultural reasons (for explanations see Horvat, 1992b). This is a sad remainder to economists that their profession plays only a minor role in the life of nations and the development of their economies. As the book on labour-managed macroeconomics will never be written by myself, it may be worth while to record some findings from my extensive research. Already in my first book on economic planning (Horvat, 1964), I discovered that the textbook recipe for the volume of investment being determined by the willingness of consumers to reduce their consumption – is a macroeconomic nonsense. In European economies investment cannot be increased so much as to reduce consumption, assuming rational calculus. The share of investment in GNP can be annually increased at most by 1–2 per cent. This magnitude is too small for individual consumers to be aware of the difference, and also consumption per capita never stops growing. This fact is due to what I called ‘the limited absorptive capacity of an economy.’ Investment can be productively absorbed only up to about 35 per cent of GNP, increasing the share in GNP to this limit only gradually from the starting position. This is the closest that economics can come to the physicists’ notion of ‘world constants.’ If it is invested either less or more that the absorptive limit, consumption will be reduced and this has nothing to do with saving/consumption propensities. If on the daily or monthly basis consumers cannot discriminate between smaller and greater consumption, the time horizon must be extended. How much? The rational choice seems to be to maximize consumption for the period of one’s life. That implies maximizing the rate of growth of production. The theoretical implications of these ideas were examined in my two early Economic Journal articles (1958, 1965). The most extensive preparation for the intended future labourmanaged macroeconomics was undertaken in my book on business

Preface

xiii

cycles (Horvat, 1971). I examined in some detail how a labourmanaged market economy operates. Not unexpectedly, I found that it operates differently from an etatist command economy and differently from a capitalist market economy. As far as the latter is concerned, the capitalist market is just one and not the only type of market. That does not seem to be generally understood. The market of a labour-managed economy is an alternative one. The space allows me to mention only three interesting differences. The first is about the role of inventories in business cycles. In the capitalist and etatist economies, inventories move in conformity with production cycle (although for entirely different reasons). In this way movements of inventories intensify cyclical oscillations. In the labourmanaged economy of Yugoslavia, inventories move inversely to production cycle and so exert stabilizing influence (Horvat, 1971, ch. 9). The second difference in related to the familiar Keynes– Hicks IS–LM mechanism. In a capitalist economy, monetary restriction reduces inflationary pressure, in the labour-managed economy it stimulates inflation (Horvat, 1991). The third difference lies in the realm of fiscal policy. In a capitalist economy, taxes on profits are unavoidable but at the same time do not represent a policy tool of great importance. In a labour-managed economy, productive capital is socially owned. Thus, profits may be left in the firm without any taxation. In fact, the greater are profits, the greater are possibilities of enlarging social capital and that, of course, is desirable. Taxes are levied on the wage-bill in order to insure that investment is neither smaller nor greater than necessary for full employment. Besides, the wage-bill tax produces some additional effects that make economic monitoring more efficient than in a capitalist economy (Horvat, 1992a). The four summary observations must replace the non-existent fourth book of tetralogy. They may prove to be useful preliminary research for an unknown future author. I wish to express thanks to Dr Mia Mikic´ for many helpful comments. B. Horvat Zagreb

List of Symbols aij  x ij/Xj A  [aij] D D  K/n E, e g g*  g  ρ G  1  g G H I k  K/L K L M, m n p, ph P, pw P p*i  pi/p1, Pi*  Pi/P1 p/P r  π  ρ R s t T 1  t U w w*  w/p1 W X1, X2, X3 α, β κ  K/X λ  L/X μ

input coefficients matrix of input coefficients developed depreciation export growth rate gross growth rate growth factor gross investment home country new investment capital-labour ratio (intensity) capital labour import life span of fixed assets home prices world prices partner country relative prices in terms of consumer goods terms of trade, exchange rate rental rate replacement subsidy rate tariff rate tariff factor Underdeveloped wage rate real wage world consumer, capital and intermediate (materials) goods combination of techniques capital coefficient labour coefficient mark-up factor xiv

List of Symbols μ  πK/wL ν π ρ  1/ν τ ω  P2K/L  P2 k

rate of surplus value number of ‘dynamic years’ rate of profit replacement rate time organic composition of resources

xv

List of Abbreviations CEFTA CMEA EC ECU EDB EFTA EM EMI EMS EMU EPU ESCB EU GATT GDP GMP GNP IMF SDR SECI VAT

Central European Free Trade Area Council On Mutual Economic Assistance (COMECON) European Community European Currency Unit European Development Bank European Free Trade Association European Money European Monetary Institution European Monetary System Economic and Monetary Union European Payments Union European System of Central Banks European Union General Agreement on Tariffs and Trade Gross Domestic Product Gross Material Product Gross National Product International Monetary Fund Special Drawing Rights South-east European Cooperative Initiative Value Added Tax

xvi

1 Introduction The conceptual and analytical apparatus to be used in this study was developed in my book The Theory of Value, Capital and Interest (1995). In order to avoid repetition, the original book will be frequently referred to. For this reason the proper understanding of this study requires the reading of the original book. If the reader cannot read the whole book, he may select the absolutely necessary chapters 1–5. Nevertheless it is still necessary to repeat certain derivations to make the argument comprehensive. The original book dealt entirely with the closed economy. Now the economy is opened, which is the essence of international trade. The canonical model will consist of two primary factors (labour and capital), three commodities (consumption, capital and intermediate goods) and two countries: a small country (A) and the rest of the world (W). Of the two factors, only labour is nonproduced. So is land, but it plays an inessential role in modern economies and will be neglected. The customary 2  2  2 model will be replaced by a 2  3  2 model in order to increase dimensionality and meet some of the objections raised by Ethier (1984) concerning low dimensionality. Three products are analytically desirable per se in any case because they have very different economic properties. One of them is a consumer good, the other two represent producer goods. Of the latter two, one has time dimension (capital) which generates important economic effects to be discussed later. The last is free of that dimension: it represents all other goods (raw materials prepared for trade, intermediate goods, goods in process) and will be referred to as ‘materials’. Materials, customarily neglected in other theoretical treatises, represent the bulk of international trade. Except for a short section on stationary economy, whose purpose it is to clarify basic concepts, the rest of the book deals with steady state growth. If the rate of growth is changed, it takes n years – n being the replacement period of fixed assets – until economy reaches new equilibrium. Consequently, only long-run equilibria are explored and in this sense ‘gravitational’ prices are used. Transitions from one steady state path to the other are not researched 1

2

The Theory of International Trade

(except in one case, in Chapter 9) and have been left for some future date. Problems of (rational) transition really belong to the theory of planning. ‘Gravitational prices’ are not necessarily constant if technological progress takes place even at a constant rate. Short-run prices result from an interplay of supply and demand. Long-run – gravitational – prices also imply equality of supply and demand, but this equality does not influence price movements (which may be due to technological progress). If there is an excess demand or supply, in a production economy the market equilibrium is achieved through changes in supply, not prices. Given enough time, the supply can always be changed as required. The analysis will mostly imply the existence of the general equilibrium though this state will be defined differently than is usual. The mathematization of economics grossly overstressed the equalization of marginal (that is, infinitesimal) quantities because algebraic derivations of maxima proceed in this way. However, business people and government planners do not use marginal equations. The only related, practically relevant, concept is opportunity cost, and this is a very helpful concept. Equilibrium position may be defined in two different ways: (1) as a position where there is no incentive to change, or (2) as a position where plans (expectations) and realizations coincide. Definition (1) mimics equilibrium in mechanics. Since the real-world economy is subject to continual changes, this definition has hardly any meaning in economics. In (2) change can be incorporated, because it can be planned (expected). Nevertheless, it is still too empty to give useful guidance for our explorations. In order to move closer to the real world, I define general equilibrium as a state in which overall supply and demand are equalized, as demonstrated by the following observable facts:

• Full employment in which demand and supply of labour are equal – that is, working hours and shifts do not change and all those who wish to work are employed. In this way also excess demand (supply) is defined: working hours and the number of shifts increase (if they decrease, there is unemployment). Unemployment is defined as workers being out of work or undergoing learning processes. The ‘natural’ rate of unemployment makes no sense

Introduction

3

if it is not absolutely voluntary – and then it is not unemployment but leisure. Unemployment and general equilibrium in the sense of Pareto optimum represents a contradictio in adjecto. • Productive capacity is used at the economically justified rate and there is no accumulation or decumulation of inventories (apart from seasonal variations). • The appearance of excess demand (supply) is not corrected by changes in prices but by changes in quantities (out of inventories or changed production). Continuous changes in prices would incur too great transaction costs (administrative and information costs, loss of business credibility, the confusion of customers, retaliation and so on). For these reasons businessmen and planners avoid price changes at all costs. If output is not speedily forthcoming, even some queuing might be preferable. To put it differently, the lengthening of the list of orders is a sign of excess demand and an invitation to increase supply. • If the business conditions have changed permanently then, of course, prices must be adjusted accordingly. The main cause of such permanent changes is technological progress. Thus, as already hinted, technological progress changes (gravitational) prices while the shortrun supply-demand divergencies are remedied by changes in quantities. • Prices of factors of production are also formed differently from textbook recipes. It is not marginal productivity of labour that determines the wage, it is the wage that determines marginal productivity or whatever is used in business calculations. My salary at an American university is ten times greater than at a Croatian one – not because my marginal productivity increases ten times after my travel to the United States, but because America is so much richer than Croatia. The other assumptions used throughout most of the book are: 1. There is vigorous competition preventing effective monopoly. 2. There are no transaction and transportation costs. 3. Labour and capital are fully mobile nationally and immobile internationally. 4. International prices (Pi ) are given. 5. Consequently, national wages and profit rate differ (w  w, r  r). 6. Balanced trade. 7. Constant returns to scale. If they are not constant, they are treated as different technologies.

4

The Theory of International Trade

8. All goods are reproducible. 9. The economy grows at a constant rate. Mainstream economics deals almost exclusively with allocational efficiency, although this is comparatively unimportant. The few attempts to measure welfare losses due to allocational imperfections indicate that they are probably not greater than a fraction of one per cent (Leibenstein, 1966, p. 393). The much more important production efficiency is generally left unexplored. The current unemployment rate in Europe is higher than ten per cent. That implies a production loss more than twenty times higher than probable allocational losses. For this reason, I shall not be much concerned with allocational efficiency. If we abstract from motivation (I have dealt with that in my book on the political economy of socialism, 1982), the establishment of general equilibrium means maximizing net output. The theory developed in this book is ‘pure’ theory in the sense in which the free fall formula s  gt2/2 is pure physics. Formula indicates the distance covered by a particle in a vacuum. The conditions do not obtain in reality: the formula is only a very rough approximation to reality and is accurate only as a limiting case. In economics pure theory often means theory that disregards reality, pure deduction from a certain number of axioms (assumptions). That is definitely not the case here. In the physical formula, the gravitational constant g is determined by experiments. Similarly, economic formulae must contain measurable quantities and make sense only if they can be refuted, but are not (so far). Pure economic theory is a source of a potentially rich collection of empirically relevant hypotheses which can be corroborated or refuted by recourse to economic facts. Assuming logical consistency, we aim to deal with measurable facts. The derivation of results will (it is hoped) be achieved in the simplest possible way. The three main features of a good theory are: (a) logical consistency, (b) simplicity and (c) empirical relevance.

The Evolution of International Trade Theory

Part I The Mainstream International Trade Theory

5

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The Evolution of International Trade Theory

7

2 The Evolution of International Trade Theory Trade will open up between two formerly autarkic economies if differences in production conditions warrant a profitable exchange of goods under the ruling terms of trade. In particular, a firm will decide to export its product x when the domestic price is lower than the international one. px  Px

(2.1)

Torrens (1808) and Ricardo (1821) developed this commonsense proposition into a general theory of comparative advantage. Even if domestic costs of production in all lines of production are higher than the international ones, it pays to export if the costs of production are not uniformly higher. Differently higher (or lower) costs make for comparative advantage which is expressed in different ratios of costs/prices px Px py  Py

(2.2)

If the international price ratio is higher than the domestic one, it is cheaper to import Y and produce domestically X. The same idea is portrayed in Figure 2.1. In the area A, Px /Py  px /py and commodity X will be exported. By contrast, px /py  Px /Py in B and this is an import area for X. At the point C, international and domestic prices are equal and there is no incentive for trade. If the line px py is uniformly above the line Px Py, the prices of both X and Y are internationally uncompetitive. Yet, the trade will still be profitable since the slopes of the lines (representing price ratios) are different. By changing the units of measurement (exchange rate), the domestic price line may be shifted downwards to the position C where domestic and international price ratios are equal. 7

8

The Theory of International Trade

Px

A

px

c

B Py

Figure 2.1

py

International and domestic prices of goods X and Y

In the long run, trade between two countries must be balanced (the value of export is equal to the value of import, all evaluated at international prices). Px X  Py Y The same balance may be expressed in terms of the price ratios Px X  Y Py

or

Py Y  X Px

(2.3)

where (2.3) represents the trade transformation curve. Since international prices are given and countries and their industries are of unequal size, the complete specialization in X and/or Y are exceptions and not a rule. This is the essence of the classical theory. Ricardo, like all classical economists, used the labour theory of value. Value was measured by costs of production and, in this case, by the diachronic labour input, since labour was the only factor of production. As the labour theory fell into disrepute, it was replaced by the utility theory of value. When it was invented, the new theory was meant to explain consumers’ behaviour that was neglected by the classical theory. It was observed that utility increases with the scarcity of goods relative to demand (except for inferior goods and habit-forming drugs). From the consumption of goods, the theory was later extended to the production of goods as well. This was, of

The Evolution of International Trade Theory

9

course, illegitimate, because production is a technological and not a taste-determined process, but that was overlooked or neglected. I dealt with the resultant great confusion in theoretical approaches in my book on value theory (1982). Now only the consequences for foreign trade theory will be explored. The alternative (scarcity) theory of value rests on the following assumptions. Just as the marginal utility of consumption decreases when the quantity of the good consumed increases, the marginal product of the increasing factor input also decreases – which is equivalent to increasing marginal costs. In other words, the analytical apparatus developed for an exchange economy, with a downward sloping demand curve, has been applied to a production economy with an upward sloping supply curve. Generalization meant treating all factors of production as formally equal and similarly production and exchange were postulated as formally equal processes. This is the essence of the neoclassical theory of value, which became the basis for the current theory of foreign trade. Neoclassical theory has been an analytical advancement and conceptually a step backwards. Labour theory deals with labour time which can be measured objectively, and this is vitally important – or should be so – for an empirically oriented science such as economics. Scarcity theory deals with utility, which is subjective and cannot be measured. Consequently, a great part of the modern theory is metaphysically oriented and so nearly useless. Next, scarcity theory often plays with tautologies pretending to be explanations. For instance, if price is low, commodities are said to be abundant; if it is high, they are proclaimed to be scarce. No exceptions are made: the theory is always true and irrefutable, which means that these statements are tautologies. If something is always true, it cannot be tested: it explains nothing. It represents a translation of words: abundant means cheap, scarce means expensive. These quid pro quos are the source of many misunderstandings. Ricardo’s labour theory of value is certainly not correct. The neoclassical utility (scarcity) theory is not usable. It remains for us to replace them with something which may be called the modern theory. But before we try to do that, let us examine the mainstream (neoclassical) theory of foreign trade in greater detail.

10

The Theory of International Trade

3 The Heckscher–Ohlin Theory The central question of foreign trade theory is how to determine the pattern of foreign trade: which commodities will be exported and imported and where. The answer provided is based on the work of two Swedish economists, Eli Filip Heckscher (1919) and Bertil Ohlin (1933). Their propositions were later formulated as the Heckscher–Ohlin Theorem (HO). Subsequently three additional theorems have been posited. These four propositions represent the core of the mainstream theory of foreign trade. Of these, two refer to comparisons between two countries (the HO theorem proper and the factor price equalization theorem). The other two deal with relationships within a single country (the Stolper–Samuelson and Rybczynski theorems). The latter two can dispense with the assumption of identical technology.

3.1

PRELIMINARIES

The main idea of the theory is very simple, although not all the derived consequences are: It is observed that (1)) countries have different factor endowments and (2) industries use factors at different intensities. These two sets of differences make international trade profitable. Comparative advantage based on (1) is a quite trivial proposition. If the supply of fertile land is plentiful, the country will produce and export agricultural products. The consequences of observation (2) are not so straightforward. The theory is next constrained by a number of assumptions such as (1) the absence of factor intensity reversals; (2) the absence of demand reversals (a strong preference for a good in country A, although it is more expensive than in country B); (3) same constant returns technology with convex isoquants; (4) similar and unique community preferences; (5) perfect competition. Given the constraints, two conclusions follow: (a) the country will export that commodity whose production uses, relatively intensively, a relatively 10

The Heckscher–Ohlin Theory

11

plentiful factor of production (‘plentiful’ being the same as ‘cheap’) and (b) although factors are not mobile internationally, free trade will equalize commodity prices and so also factor prices. Next, assumption (1) implies that industries are equally flexible. Since they are not, the assumption will almost certainly be vitiated (see Fig. 4.1). Technologies are different. Competition is not perfect. Thus, claim (a) will certainly be refuted, and so will (b), which may additionally be invalidated by complete specialization and trade impediments (this simplified description of HO theory relies on Hefferman and Sinclair, 1990, pp. 25–38). Consequently, we should expect to find that HO theory has no predictive value. We will proceed to analyse HO theory in more detail. After that, we shall deduce a number of more fundamental theoretical objections. Perhaps the essential idea underlying HO theorizing consists in the unique determination of commodity prices by factor prices – given a technology which determines quantities – and factor prices depend on factor proportions. If it is assumed that production functions are identical in the two countries compared, then the only difference between them is to be found in factor endowments. If constant returns prevail, then marginal rates of substitution – determining prices – will depend only on the proportions of the factors employed. The basic relations are derived in the following way. Let two goods (X, Y ) be produced by means of two factors (L, K). Let X be labour-intensive, that is, in the production of X to the same factor price ratio w/r corresponds higher factor ratio L/K than in the production of Y. The relevant functions are assumed to be monotonic (it will later be shown that they need not be: see Section 4.2) and therefore all variables are uniquely determined. The factor price ratio is positively related to the product price ratio, w/r  f (px /py), and inversely related to factor proportions, w/r  g (L/K). In this way all important factor proportions (L/K) uniquely determine relative factor (w/r) and commodity (p x /p y) prices. The functional relationships are shown in Figure 3.1 (Chacholiades, p. 246). Fig. 3.1 is the basis for all the four theorems – Hecksher–Ohlin, Stolper–Samuelson, factor price equalization and Rybczynski – underlying the neoclassical theory of international trade. The first theorem determines comparative advantage (exports of commodities). The other three follow directly from Fig. 3.1: there are three monotonically interrelated variables – px /py, w/r, L/K – and when one is fixed, the other two are uniquely determined.

12

The Theory of International Trade w r

X Y Px/Py

L/K

Factor prices, commodity prices and factor proportions

Figure 3.1

The relationships in Fig. 3.1 are obvious from the assumptions stated: given the production functions assumed, px /py falls as w/r falls and w/r falls as L/K increases. This can easily be derived from price equations for commodities X and Y: px  wλx  rκx,

L λx  x x ,

K κx  x x

py  wλy  rκy ,

λy 

Ly , y

Ky κy  y

| pp λ |λ

x

w  r

y x y

κx κy px py

|  |

px py

κy  κ x

(3.1)

(3.2)

p λx  x λ y py

As px /py increases, so does w/r. For the relation w/r  g (L/K), see (3.7).

3.2

THE HECKSCHER–OHLIN THEOREM

The HO theory is based on the following more complete set of assumptions:

The Heckscher–Ohlin Theory 1. 2. 3. 4. 5. 6. 7. 8. 9.

13

Factor endowments are given. Constant returns to scale. No joint production. The number of factors of production not greater than the number of commodities, m  n. Identical production functions. Strong competition prevails in both factor and product markets. Identical and homothetic tastes (no influence of consumer preferences). No factor-intensity reversals (the same type of factor intensity for all variations of w/r). Before trade opens, both commodities are produced and consumed in both countries.

Ricardo and the classical theorists assume nothing in particular (except labour as the only input and strong competition) and derive international trade from the differences in production functions. HO theory implies nine restrictive assumptions. In particular, it assumes identical production functions and derives trade from the differences in factor endowments. Ricardo predicts that relatively cheaper commodities will be exported and HO predicts which commodity will be cheaper and that the labour- (that is, factor-) abundant country exports labour- (factor-) intensive commodities and increases their production. The comparison of assumptions and predictions make it easy to establish which theory is superior. Taking into account the assumptions stated, the HO theorem may be formulated in the following way: Production of the commodity, that uses the relatively abundant factor more intensively, enjoys comparative cost advantage. Thus, each country will export the commodity for which production is used relatively intensively the more abundant factor. Note the link provided between factor intensity of production and the factor abundance of the country in which the commodity is produced. Yet this is not a mathematical but an empirical relationship (short of a tautology). For this reason some authors distinguish factor intensity of a production process (Fi /Fj, F  factor) from factor abundance of a country (Fhi /Fwi, h  home country, w  world). That, however renders the analysis rather messy while reasonable empirical data are not available.

14

The Theory of International Trade

There are two versions of the theory depending on how factor intensity is defined.

• Price

definition of the factor endowments as measured by w/r (capital intensity is expressed by high w/r). • Physical definition, when factor endowments are measured by factor proportions, L/K (capital intensity of a process is expressed by high K/L). The problem, of course, is that capital cannot be measured in physical units and, moreover, neoclassical capital cannot be measured independently of distribution. Both definitions are straightforward in a two-factor model. When there are several factors, it is not clear what ‘factor intensity’ means. Similarly, factor intensity becomes meaningless when there are more than two countries. If country A is capital-abundant in relation to country B, and labour-abundant in relation to country C, HO theory predicts that it will export both capital- and labour-intensive commodities (Bhagwati, 1964, p. 20). The price definition is a near-tautology. Given the identical technology, it says that cheaper production entails comparative advantage. The physical definition of factor abundance is non-tautological and more involved. Now, the argument is reversed. Instead of showing that the cheaper factor (more abundant by definition) is used more intensively, we must show that the factor used more intensively (more abundant by definition) is also cheaper. Then the price of the labour-intensive commodity will be lower in the labour-abundant country and so indicate comparative advantage. Now, if the factors are fully used, the production functions in the two countries are identical and comparatively more labour is available, then the price of labour in terms of capital, w/r, must fall. The continuation of the argument is the same as with the price definition of intensity: cheaper labour makes for cheaper labour-intensive commodity production and for comparative advantage. The same result may be derived algebraically (cf. Chacholiades, 1978, p. 261). Full employment equations under constant returns are λ x X  λy Y  L

λx  Lx /X, λ y  Ly /Y

κ x X  κy Y  K

κ x  K x /X, κ y  K y /Y

(3.3)

15

The Heckscher–Ohlin Theory The factor proportion is equal to L K



λ λ (X/Y)  λy

(3.4)

κ x(X/Y )  κy

The factor-price ratio must be identical for the production of two commodities w/r  MRS XLK

Y

w/r  MRS LK

 

 

dκ x dλx

(3.5)

d κy

(3.6)

dλy

Differentiation of (3.4) and substitution of (3.5) and (3.6), when X/Y is kept constant, gives d(L/K)  0 d(w/r)

(3.7)

Consequently, when w/r increases, L/K falls. Clearly, all these derivations depend on monotonic relationships among variables and lose meaning if there is factor intensity reversal.

3.3

THE FACTOR–PRICE EQUALIZATION THEOREM

Assuming free trade, strong competition will lead to an equalization of commodity prices. Since, in contrast to commodities, factors are not supposed to be internationally mobile, it is legitimate to ask what will happen to their prices. Many economists take the view that free trade will also equalize factor prices – wages, rents and interest rates (Samuelson, 1948, 1949; Land, 1959; Chipman, 1966 and others; Pierce, 1959, is critical). Competition in the market for products leads to indirect competition in the market for factors. Ignoring transportation costs, the following propositions emerge: free trade leads to commodity-price equalization and (a) complete specialization in production if factor prices remain unequal, or

16

The Theory of International Trade

(b) incomplete specialization in production in each country and the equalization of factor prices between countries. Fig. 3.1 shows how factor-price ratios are uniquely related to commodity-price ratios. Since competition equalizes commodity prices (which are thus given), and production functions are identical, factor prices will also be equalized. J.R. Hicks provides a simple derivation of the theorem (1983, p. 226). Suppose we have commodity X and commodity Y and each of them is produced in economies A and B in equilibrium. Consequently, unit costs of production (under competition equal to the value of one unit of output) must be the same in both countries: λxw A  κx r A  λx w B  κx r B

(3.8)

λ y w A  κy r A  λ y w B  κy r B From these two equations we derive the condition r B  r A  (λx /κ x)(w A  wB )  (λy /κ y) (w A  w B)

(3.9)

Since labour–capital ratios are presumably different in the production of two commodities, λx /κ x λy /κ y, the condition can only be satisfied if the factor prices are the same, w A  w B, r A  r B. It is here where Hicks leaves the theorem as proved. One should, however, notice that the result holds only if the technical coefficients (λi, κi ) are the same in both countries (as Hicks cold-bloodedly assumes). However, empirical technical coefficients are notoriously different. It is worse than that: it is impossible to define two identical production functions empirically (except for two isolated projects). Using the awe-inspiring language of theorems, the theory says that the factor prices will be the same, if the two economies are sufficiently similar (same GNP per capita, same rate of growth, same system of taxation, same methods of production and so on). And that is hardly very enlightening. It is not quite clear how rents are supposed to be equalized, since the plots of land are very heterogeneous and so not comparable. The authors of the proposition are mysteriously silent about the details. The same international price for wheat may be related to widely different areas of land used in its production. Rent must be determined per unit of land and so agricultural land of different

The Heckscher–Ohlin Theory

17

countries is assumed to have the same productivity on the average. Since, usually, data on land values are more reliable than information about rents, the latter may be derived from the former: the land value is a discounted infinite stream of rents at some interest rate. The latter is presumably an internationally equalized interest rate. In this case rent equalization depends doubly on interest equalization (interest as production cost and interest as evaluation criterion). Even so, the assumption of the same average productivities of land is highly arbitrary: high land-labour ratios on the Ukrainian chernozëm may still be economically lower than low labour-land ratios in the Arabian desert. Here we may mention an interesting empirical study (K.H. O’Rourke et al., 1996). The authors document a convergence of wage– rental ratios in the late nineteenth century. ‘Wage–rental ratios boomed in the Old World and collapsed in the New, moving the resource-rich, labour-scarce New World closer to the resource-scarce, labour-abundant Old World.’ (p. 499). They then carried out an econometric analysis which showed that there was commodity–price convergence which accounted for about a quarter of wage–rental convergence, but changing land-labour ratios accounted for none (p. 515). The whole idea of rent equalization is based on an elementary confusion. If land is a factor of production, then rent per unit of surface is the price for its services. Since land is not homogeneous, the differences in quality are measured by differential rents. That much already Ricardo knew. No amount of competition will equalize differential rents. An escape route is to consider only margins. Thus, Samuelson in his first article (1948) compares marginal physical products. This procedure raises at least three questions. First, if marginal physical product is defined as quantity of wheat per marginal acre, than equal MPPs would mean unequal marginal net value (revenue) products because costs of production differ if plots of land are not homogeneous. On the other hand, equal marginal revenue products would imply unequal physical size of plots and so unequal rent per acre. Next, at the margin we cannot talk of rent as usually defined (generated by all intramarginal land units) but of something that might be called ‘marginal rent’. Finally, marginal differential rent is zero by definition of competition and by the fact that land is a non-produced asset that involves no costs. If something is left over, it must be assumed that competition is imperfect and there is also absolute rent. To assume away all such problems, in his second article Samuelson simply declares that land is ‘qualitatively identical’ (1949,

18

The Theory of International Trade

p. 182). Yet qualitatively identical land is not real land but an arbitrary construct. It may sometimes be represented as a broad average, as in empirical research by O’Rourke quoted above. This, however, renders marginalist analysis meaningless. A refuge may be taken in replacing physical land by land value. Now, of course, rents per unit of land value are equal, given the interest rate. But that is merely a tautology: land is defined as capitalized value of rents and rent as capital income from land. Physical land disappears and with it the meaning of factor price. All that can be concluded is as follows: if commodity prices, wages and interest are determined competitively, so is rent. But competitive rent is not equal rent per physical unit of land. A different general critique of factor-price equalization proposition comes from I.F. Pierce (1959). He shows that the likelihood of unique solution rapidly decreases as the number of traded goods increases. In a multi-commodity world, this likelihood is zero. Identical technologies are generally assumed in the HO theorizing and we shall not dwell on that longer. But there are four problems worth noticing: (1) Full prices. In (3.8) not full prices but only value added parts are equalized. Material costs are left out. It is clear that it cannot be simply assumed that they do not matter. Competition equalizes market prices and may or may not equalize valueadded parts of them. The additional constraint to be imposed is that value-added always represents the same proportion of market prices. (2) Dimentionality. The number of factors (m) must be equal to the number of commodities (n). If m  n, there is not a sufficient number of equations to determine factor prices. If m  n, the outcome is indeterminate and may lead to an even greater divergence in factor prices than the absence of trade (Land, 1959, p. 141). If we think of specific factors, m  n may represent the usual case. Roy Harrod remarked: ‘I believe that the true explanation of the flow of trade springs from the number of commodities . . . being less that the number of factors, owing to the existence of at least one specific factor for every commodity . . .’ (1958, p. 255). (3) Cone of diversification. Let X and Y represent two unit value revenue curves for commodities X and Y produced by capital and labour. Prices are given and determined in the international

19

Capital

The Heckscher–Ohlin Theory

v1

x y

v

c

v2

c Labour

Figure 3.2

Isoquants, factor-proportion rays and isocost line

markets. Let cc be the isocost line whose points of tangency with cures X and Y represent minimum costs of producing X and Y and so determine factor proportion rays V1 and V2. Under perfect competition prices and costs are equal. V10 V2 represents the Land-Chipman ‘cone of diversification’ (Land, 1959; Chipman, 1966). V denotes some average factor proportion when both X and Y are produced. It is visible that along V, cost of producing X and Y are lower than along V1 and V2 in isolation. This will be always so when the vector V lies inside the cone of diversification. The line cc denotes equal factor prices in the production of X and Y. If a second country is added, the picture will be similar and the problem of the exchange rate may be avoided by expressing prices in terms of X and Y. The common tangent determines factor prices as long as factor rays of different countries are inside the same come of diversification. If two isoquants cross twice, this will represent factor intensity reversal and two different cones of diversification will be created. If they do not overlap at least partly, factor prices cannot be equalized (Chipman, 1966, p. 24–25). If every country does not produce every commodity, the specialization will result and again factor prices need not be equalized. (4) Specificity of factors. As already mentioned, authors conspicuously avoid clarifying what the equalization of rents means. Samuelson

20

The Theory of International Trade remarked: ‘Land and labour are assumed to be qualitatively identical inputs . . .’ (1949, p. 182). Yet, the essence of land is that it is not ‘qualitatively identical’ since in this case differential rent would disappear. The problem may be circumvented by noting that the value of land is capitalized rent at the ruling interest rate. Yet in this case rent is eliminated as a separate factor price and we are left only with the interest rate. The factor price ‘wage rate’ poses a different problem. Minhas notes that wages varied from some $250 in poor countries to $3 600 in advanced countries (1962, p. 146). This does not look like equal factor prices. No amount of free trade will iron out this difference. It is obvious that wages can be equalized only by means of economic development of those countries which lay behind and not by market exchange.

We are left with capital (assuming that it can be unequivocally measured). Minhas reports that the profit rate varies among countries from 22 per cent to 15 per cent. Part of this difference may be attributed to differences in risk. However, the specific feature of capital is that it has double nature. Physical factories are not exported or imported (at least not usually). But the value of capital they do or will represent enters international trade. As a result, here we have direct, not indirect competition. World financial markets influence interest – and therefore profit – rates. The same conclusion may be reached via a slightly different route. Neoclassical theory assumes that factors of production are symmetrical. But they are not. Labour is not a symmetrical factor of production compared with capital or land. Wages are not determined by marginal productivity of labour but by the level of development, which may be measured by per capita GNP. Workers – as members of society, and not as dead instruments – insist on participating in the benefits of social wealth. After an initial low level of development, there is an empirically documented convergence in per capita GNP which is caused by technological progress and has nothing to do with the HO scarcity hypothesis (Horvat, 1974). Neither is capital symmetrical. Its quasi-price – profit – is a source of financing growth. Since the growth rates are different, so must be profit rates as well (unless the planning authority intervenes). Finally, land is a non-human non-produced factor, notoriously heterogeneous. Rents represent the remainder of income after wages and profits have been deducted.

The Heckscher–Ohlin Theory

21

Summing up the argument, the theorem evaporates in the thin air of artificiality.

3.4

THE STOLPER–SAMUELSON THEOREM

According to neoclassical economics, as reflected in HO theory, the scarcer a factor the higher its price. When two autarkic economies begin to trade – assuming always full employment – the labour-abundant one will export labour-intensive commodities, since they are supposed to be relatively cheaper. The converse is true for a relatively capital-abundant economy. Consequently, the opening up of trade raises the relative price of labour in the labour-abundant economy – because labour now becomes scarcer – and reduces it in the capital-abundant economy, because labour there becomes more abundant through trade. Or, in the original words of the authors: ‘International trade necessarily lowers the real wage of the scarce factor expressed in any good’ (1941, p. 66). It may be added in passing that joint production destroys the theorem. In this context we may adduce an exercise of Murray Kemp. Two commodities are produced, X1 and X2. Under perfect competition, the value of the marginal product of a factor is equal to the reward of that factor r  pi f i ,

f i 

δfi (Li Ki ) δKi

i  1, 2

(3.10)

w  pi ( fi  ki f i ), ki  Ki /Li where r is rental rate per unit of capital and w is the wage rate. What we would like to do is to express changes of factor prices in terms of factor intensity differences. Assuming constant returns to scale, Xi ⬅ Fi (Ki, Li )  Li fi (ki )

(3.11)

Divide by L xi  li fi (ki )

xi  Xi /L

l i  Li /L

(3.12)

22

The Theory of International Trade

Let l i be the proportion of labour force employed in ith industry. Then the average labour capital ratio may be expressed as a weighted sum of sectoral ki  Ki/Li. k  k1 l 1  k2 l2  k1(1  l2)  k2 l 2  k1l1  (1  l1 )k2

(3.13)

Differentiate to get: dli (1)i  dk k2  k1

(3.14)

As full employment is maintained throughout, K and L are given and fixed. Differentiate (3.12) and use (3.14): dxi dl  i dk dk

fi  (1)

i

fi k2  k1

(3.15)

Finally, differentiate (3.10) with respect to commodity prices and use (3.15): dr fi i  f i  (1) k2  k1 dpi

(

dw k1  f1  k1 f 1  f 1 1  dp1 k2  k1 dw k 1 f2   dp k2  k1

(3.16)

)



k2 f1 k2  k1

(3.17)

(3.18)

The conclusion is that ‘an increase in the price of any commodity gives rise to an increase in the real reward of whichever factor is used relatively intensively in the production of that commodity, and to a decline in the real reward of the other factor’ (Kemp, 1969, p. 17).

3.5

THE RYBCZYNSKI THEOREM

While the Stolper–Samuelson theorem deals with factor and commodity prices (holding fixed factor supplies), the Rybczynski theorem represents its dual and is concerned with factor and commodity

The Heckscher–Ohlin Theory

23

quantities (given commodity prices). In an incompletely specialized economy factor prices are supposed to be internationally equalized and fixed by the factor-price equalization theorem. Thus, the production technology chosen is also constant. When the available factors of production are fully employed, an increase in the supply of one factor – the supply of the other factor remaining fixed – raises the output of the commodity which uses that factor intensively and reduces the output of the other commodity. This happens because the expanded production, using the increased quantity of the factor that has become more abundant, must also use the other factor as determined by fixed technology. In this way less is left for the production of the second commodity and it must contract. It also follows that the terms of trade (relative commodity price) of the commodity using relatively much of the factor whose quantity has increased will deteriorate (Rybczynski, 1955, pp. 339, 340). If, for example, manufacturing is capital-intensive, the accumulation of capital will increase manufacturing production and reduce agricultural production at constant terms of trade (Johnson, 1962, p. 89). Solving the equations (3.3), we identify labour and capital constraints for commodities X and Y. Y 

L λ κ K  x X   x X λy κy κy λy

(3.19)

When λ x /λy  kx /ky, Y is more labour intensive than X. Solving the two equations for X and Y. X 

Y 

Lκ y  Kλ y λ xκ y  κ x λ y Kλ x  Lκ x λx κ y  κ x λ y

(3.20)

(3.21)

When industry X is more labour-intensive, λx κ y  κ x λ y, the denominator is rendered positive. If the supply of labour increases, the labour-intensive output of X increases and the capital-intensive Y is reduced.

24

The Theory of International Trade

4 Critique The scarcity theory suffers from a fatal ambiguity. When it was originally formulated in relation to consumption, scarcity was correctly defined with respect to demand. As the theory was extended to cover production, scarcity came to be defined as a technological relationship. As the ratio of two factors declines, the factor in the numerator becomes relatively scarce. The two concepts of scarcity may coincide, but they need not. They may be made identical by special restrictive assumptions, but this is artificial. If a country is technologically capital abundant (K/L high), it may nevertheless be economically labour-abundant when tastes in the two countries are different or if there is permanently high unemployment. Thus, it will try to export labour, not capital, in terms of commodities. Also, the theory is in difficulties when more than two factors of production are involved. The third main point of confusion is that the scarcity theory with respect to factors of production was developed for single industries. Thus, the composition effect was not noticed. Any real-world economy is composed of different industries that may vary substantially in their capital intensity. If technology remains unchanged, but industry mix changes for whatever reason unconnected with factor proportions, the capital intensity of the economy will change. After these general remarks, let us now examine that formidable battery of restrictive assumptions underlying the HO theorem given in Section 3.2.

4.1

THE VALIDITY OF UNDERLYING ASSUMPTIONS

Assumptions (1) (given factor endowment in the short-run), (6) strong competition (no impediments to adjustments), (7) identical tastes, and (9) both commodities produced in the pre-trade situation, seem to be relatively harmless simplifications. Assumption (2) (constant returns to scale) is harmless in the short run but dangerous in the long run, because output depends not only on factor proportions but also on the quantity of inputs and, also, the assumption 24

Critique

25

of perfect competition is logically unwarranted. With perfect competition production cannot be optimal, the economy will produce inside its production-possibilities frontier (Chacholiades, 1978, pp. 199–200). Assumption (3) (no joint production) is an admissible simplification for some purposes and not for others. Assumption (4) (m  n) is important for the definition of the factor of production used. It is admissible in the usual case of assuming two or three general factors (labour, capital and land). It becomes arbitrary in the specific factor models since the number of specific factors may be greater than the number of commodities, m  n. Assumption (5) (identical technologies) is perhaps the most farfetched and critical one. It implies three logical steps: (1) productive knowledge is available at no cost and instantaneously; (2) that makes possible identical production functions in use; and (3) countries will always choose positions on the frontiers of neoclassical production. Even if we neglect information imperfections, obviously none of the steps is warranted. In the real world, production functions are not identical and it is not clear how can they be analytically adjusted to look identical (except by means of tautologies). One obvious consequence is that trade will not equalize factor prices. This conclusion has already been reached by other economists (cf. Haberler, 1961, p. 19; Harrod, 1973, p. 37). Wages in poor countries are much lower than in the rich ones and no amount of free trade will equalize Indian and American wages, even if they find themselves in the same ‘cone of diversification’. What is necessary is economic development, and this is not a matter of trade but of investment. Productive capital is extremely unevenly distributed around the world (Olson, 1996, p. 19). Assumption (8) postulates the absence of factor intensity reversals for the same commodity originating in different countries or produced at different prices. If the production of a commodity is labour-intensive in one country or at one set of prices, it must remain so in all countries and at all factor-price ratios. Already two different isoquants represent factor intensity reversals at the point where they touch each other, a fortiori when they cross. In both cases the elasticities of substitution of the two curves are different (Fig. 4.1). This led Minhas to observe: ‘In the case . . . of any two industries with different elasticities of substitution, the reversal of relative factor-intensity is as inevitable as the meeting of two straight lines with different slopes’ (1962, p. 143). Therefore there is no

26

The Theory of International Trade K

Isoquants

L

Figure 4.1

Factor-intensity reversal

unique relationship between commodity and factor prices and ‘a reversal of capital intensity of two commodities at ω* the same commodity price consistent with two different factor-price ratios, one on each side of ω*’ (1962, p. 150). (ω* corresponds to the crossover point in the relative capital intensity.) It is clear that all the four theorems break down in their generality if the relative factor intensities are not monotonically related to relative prices (as in Figure 3.1) because the fundamental assumption is that they are technologically and so uniquely determined (cf. Steedman and Metcalfe, 1979, pp. 38–45, 64–75). In addition to assumptions quoted, there are several hidden general theoretical assumptions practically never quoted. They are: (1) analytical identity of financial and real capital, (2) analytical identity of one-commodity and many-commodity economies, (3) instantaneous adjustments, (4) symmetry of labour, capital and land, (5) no role for human initiative and other stochastic factors. As shown in my theory book, none of them is justified (Horvat, 1995, p. 16). To this list of assumptions at least one other may be added, (6) no information imperfections. Joseph Stiglitz shows that this assumption is particularly damaging for neoclassical analysis (Stiglitz, 1995). Apart from assumptions, there are further logical and empirical difficulties. Value and physical definitions of the HO theorem may contradict each other. In such a case, which is the relevant one? There are necessary conditions for them to contradict each other and there is just one sufficient condition: the labour-intensive commodity must be cheaper in the capital abundant country (Chacholiades,

Critique

27

1978, pp. 271–72). The relative factor abundance of compared countries may also change because of differential rate of growth of constituent industries.

4.2 THE VALIDITY OF NEOCLASSICAL ECONOMIC THEORY Difficulties and logical contradictions in neoclassical theory are analyzed in my theory book as ‘neoclassical aporiae’. I shall not repeat the analysis here; the interested reader may consult the original book (Horvat, 1955, pp. 12–27; pages quoted below refer to this book). More relevant to the present discussion is a different approach. The HO structure has been erected on the neoclassical foundation. And the foundation is basically composed of seven postulates. Neoclassical theory postulates an inverse monotonic relationship between prices and quantities of commodities and factors of production. It is said that the use of capital, land and labour decreases if interest rate, rent and real wage increase. It has already been observed that the composition effect is ignored when two or more industries are present. Now we consider the seven neoclassical postulates in some detail. First postulate: If the rate of interest is lowered, capital intensity increases. Finding: Capital intensity may decrease but also increase depending on whether producer good industries are less or more capital-intensive than consumer good industries. When the producer good industries are more capital intensive, the overall capital intensity is an increasing function of the rental rate (p. 133). Second postulate: An increased rent-wage ratio decreases land intensity (land per worker). Finding: Increased rent may also increase land intensity (pp. 184–91). Third postulate: There is a monotonic relation between factor prices and factor quantities. Finding: There is not, because reswitching of land and capital occur. In other words, factor-intensity reversal is a distinct possibility, theoretical and empirical (Steedman, 1979, p. 70). Fourth postulate: If labour supply increases (decreases), real wage rate decreases (increases). Finding: If labour is always fully employed, then – for a given labour force – an increased output of investment goods reduces the output of consumer goods. Consequently,

28

The Theory of International Trade

the real wage will be reduced regardless of no changes in labour supply. This is so even if an economy is open, because consumption (wages) cannot be increased if it cannot be paid for. Fifth postulate: The supply of commodities and their prices are inversely related. Finding: For inferior goods and habit-forming drugs that is certainly not so. This has been known for a long time. Yet, such goods are not very important and may be safely ignored. But now a new class of very important commodities is added. Prices are increasing functions of interest rate (p. 113). Interest (profit) is used to finance investment and so, in a fully employed economy, production of investment goods increases when their prices increase. Sixth postulate: Assuming constant returns and diminishing marginal productivity of labour, there is an inverse monotonic relation between the rate of profit and labour productivity (output per worker). Finding: That holds true if consumer good industries are more capital-intensive, otherwise not (p. 113). Seventh postulate: There is an inverse relation between the rate of profit and consumption per capita. Finding: True, since the wage– profit curve is downward sloping (see Chapter 11). As six fundamental postulates are theoretically false, it will come as no surprise if none of the four core HO propositions survives. This is the conclusion already reached by Steedman, Metcalfe and Mainwaring after having carefully scrutinized ‘the internal logic of the HOS analysis’ (Steedman, 1979, p. 64).

4.3

EMPIRICAL EVIDENCE

The theory predicts that similar countries will trade less while in fact similar advanced countries engage disproportionally much in mutual trade. Also, the intra-industry trade is expected to be negligible. In reality, intra-industrial trade expands much faster than the inter-industrial trade. More important than factor proportions is the structure of economy. Norway and Greece are relatively capitalabundant not because capital is relatively cheap but because Norway relies on hydroelectric power generation and the extraction of oil from the seabed and Greece has one of the largest merchant fleets in the world. All three activities are highly capital-intensive. By now it should be clear that the predictions of the theory are not likely to come true. When in 1954, Wassily Leontief decided to test the theory empirically, he was greatly surprised to find that

Critique

29

the result was negative. Leontief used the 50-sector 1947 American input–output table and estimated capital labour requirements for one million dollars’ worth of export and import competing commodities. He found that US import replacement required 30 per cent more capital per worker than exports. Capital-abundant America was importing capital-intensive commodities (and exporting labourintensive ones). Leontief and others repeated computations for American trade compositions in 1951, 1962 and 1972: two findings again refuted the theory, while the last one slightly corroborated it (Caves et al., 1993, p. 130). Leontief was persuaded – and so was the profession, almost without exception – that the theory was correct and that the use of his empirical data was faulty. Several years after Leontief, I performed the same exercise for the obviously labour-abundant Yugoslav economy using the 27-sector input–output table for 1955 (Horvat, 1962, pp. 154–56). It turned out that Yugoslavia was exporting capital-intensive commodities (and services). I did not find it difficult to explain these test results by the structure of the economy (the great share in export earnings of highly capital-intensive railway transit and maritime shipping, and in the imports of labour-intensive agricultural products). In the subsequent years, a number of empirical studies were performed (A-1). The results showed no clear direction: refutations and confirmations showed a stochastic pattern. The theory was found not to have any predictive value. If economics were natural science, it would have been concluded that the theory was definitely empirically refuted. Not so in economics. The literature on HO and related theorems is swelling; the textbooks and university courses pay great attention to this useless theory and Leontief’s finding – characteristically enough – was not considered (even by himself) a falsification but a ‘paradox’ of an otherwise good theory. The ‘Leontief paradox’ has become a standard item in university textbooks and exams and the HO theorem holds the place of honour. This phlogiston theory of foreign trade poses an interesting question for the methodology of economic science.

4.4 THE EVALUATION OF THE HECKSCHER–OHLIN THEORY The analysis revealed that the HO theory is either logically inconsistent or empirically refuted or both. In the tradition of serious

30

The Theory of International Trade

science, it must be discarded, although an enormous effort has been invested in its refinements. The discarded theory necessitates that it be replaced by a better one. Subsequently we shall explore some of the possible ways in which this might be done. If neoclassical theory is problematic and HO theory, built on that basis, is unsustainable, that does not imply that all elements of these theories must be discarded. For instance, the concept of factor proportions contains a rational idea, both logically and empirically. Given endowments and technological knowledge, there is, presumably, some optimal combination of factors of production. Deviations in either direction impair labour productivity. Further, it is an empirical fact that advanced countries displaying high labour productivity are more capital-intensive than poor countries. It must not be deduced, however, that this is due to a mere quantity of capital (although quantity plays a role, too) – to the mechanical addition of identical units of capital. It is primarily due to superior technological knowledge embodied in the stock of capital per worker. Then again, the value of capital, expressed in current labour productivity (measured, say, in wage rates) may be the same in a poor and in an advanced country, and yet it is clear that in an advanced country workers produce greater quantities of commodities. Similarly, a comparable stock of labour is not simply an aggregation of individual workers. Rigorously defining such distinctions is vital for clear thinking. The first precondition for that is an adequate theory of value. Since in the six (out of seven) fundamental relations the dependent variables may move in the opposite direction to that predicted, the theory that arbitrarily assumes just one type of relationships is itself arbitrary. It will generate ‘paradoxes’ and cannot be empirically corroborated. Even less can it be meaningfully mathematized. Mathematical relations require precise definitions and do not allow ambiguities for an uniquely determined model. Finally, one might ask why was it necessary to demonstrate that HO theory is no theory at all in the usual sense but an arbitrary construct when this has already been accomplished. For instance, Ian Steedman demolished HO theorizing effectively in his article in the New Palgrave (1987). The answer is that such critique has simply been ignored. Perhaps the best illustration of this fact is provided by the articles by R.W. Jones on HO theory and J.S. Chipman on international trade theory. Although both articles were published in the same volume of the New Palgrave, both authors

Critique

31

managed to write their learned treatises without even mentioning Steedman’s critique. Nor was any other serious critique included in the list of more than 200 references. The ignored critique must be repeated. The second reason is that my approach is somewhat different and, I believe, simpler and more straightforward. Also, I had to justify my not using the mainstream constructs in my own work.

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The Theory of International Trade

Appendices to Part I 1

EMPIRICAL EVIDENCE

Bhagwati (1964, pp. 4–17) surveys various empirical tests of the Ricardian theory, whereby export–import prices are related to different labour productivity. He finds no clear refutation. Except for simple linear regressions, he finds corroboration of the hypothesis to be from mild to substantial. He concludes that ‘all we could say is that, if the pattern of exports and imports changes in any way, the new pattern will also be characterized by the postulated Ricardian ranking in terms of comparative labour productivities and/or unit wage ratios’ (p. 17). A rough empirical test of Ricardo’s criteria was conducted by Robert Stern in 1950. Wages in the USA were 3.4 times higher than in Great Britain. Therefore the per worker output in individual industries was increased 3.4 times. If the value obtained was lower than the actual empirical value, the industry was considered to have export advantage. British and American exports to France were considered and it was found that out of 26 industries enjoying calculated comparative advantage in Britain, 22 exported to France more than the same American industries (Stern, 1962). Chacholiades (1978, pp. 298–306) surveys various empirical studies of export–import intensities crucial for the HO theory. He reports refutation of the theory in Japan (Tatemoto and Ichimura, 1959), confirmation in East Germany (Stolper and Roskamp, 1961), refutation in Canada (Wahl, 1961), confirmation and refutation in India. Leontief tried to save the theory by arguing that American workers were three times more effective than those abroad, which was just an arbitrary exaggeration. Others involved human capital and natural resources (De Marchi, 1976, and others). Still others engaged in conceptual hair-splitting, although to no avail (Bowen et al., 1987). A number of economists attributed the Leontief paradox to factor intensity reversals. The other explanations offered were: (1) capitalbiased consumption, (2) tariffs and (3) technological differences. Minhas observes that factor intensity reversals are quite likely and so ‘it is not legitimate to deduce a country’s relative factor endowments from the relative factor intensities of export and import substitutes.’ (1962, p. 152). Yeung and Tsang (1972) found strong indications in the studied variable elasticity of substitution (VES) production function for the U.S. manufacturing and found factor-intensity reversals very likely. Jones and Neary observe, concerning the HO model, that ‘in the simplest form – two goods, two factors and identical technologies worldwide – the model’s predictions are overwhelmingly rejected by the data’. As already observed, such empirical refutations would be more than sufficient to discard a theory in natural sciences. Not so in economics, since the authors in the same passage say that this does not diminish the usefulness of the HO model whose ‘rela-

32

33

Critique

tively rich production structure . . . has made it a source of fruitful hypotheses for empirical testing . . . as well a useful vehicle for the study of a wide range of theoretical issues (1984, p. 20). D. Trefler observes that the HO theorem ‘performs terribly. Factor endowments correctly predict the direction of factor service trade about 50 per cent of the time, a success rate that is matched by a coin toss . . . Also, rich countries appear scarce in most factors and poor countries appear abundant in all factors, a fact that squares poorly with the HOV prediction that abundant factors are exported’ (1995, p. 1029). Trefler finds a pattern in the deviations from the HOV theorem and suggests that such data patterns may be used for a new theoretical analysis. James and Elmslie(1996) select only those countries which have similar relative factor endowments, a condition necessary to achieve factor price equalization. Yet the empirical results are poor again (p. 153). Backer concludes that ‘factor endowments may not even be a particularly important influence on trade’ (1995, p. 63). 2 LEAMER’S ATTEMPT AT RECONCILIATION OF THE THEORY WITH FACTS One attempt at reconciliation, that of Leamer (1980, 1987, pp. 166–67), deserves a few more lines because it was included in the prestigious The New Palgrave Economic Dictionary and in some widely used textbooks (Caves et al., 1993, p. 133) and is considered by many economists (Porter, 1990, p. 776) as a definitive solution. Leamer argues that a country is revealed capital abundant if one of three conditions holds A. Ke  Km  0, Le  Lm  0 B. Ke  Km  0,

Le  Lm  0,

(Ke  Km)/(Le  Lm)  Kc/Lc

(A-1)

C. Ke  Km  0, Le  Lm  0, (Ke  Km)/(Le  Lm)  Kc/Lc where Ke, Km, Le, Lm, Kc, Lc are capital and labour embodied in exports, import substitution and consumption (defined as production minus export). Leontief’s Ke /Le  K m/Lm as a condition for capital intensive export is in Leamer’s view a theoretical mistake and therefore no paradox exists. All one has to do is to use differences instead of ratios. A. If embodied K exported is greater than embodied K imported, while L exported is less than embodied labour imported, then export is revealed capital intensive relative to import. Ke  a Km,

L e  b Lm ,

a  1,

b  1

(A-2)

Traditional measure of capital intensity is a Km Ke K a   m,  1 Le b Lm Lm b

(A-3)

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The Theory of International Trade

If net K is exported and net L imported, Leamer agrees with the tradition. B. If both K and L intensities are greater in export than in import, Ke  a K m,

a  1

L e  b Lm ,

b  1

(A-4)

the intensity ratio is no longer uniquely determined. For a/b  1, import is capital intensive. For a/b  1, export is capital intensive as in (A-3). To avoid ambiguity, Leamer imposes additional condition: the ratio of net export of embodied capital and labour, (Ke  Km)/(Le  Lm), must be greater than some standard c  Kc/Lc, where c is capital intensity in consumption which is taken to represent world endowments under somewhat fanciful assumption of identical and homothetic tastes on the world scale. Similar conditions hold for the case C. Without B-condition we have a seeming contradiction since (A-4) implies Ke  Km,

Le  Lm

(A-5)

that both embodied capital and labour are exported. That may be interpreted as if export is revealed both capital and labour intensive. All we need to avoid such a contradictory interpretation is to postulate a  1 b

(A-6)

which means that for capital intensity of exports, exports must embody relatively more capital than imports. Leamer chooses a different route. Instead of using ratios, he uses differences K (a  1) Ke  Km K  m  c Le  Lm Lm(b  1) Lc

(A-7)

The ratio (A-6) is replaced by the ratio (A-7) with respect to the same standard. The relation (A-7) may be satisfied regardless of whether a  b or a  b. The use of ratios of differences instead of prime ratios expressing factor proportions – the basis of the HO theory – is likely to lead to a new paradox. One is obvious. The ratio of differences in (A-7) requires additional that trade be balanced. If it is not, anything may happen. The second paradox was discovered by Brecher and Choudhri (1982). Net export of labour embodied – shown in the denominator of (A-7) – is equal to the differences between home supply of and home demand for labour: T L  L e  L m  SL  D L  0

(A-8)

Critique

35

If this difference is positive, the country is revealed as labour-abundant. Domestic labour demand (consumption), given homothetic tastes, is proportional to the world consumption ( world output): DL  sW L

(A-9)

where s is the share of domestic in world consumption. Assuming identical and homothetic tastes, we may write: s 

GNP S  L WL GNPW

(A-9)

since net labour supply is positive: SL  DL  SL  sW L  0 Rearranging (A-9): GNP/SL  GNPW /WL,

(A-10)

we find that domestic per capita product is smaller than the world one. If a country is capital-abundant and both net factor exports and imports are positive, then consistency requires that it must have smaller than world average per capita output. We may now apply the findings. The United States is well endowed with capital; K/L ratio is higher than in the world on the average. Contrary to HO theoretical prediction, US exports are found to be labourintensive and not capital-intensive: Ke K  m Le Lm

(A-11)

As the United States exports both capital and labour embodied, Ke  Km, L e  L m its exports are revealed as both capital- and labour-intensive. To solve the problem, Leamer constructs the measure B: Ke  Km K  c Le  Lm Lc

(A-12)

which indicates that US exports are capital-intensive although in (A-11) they were not. Using (A-12), capital intensity of exports is shown to be the same as that of US home production. However, the argument implies that the US must have per capita GNP smaller than the world average. Since this is not the case, one paradox is substituted by another. How is it possible to have capital-intensive total output and labour-

36

The Theory of International Trade

intensive export (which is a fraction of the total)? It is possible because the industrial compositions of GNP and exports differ and individual industries vary greatly in K-intensity. A composition of highly K-intensive total output and the predominance of labour-intensive commodities in exports will indicate ‘Leontief’s paradox’. Since capital intensity is not uniform across industries, the composition effect is always present. Industries produce export and import goods and not net export. That is similar to the rather late realization in the capital theory that when using more than one capital good, various composition effects become apparent (Horvat, 1995, pp. 133–35). The merit of Leamer’s article is that it pointed out the possible ambiguity in the definition of capital abundance/intensity. But it did not resolve the ‘Leontief paradox’.

Part II The Systemic Theory of Value

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5 Diachronic vs Synchronic Labour Input: The Two-Century Old Misunderstanding A certain amount of human labour must be invested in order that any object of nature can acquire use value and be appropriated by someone. Even picking readily available fruits requires labour. If two man-made objects are exchanged, their owners will determine the common value by estimating the labour expended. The value of reproducible objects depends exclusively on labour expended; that of nonreproducible ones on scarcity relative to demand. The former value can be measured by the labour time necessary for production; the latter is purely subjective and therefore nonmeasurable. Since most of commodities are reproducible, the objective measure of exchange value is labour-time expended. This is the common sense basis of the labour theory of value. It has been assumed that the labour embodied in a commodity represents the simple addition of the labour time expended in the production process. That is fairly correct for the stationary economy with its unchanged structure and repetitive processes when variously dated labour inputs are economically identical. It is also approximately correct for the production processes of short duration. Both conditions prevailed in early times when labour theory was invented. But in a changing economy with substantial amount of fixed capital, the underlying assumptions are patently wrong and so are labour–time calculations of exchange value based on such assumptions. The basic insight of classical economists such as Smith, Ricardo, Mill and Marx was correct. The mistake committed lies in the fact that they added diachronic labour, which is necessarily heterogeneous because it pertains to different points in time. What should have been done is to sum up synchronic labour, i.e. labour at the same point in time. Since economic changes can be twofold (labour 39

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The Theory of International Trade

productivity can change and the quantity of labour can change), synchronization procedure must also be twofold. I shall call these procedures: time synchronization and systemic synchronization. The former is quite obvious: only labour of the same productivity (which changes in time) can be considered homogeneous and so can be summed up. In this case technological progress is the source of interest. The latter is not so obvious and has far-reaching consequences. We must replace production by individuals by societal production. Not an individual Robinson but the society is the paradigmatic entity for the new theory. In this case the growth (decline) of labour force is the source of positive (negative) interest. Capital inputs as embodied labour costs must also be doubly synchronized.1 Now we need again social economy instead of individual firms. Synchronic labour and capital costs represent the foundation of a new theory of value in which value is a measurable quantity. Also, by reducing diachronic to synchronic labour input, the labour theory achieves an important analytical advantage. As is well known, fixed capital has time dimension which causes innumerable analytical difficulties. Synchronic labour input eliminates time dimension and transforms fixed capital into circulating capital amenable to simple analytical treatment. The celebrated Marxian schemes of reproduction (Marx, 1967; symbols are his): c  v m  w also for the decomposition of prices: c  v m  p i.e. value per unit of a commodity, are theoretically faulty in a fundamental way because the dimensions are not right. Fixed capital (c) is a stock and the surplus value (m  Mehrwert) certainly is not. Variable capital (v) is sometimes treated as a stock (of wage goods available ex ante or ex post) and sometimes as a flow (wages paid between two points of time). Obviously, stocks and flows cannot be summed up. Modern writers use circulating capital as a simplification because they do not know how to deal with fixed capital in a reasonably simple way. But circulating capital is akin to intermediate goods and not to capital with its time dimension. Thus, an important feature of real economic processes is lost. Systemic synchronization reveals that a changing economy displays

Diachronic vs Synchronic Labour Input

41

two important dynamic effects, which I call the employment effect and the replacement effect. The former determines the rate of interest even when output per capita remains constant; the latter determines fixed capital cost. Both of them are of considerable theoretical and practical importance. They are best analysed within the framework of the corrected labour theory of value. The ‘corrected’ means that diachronic labour inputs of classical theory are replaced by synchronic labour inputs. The same applies to capital (embodied labour) inputs. Output per unit of capital input increases due to a mere fact of growth and so produces a rare phenomenon of ‘free lunch.’

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The Theory of International Trade

6 The Employment Effect Even an economy with constant per capita output will produce interest if quantity of labour changes. The source of interest is neither productivity of capital nor the roundaboutness of the production process (Böhm-Bawerk) nor the abstinence nor any other fancy explanation, but the growth of employment. Additional workers must be employed if we are to have full employment, which is a necessary condition for rational (optimal) social production. In this sense, the theory of profit is a normative theory. Pareto optimality and unemployment are, clearly, contradictions. And resources necessary for the establishment of additional working places are obtained from the reduction of consumption (given production), i.e., from the generation of surplus which corresponds to profit. Even with constant labour productivity (no technological progress), mere changes in employment create positive or negative surplus. If technological progress occurs, the surplus will be correspondingly greater. Labour growth increases, while technological progress decreases the amount of labour necessary for the production of the same final output and that must be born in mind. The problem will be reduced to bare essentials.2 Let us consider the Austrian world of roundabout processes in which labour is the only input. Production is of distributed-inputspoint-output type. Suppose all processes last two years and use identical technology with one unit of labour input each year per unit of final output called B(asket). In two years one unit of commodity B is produced by total input of labour of two units, one per year. Suppose labour expands by factor G  1  g and economy consists of two processes operating simultaneously. The columns indicate diachronic summation of labour inputs, which is always two labour units per unit of commodity B. The rows indicate synchronic summation of labour inputs, which is G(1  G)  G(2  g) per unit of B. The synchronic input is greater than the diachronic one, G(2  g)  2, because of the growth of labour force. The reverse is true for a declining labour force. If employment expands at the rate g, each dated labour input must be 42

43

The Employment Effect Processes Years

0 1 2 3

1 1 B

G G GB

Employment

G2 G2

G3

1 1  G G(1  G) G 2(1  G)

expanded at the same rate in order to evaluate all inputs in ‘present’, synchronic labour values. In year zero labour input is one. By the time output is delivered in year two, it will expand to G2. In year one labour input in the same process is also 1, and since it is frozen in the production only one year, by the time B is delivered it will have expanded to G. For this reason, while diachronic labour costs are two labour units, the synchronic costs amount to G  G 2  G(1  G) labour units. The rate g plays the role of interest rate. No fixed assets are around and so this time interest is generated by the growth of labour. Thus the appelation ‘employment effect’. The synchronic summation of labour inputs represents systemic costs of producing net output in any given year. We still have to show why this is relevant for price formation. The Ricardo–Marx labour price for commodity B is p  2. That is not a correct price because, by violating the principle of synchrony, it leads to misallocation of resources. The allocational efficient price is p  G(2  g). For example, for g  10 per cent the correct labour price is p  2.31. Ricardo uses a similar example to derive a different conclusion: Suppose I employ twenty men at an expense of £1000 for a year in the production of a commodity, and at the end of the year I employ twenty men again for another year, at a further expense of £1000 in finishing or perfecting the same commodity, and that I bring it to market at the end of two years, if profits be 10 per cent, my commodity must sell for £2310; for I have employed £1000 capital for one year, and £2100 capital for one year more. Another man employs precisely the same quantity of labour, but he employs it all in the first year; he employs forty men at an expense of £2000, and at the end of the first year he sells it with 10 per cent profit, or for £2200. Here then are two commodities having precisely the same quantity of labour bestowed on them, one which sells for £2310 – the other for £2200 (1821, p. 37).

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The Theory of International Trade

The reasoning is quite illustrative for the mistake usually committed by the labour theorists and their critics. First of all, the summation of labour inputs must not be diachronic (as visualized by a single firm) but synchronic (pertaining to the system as a whole). As demonstrated above, the systemically necessary labour is not 2 (i.e. 2  20 workers) but 2.31, which is exactly the figure reported by Ricardo for the value of output. Next, the alternative (one-year) technique sells output at £2200 because the labour input is lower (2  20 workers plus 10 per cent for the increase of the labour force). Under competition, both techniques cannot coexist and the systematically less productive twoyear technique will be abandoned. Finally, Ricardo does not ask himself why the rate of profit should be ten per cent. Evidently, he takes it as exogenously determined quantity simply given at the market. However, if (1) technology applied does not change, (2) all profits are invested in the creation of new jobs and (3) all workers are employed, the equilibrium rate of profit is equal to the rate of increase of active population. Consequently, labour theory is a general equilibrium normative theory. Obviously, if there is unemployment and there exists a class of capitalists who consume part of profits, prices will be different. But such a price structure makes optimal allocation of resources impossible.

7 The Replacement Effect Labour input is measured by labour time. If economic systems – similarly to physical systems – move (change) in time, the measuring rod of time itself will change. Dynamic systems involve time in an essential way and so there is no absolute time independent from the rate of change (speed of movement). Let the unit investment expand at the rate g per year. If machines have the rectangular life-time profile – the productive capacity is fully used and remains unimpaired over n years at the end of which machines are scrapped without cost or benefit – then at time t  n replacement amounts to3 R n  Il  1

(7.1)

The number of machines in operation is equal to the number of all machines installed in the last n years: n

Kn 

ΣI 1

t



Gn  1 g

(7.2)

For t  n, the system achieves balanced steady growth and its structure does not change any more. From (7.1) and (7.2) we derive the relation between current replacement and the stock of machines: 1 R g   n ν K G  1

(7.3)

where 1/ν represents a diminishing function of the rate of growth, which follows from the properties of the geometric series: ν  1  G  G2  . . . G n1 n1 1 δ 1 δ  (1  G  . . . G )  0, δg ν δg

()

g  1

(7.4)

1/ν represents dynamic replacement cost, which corresponds to replacement cost in the stationary economy: 45

46

The Theory of International Trade lim g→0

1 1 R0   0 ν n K

(7.5)

For positive rates of growth, 1/ν  1/n and the difference is the greater the higher the rate of growth. Both ν and n have the dimension of time. We thus encounter an economic relativity effect whereby n static years are lengthened into ν dynamic years. To contraction of capital cost corresponds the dilatation of economic time. The effect varies quantitatively very little if time profiles of output are different. The rectangular time profile has been chosen because of mathematical convenience and also because there is some evidence that it approximates the average case better than the other pure profiles. If it is compared with linear and proportional decay profiles (for g  5% and n  30), dynamic replacement as a fraction of static replacement for the three profiles appears to be 0.43 as against 0.35 and 0.38 (Horvat, 1973, p. 102). These figures also indicate that the effect is rather strong. For high rates of growth, replacement costs practically disappear (n/ν is between 0.03 and 0.05 for g  15%, i.e. 30 static years are lengthened into more than 600 dynamic years, which means that for all practical purposes fixed assets last forever). Now, the gross rate of profit consists of the rate of growth and the dynamic rate of replacement: π  g 

1 ν

(7.6)

For high rates of growth, 1/ν tends to disappear, and the gross rate of profit is approximately equal to the rate of growth. This is of considerable practical importance for economies expanding at rates higher than, say, five per cent (such as the ‘Asian Tigers’ and the former Yugoslavia). The faster they expand, the less costly it is, even regardless of technological progress This is also theoretically quite important. Capital cost is not only technologically determined but also determined by the mere rate of change of capital. Technological (static) replacement cost for unit of fixed assets is 1/n. Economic (dynamic) replacement cost is 1/ν and it decreases as the rate of growth increases. Since technology does not change, capital cost per unit of output decreases in the same proportion as per unit of fixed capital. In other words, it

47

The Replacement Effect

is possible to obtain larger for the same cost of smaller output, i.e. at no additional cost. This is a clear case of a ‘free lunch’ in economics. Two other cases merit attention. If an asset is fully expended in one production cycle, which means that service life is reduced to n  1, then ν  1 whatever g, and the asset is really an intermediate good, i.e. raw material or semi-finished product. An intermediate goods is an asset whose service life is one production period. If the service life is extended into infinity, n  ν  ∞ , replacement disappears. In both cases there is no replacement effect. Thus, the frequent assumption in economic models that capital is circulating or that its duration is infinite implies neglecting an essential dynamic effect. We may now systematize our findings. If the rate of growth is different from zero, dynamic capital cost (R) will diverge from the static capital cost (R0). The transformation factor β: β 

Rt 1/ν n ng    n 1/n ν G  1 R0t

(7.7)

transforms greater static cost into smaller dynamic cost or, what is the same, longer dynamic time into shorter static time (assuming g  0). The characteristics of β are: lim  β  1

δβ  0 δg

limβ  0

limβ  1

δβ 0 δn

limβ  0

g→0

n1

g→∞

limβ  n g  1

(7.8) n→∞

There is no transformation and, consequently, no replacement effect in stationary economy (g  0) and for intermediate goods (n  1), which do not last in time. Faster growth and longer durability reduce capital cost below its stationary value of the base period. Very high rates of growth and very long service life of fixed assets eliminate capital cost. Finally, for negative rates of growth (g  0), capital cost increases above the stationary level (β  1) up to the limit of full amount of the existing capital (nR0 for g  1). The replacement effect is portrayed in Fig. 7.1 in which discrete analysis, used so far, is replaced by continuous analysis to make the explanation simpler.

48

The Theory of International Trade I

It(g > g)

It(g = 0)

It(g = 0) It(g < 0) t

Kt = ∫ I(t)dt

Rt

t–n

t–n

Figure 7.1

t

Replacement effect (rectangular time profile of assets)

1 r= υ +g g

1 v

1 n

g

0

Figure 7.2

Replacement and rental curves

The Replacement Effect

49

Fixed capital consists of n yearly gross investments and is represented by the area under the investment curves. In a stationary economy It  Rt  constant. The higher g, the larger will be Kt. But Rt  Itn does not change. Therefore 1/ν  Rt/Kt will diminish as the rate of growth increases. Alternatively, for Rt  It-1  1, it is simply the case ν  Kt and ν will increase the faster the rate of economic growth of K. For g→∞ , the ‘mass’ of capital tends to infinity and economic time becomes infinitely long, K→∞ , ν→∞ . Rt and Kt are compared at the same point of time, which is an application of the synchrony principle. The resulting replacement curve is shown in Fig. 7.2.

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The Theory of International Trade

8 The Interplay of Employment and Replacement Effects If only welfare generating part of final output (i.e. consumer goods) is considered, two dynamic effects represent two opposing forces. The production of a given basket of consumer goods B requires more social labour time (increased demographic investment) when labour force is increasing under full employment. It also requires les social labour time when the rate of growth is higher because replacement per unit of capital decreases with the rate of growth (1/n for stationary economy, 1/v for the growing one). To disentangle these effects, consider two simple models, one for a stationary and one for a growing economy. Let gestation period of investment be ng  1 year and the life span of fixed assets (of constant productivity and scrapped without cost or benefit) n  3 years. After first replacement at t  3, the balanced composition of capital is achieved and the system settles at a steady growth path. The productivity of installed capital – the output–capital ratio – is equal in both economies: one unit of capital produces one B(asket). Since we are interested in synchronic effects, we must consider investment–output ratios, and now the picture is very different. The balanced composition of capital of a stationary economy means that only 1/n K annual investment outlays are necessary for production of the same output as that by installed capital K and that lasts forever. In a growing economy additional complications occur. g  0

p0 

output  3B  nB investment

(8.1)

g  0

pg 

1  G  G2 Gn  1 v B  B  nB 3 gGn G G

(8.2)

In a growing economy, n static years are lengthened into v dynamic years and in the same proportion output is increased. At 50

51

The Interplay of Employment and Replacement Effects

Year

Processes

0 1 2 3 4

1 B B B

0 1 2 3 4

1 B B B GB

1 B B B

Stationary economy Investment

1 B B

1 B

1

Output

1 1 1 1 1

Productive Capital

0 B 2B 3B 3B

0 1 2 3 3

Growing economy G GB G 2 GB G 2B G2B G3B

G3 G4

1 G G2 G3 G4

0 B B(1  G) B(1  G  G 2) GB(1  G  G 2)

0 1 1G 1  G  G2 G(1  G  G 2 )

the same time the unit investment is increased to (1  g)n because of g  0 which reflects the growth of labour force. The net effect is given by (8.3): 1 v 1 Gn  1 pg 1  G n    1, g  0  po Gn n Gn gn gn

(8.3)

When g  0, the production coefficient (output-investment ratio) declines, p g  p0. Demographic investment grows slightly faster than v output, G n  , 1  G  G2  (G n  1)/g  v, or faster than the n time lengthens. The mechanics of growth will be clearer if we reproduce the year 3 from the preceding table for both stationary and growing economy, remembering that n  3.

Stationary economy Growing economy

R3 1 1

I3 1 Gn

K3 n v

Y3 nB vB

The structure remains the same in the later years of the steady state growth. Since the first batch of investment is the same, I0  1, the first replacement at t  3 will be the same in both economies, Rn  1. In the stationary economy all investment is used to replace the scrapped capacity, while in the growing economy (G n  1) is used for the

52

The Theory of International Trade

enlargement of capacity. Capital expands as inverse values of capital costs, v : n, and that is also the expansion of the notional economic time. The same is the expansion of output, since technology remains unchanged. Capital cost per unit of output is reduced from 1/(nB) to 1/(vB). This means that in a growing economy, capital cost is smaller v/n times. This is slightly overcompensated by the increases of demographic investment Gn times. In the nth year the share of investment goods in output in the stationary economy is 1/(nB), in the growing economy is Gn/(vB), and the two shares relate as 1/(nB) v   1 G n/(vB) nGn and by (8.3) the ratio is smaller than one. Consequently, the ratio of the shares of consumer goods is greater than one in favour of the stationary economy. The same applies to per capita output since total output is growing at the same rate as labour force. Thus, in order to achieve full employment investment has to grow and total consumption will grow while per capita consumption will be slightly less than in a stationary economy. However, it will be much lower if labour force continues to grow while economy remains stationary. Thus, the relevant choice is between slightly smaller and much smaller consumption per capita. All this only in the case if per capital output remains constant. In the real world it grows, because investment induces technological progress and, therefore, growth. A possible alternative approach is as follows. If there are two equal productive capitals K 0  K g but with different balanced compositions corresponding to g  0 and g  0, then for equal addition to productive capacity gK, replacement costs are 1/n K resp. 1/v K. With constant technology, output is proportional to capital and so 1/n and 1/v are also comparable replacement costs (i.e. synchronic capital costs per unit of production). The faster growth of the system, the greater the difference (1/n  1/v) in Fig. 8.1. This difference represents the saving of capital cost due to a mere speed of change and is unrelated to any material input. In other words, it is a ‘free gift of nature’ or already noted ‘free lunch’. For small g, the ratio of investment cost to capital cost saved is 1 1 close to two, lim g/  苲 2. g→0 n v

(

)

The Interplay of Employment and Replacement Effects

53

g

1 n 1 1 – n v

0

Figure 8.1

g

The growth rates of labour and capital and capital cost (per unit of capital) saved

If g is interpreted as interest rate, it becomes evident that it is always greater than capital cost saved. Capital (embodied labour) cost is likely to be saved not only because of growth as such but also because growth is likely to propel technological progress (Verdoorn effect). If technological progress is of a such magnitude as to expand output of K to that of K(1  1/v), then capital cost disappears and all investment is new investment enlarging output capacity.4 ‘Free lunch’ has various theoretical consequences, among them the following one. Suppose two economies have equal factor endowments and are equipped with exactly the same technology. Thus, production functions are the same. The economy expanding faster will enjoy absolute advantage by producing everything at lower capital cost. Or, in terms of the labour theory, the total expenditure of labour per unit of output will be reduced in the economy expanding faster. Since capital participates in the production of various commodities in different proportions, the uniform absolute advantage will also imply different comparative costs in different industries. These differences will be caused by comparatively higher gross profit rates (replacement plus new investment relative to installed capital). That indicates comparative advantage of labour intensive industries. The conclusion is somewhat unexpected: the faster an economy grows, the more its export will be labour intensive. This, of course, is another logical refutation of the HO hypothesis.

54

The Theory of International Trade

9 The Traverse It might be thought that the ‘free gift of growth’ is really not free because there must be some initial investment somewhere. To find out the traverse from a stationary to a growing economy, consider the following schematic example. Let replacement be rectangular and the life span of fixed assets be n years. Let gestation period of investment be ng  1 year. The annual factor of growth is G  1  g. Starting from a stationary situation, the labour force begins to grow and so will investment at the same rate in order to preserve full employment: Year Investment, I Replacement, R

0 1 2 1 G G2 1 K 0 v

0

0

...

n Gn

n1 Gn1

n2 Gn2

...

0

1

G

n

Productive capital, K

0

11G...

Σ 1

n1

Gt1

Σ 2

n2

G t1

ΣG

t1

3

Because of the gestation period of one year, investment in t  0 becomes productive only in t  1 and remains so throughout the life span of n years. At t  n  1, the first batch of capital must be replaced. Investment grows at the rate g, but productive capital grows at a higher rate which in t  2 amounts to (1  G)  1  g  1, in t  3 the rate of growth is (1  G  G 2 )/(1  G)  1  g  1/ (2  g). Since productive capital – the number of working places – for some time grows at a higher rate than the work force, a possible unemployment will be gradually eliminated. The rate of growth of productive capital gradually decreases and, after the end of service n1

life, becomes constant at (

Σ

n

G t1 /

2

Σ

G t1)  1  g. The system

1

settles at steady growth path. Output in t is proportional to productive capital K t. During the first n years, productive capital grows at a decreasing rate higher than g, because there is no replacement and therefore no synchronic capital costs. 54

The Traverse

55

Individual investment projects are worthwhile if the discounted stream of quasi-rents is greater than the discounted stream of investments. This procedure is not applicable, and for two reasons. First, quasi-rents are accounting quantities, while we deal with real investment and consumer goods. This is the essence of synchronic calculation. Quasi-rents are replaced by consumer goods assuming that they determine economic welfare. Secondly, we deal with the national economy and not with individual investment projects. Therefore the discounted streams of consumption and investment are infinite and so the difference between two is not defined. There is a simple alternative approach. Output Y is proportional to produc1 tive capital K, Yt  K , where κ  1 is capital–output ratio. κ t Output of consumer goods is given by Ct  Yt  I t. From the table describing traverse, we realize that around t  2 output becomes positive: 1/κ K t  I t  0 From that date consumer goods output expands at a rate higher that g until t  n, and at exactly g afterwards. It follows that in the first 2–3 years, the consumption must be unambiguously reduced. The ‘saving sacrifices’ are equal to accumulated investments in the initial period. Afterwards, the situation is reversed forever. Thus, we have constant saving S to be compared with permanently increasing consumption, all values being discounted to t  τ when consumer goods output becomes positive: S

lim

t

Σ

t→

τ

 0 Ct

Initial ‘saving sacrifices’ may be safely neglected. It may be objected that the appropriate welfare measure is not consumption as such but consumption of people living at the time investments are made. In this case we must take into account the average expectation of life of all people living at a certain point in time which is about t  40 years (cf. Horvat, 1965). Therefore, S

苲 0

40

ΣC τ

t

The result is essentially the same. It pays to grow.

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Part III The Basic Three-Industry Model

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10 Steady State 10.1

INTEGRATED WORLD ECONOMY

Consider an integrated – and therefore closed – world economy consisting of three industries producing consumption goods X1, capital goods X2 and intermediate goods or materials X3. (Xi denotes the type of the good and its quantity). Table 10.1

Commodity flows in an integrated world

Intermediate goods From Baskets Machines Material Labour

Final output

Total output

To

X1

X2

X3

x

X

X1 X2 X3

x 11 x 21 x 31 L1

– x 22 x 32` L2

– x 23 x 33 L3

x1 – –

X1 X2 X3 L

Consumption goods X1 may be conceived as the number of baskets of consumer goods in standard proportions, capital goods X2 as the number of standard machines (or plants) and intermediate goods X3 as the tons of reproduction materials in standard proportions. Standard proportions make possible the aggregation of goods in industries. More generally, goods incorporate the labour time of standard productivity. Since the labour time is homogeneous, it may be aggregated. Note that X 1 is not used as input in any of other industries, and X3 industry does not produce any commodity for final use (consumption or investment). In a stationary economy even X 2 industry does not produce final output since entire output is used to replace the scrapped machines. Stationary economy implies that labour L, capital K, output Xi and technology remain constant through time. Technology is defined by technical coefficients aij 

xij Lj Kj , λj  , κj  Xj Xj Xj 59

60

The Theory of International Trade

Commodity flows may now be transformed into material balances of labour, fixed and circulating capital. Total labour force and capital stock are equal to the sum of labour and capital allocated to the three industries. λ 1 X1  λ 2 X2  λ 3 X 3  L κ 1X1  κ 2 X2  κ 3X 3  K  nX 2

(10.1)

a31 X1  a32 X 2  a33X3  X 3 Xi are production flows, K and L are stocks. It is assumed that capital goods last n years with full capacity and then they are scrapped without cost or benefit. Therefore K  nX2 and κ j /n  a2 j. It is also assumed that the production cycle lasts one time unit and that all labour and capital are available at the beginning of the production cycle. Final output of consumer goods is fully used for real wages w  x1 / L. The equations (10.1) will be slightly rearranged: λ 1X1  λ2X2

 λ3X3

L

κ1X 1  (κ2n)X2  κ 3 X3

 0

a31X 1  a32 X2

(10.2)

 (a331)X 3  0

There are three equations and three variables X1, X2 and X3. Labour force is given. The determinant of the system is D 

兩

λ1 λ2 λ3 κ1 (κ2n) κ3 a31 a32 (a331)

兩

D is determined by the technology of the system. The solution is now straightforward:

兩 兩

兩 兩

X1 

λ3 L λ2 1 1 0 κ2n κ3  [(κ2  n)(a33  1)a32κ3]L D D 0 a32 a331 (10.3)

X2 

λ 1 1 κ D 1 a31

L λ3 1 0 λ3  [(1  a 33)κ1  a31κ3]L D 0 a331

(10.4)

61

Steady State X3 

兩

λ1 λ2 L 1 κ1 κ2n 0 D a31 a32 0

兩



1 [κ a  a31(κ2  n)]L D 1 32

(10.5)

Production of any of the commodities is proportional to the number of workers employed. Assume that final output of consumer goods represents a constant proportion of total output x1  b X1,

b  1

then real wage is given by w*  b X1/L or from (10.3) w* 

b [(κ2  n)(a33  1)  a32κ3], D

b  1

(10.6)

and is, like all outputs, inversely proportional to D. Input-output Table 10.1 may be represented as a system of equations  x1  X 1

a11 X 1

1/nκ1 X 1  1/nκ 2 X2  1/nκ 3 X3

 1/nK  X2

a31 X1  a32 X2  a33 X 3

 X3

(10.7)

In more compact notation a11 0 0 AX  x  X, A  1/nκ1 1/nκ2 1/nκ3 , X  a31 a32 a 33

[

X  (1  A)1 x

] [ ] [] X1 X2 , x  X3

x1 0 0

(10.8)

Denote the elements of the Leontief Inverse (1  A)1 as Aij and let x1  1. Then from (10.8) X1  A 11 X2  A 21 X3  A 31

(10.9)

62

The Theory of International Trade

For the production of one basket of consumption goods, the necessary output of commodities is equal to full coefficients given by the Leontief Inverse. Adding up the rows of the input–output Table 10.1 gives material balances. Adding up the columns evaluated at appropriate prices [ p1, p2, p3, w] produces value balances which is the dual of the first procedure. Prices’ solution is the dual of quantities’ solution: p A  w λ  p, p  w λ (I  A)

λ  [λ 1 λ 2 λ 3] 1

(10.10)

p  [ p1 p2 p3]

Any price pj is given by pj  w Σ i λi A ij

(10.11)

Prices are directly proportional to wages. The factor of proportionality is the sum of products of labour coefficients and full coefficients. Putting w  1, we obtain labour prices which appear to be functions of technology exclusively. These prices may be called gravitational prices since it is assumed that all price and quantity adaptations have been carried out. Thus, quantities were found to be proportional to labour, while prices are proportional to the wage rate.

10.2

OPEN ECONOMY

We shall now disaggregate the world economy into small open economy A and the rest of the world W (also an open economy). In this context ‘small’ means that the home country cannot change international prices Pi, which are considered to be given. We now have two countries and three commodities and commodity flows are represented in Table 10.2. In an integrated world the only final (net) output consisted of baskets of consumer goods while machines or plants (as replacements of worn-out plants) and materials were fully used in the reproduction process in a stationary economy. Now the other two industries also have final outputs which may be positive (surplus) or negative (deficit). In the first case we have exports, in the second imports. The world production of X 1, X2 and X3 is distributed

63

Steady State Table 10.2

Commodity flows in an open world economy

Intermediate goods

From Baskets Machines Material

Final good

Intermediate goods

Final good

To

X A1

X A2

XA3

xA

X W1

X W2

X W3

xW

X1 X2 X3

x A11 x A21 x A31

– x A22 A x32

– x A23 A x33

x A1 x A2 xA3

x W11 x W21 xW 31

– xW 22 xW 32

– xW 23 xW 33

xW 1 xW 2 W x3

between country A and the rest of the world W. As trade must be balanced, exports Ei and imports M i  Ei must cancel out E Ai  E iW  0

(10.12)

If the two economies are completely specialized, then the export of Xi from A will be the import of the same commodity into W. If they are incompletely specialized, they will produce and trade (export and import) in the same commodities. Generally, if there is intra-industry trade, any final output represents a balance between final output for home consumption, exports and imports x iA  (x iH  x Ei  x M i )A, i  1, 2, 3 and similarly for W. Now the typical balance equation reads Σ aij X j  x i  X i and it is possible to calculate export and import content of commodities. If the information on capital and labour intensities of various industries are available, we can also calculate factor intensities of export and import. This is how I found that Yugoslav export was less labour-intensive than the import substitution and Leontief found the export–import factor intensities to be the other way round in America.

10.3

GROWING ECONOMY

If the labour force increases, production must increase at the same rate in order to keep the labour force fully employed. Technology

64

The Theory of International Trade

does not change and all production proportions remain unchanged. This is known as the steady state growth. If at the same time technological progress takes place, output growth will be faster than labour growth. Technological progress consists in a continual lowering of technical coefficients. Since coefficients decrease at different rates, individual industries will expand at different rates. The total expansion must be such as to provide employment for the entire labour force of increased productivity. If individual industrial capitals expand at rates gi, the average rate of growth is given by Σ g i Ki  g K

(10.13)

and g is interpreted as profit rate π. This is correct provided that (a) all profits are spent for investments and (b) individual industries use the same rate of profit which is different from the individual growth rates, π  g i (Horvat, 1995, pp. 247– 49). In the literature profit is usually interpreted as a metaphysical entity (lengthening of the production process, preference for immediate gratification, inherent creativity of capital, product of waiting or abstinence). Here profit is uniquely determined as the amount of investment necessary to provide new jobs for the increasing labour force of increasing productivity. Gross investment consists of replacement investment and new investment G  R  I

(10.14)

The higher the rate of growth, the greater is the share of I and the smaller the share of R although technology remains unchanged. I labelled this effect the replacement effect and the emergence of profit from increased employment the employment effect (see Chapters 6 and 7). At the beginning of the production year, the available resources and the corresponding stock technical coefficients are K 1  K 2  K3  K L 1  L2  L3  L κ1, κ2 , κ 3, κj  K j /X j λ 1, λ 2 , λ 3 , λ j  L j / X j

(10.15)

65

Steady State

For simplicity reasons, it is assumed that there are no stocks of material: reproduction material is used as soon as it is produced and the production time is negligible. Since constituent industries grow at different rates, one might expect that the same applies to πK and wL. However, that does not happen in the real world. Statistical evidence indicates that the shares of profits and wages remain approximately constant through time. This is because X 1, X2 and X3 are aggregates of constituent outputs – which may change widely differently – and these aggregates grow at the approximately the same rate. Under these conditions, steady state growth is quite realistic. But it cannot be assumed for individual industries in a disaggregated economy. We are now ready to incorporate the rate of growth into our three-industry model gross output

Xi(t1)  Xi(t) (1g)

final output

x1(t1)  x1(t) (1g) increased consumption x2(t1)  x2(t) (1g) increased new investment

(10.16)

x2 (1g) x2 (t)  π rate of profit (t1)  K (1g) K(t) Final output now contains not only addition to consumption but also addition to capital. From (10.2) it is evident that all outputs Xi and L increase at the rate of growth g which leaves the structure of the system unchanged. It follows the conclusion of (10.3), (10.4) and (10.5) that all outputs X i are proportional to the labour force L. Since replacement and profit rates make rental rate (R  Π)  ρ  π  r K

(10.17)

we may rewrite equations (10.7) so as to replace depreciation rate 1/n by the rental rate r in the price equations. wλ1  p1a11  p2 κ1 r  p3 a31  p1 wλ2 

p2 κ 2 r  p3 a32  p2

wλ3 

p2 κ 3 r  p3 a33  p3

(10.18)

66

The Theory of International Trade

The structure of the system remains the same and, therefore, the same qualitative solutions follow: prices are proportional to the wage rate w and are functions of the same technology. If the technology does not change, prices will nevertheless change due to employment and replacement effects affecting the rental rate r.

11 The Wage–Rental Curve The wage–rental curve (also called wage–profit frontier, wage curve or distribution curve) portrays the relation between real wages and gross profits (cf. Horvat, 1995, pp. 119–26). Since value added consists of wages and gross profits, one would expect that higher profits will cause lower wages and vice versa – given the output possibilities of the economy. The latter are determined by the existing labour force L, installed output capacity represented by fixed capital K and by the known technology (fixed technical coefficients λi, κi and a 3j. Since Sraffian analysis had become known, it has been accepted that wage–rental curves are falling. That is certainly true for oneand two-commodity economies. Given production possibilities, the more production goods are produced the less will be the output of consumer goods. However, in a three or many-commodity world, that is not so obvious. Consider again the system (10.1), but let economy grow at the gross rate π  ρ  r. The second equation in the system will be transformed into rκ 1 X 1  rκ 2 X 2  rκ 3 X 3  X 2

(11.1)

Determinant of (10.2) will now look as follows

兩

λ1 λ2 λ3 D  κ1 (rκ 2  1) κ3 a31 a32 (a33  1)

兩

From (10.6) we have w* 

x1 b  [(rκ2  1)(a33  1)  a32κ3], L D

b  1

(11.2)

The real wage w* in terms of consumer baskets is certainly positive and so D and the numerator must both the positive or negative. 67

68

The Theory of International Trade c, w*

w

α w* 2

w* 1

β r

Figure 11.1

r1

r

Two wage curves α and β

In (10.5), the numerator is clearly positive and so must be D. If D  0, so is the numerator in (11.2). We also know that (rκ2  1)  0, (a33  1)  0 After some tedious algebra we find that real wage rate is a falling function of the rental rate w*  f(r), d w*/dr  0

(11.3)

From (11.2) it is clear that each technology generates a different wage curve. Two of them are shown in Figure 11.1. The full employment growth rate corresponds to full employment rental, r–  g–  ρ–. That rental determines the choice of technology α which generates the maximum possible consumption per –. If technology β were chosen, wage (consumption) capita c  w –. If profits are greater than necessary, would be lower, w*  w –. – r1  r, technology β is preferable and wages are reduced to w*  w Excess profits are spent unproductively (for instance, on luxuries for capitalists). Under full employment (r–), technology β would make – possible wages w *. 2 Due to excess profits (r1  r ), wages are reduced by the amount (w *2  w*) 1 and that represents actual exploi–) tation. Because of wrong technology, potentially possible wages (w are reduced by a greater amount w–  w*1  w *2  w*1 and the

The Wage–Rental Curve

69

difference represents virtual exploitation. If profits are lower than necessary for full employment investment, r  r– (not shown in Figure 11.1), yet another technology might be chosen. Wages of employed workers might (but need not) be increased but unemployment would be created and average per capita consumption would be reduced. Thus, gross profit rate higher or lower than r leads to misallocation of resources and reduced consumption.

70

The Theory of International Trade

Appendix to Part III 1

A NOTE ON PRICE MOVEMENTS

It has been shown (in 10.10) that prices are determined by p  w λ (I  A)1

(A-1)

No monetary flows are involved and yet there may be an inflation if nominal wage rate increases. Even increasing wages may not cause inflation if full labour coefficients λ ((I  A)1 sufficiently decrease. That will happen if either direct labour coefficients λ i decrease, or input coefficients in A decrease or both. Such decreases of technical coefficients represent an overall productivity increase. If (I  A)1 is held constant, prices change in proportion to w and λ. Since λ i  L i / X i is the reciprocal value of labour productivity, an approximate criterion for the stabilization of prices is to allow wages to increase as much as labour productivity. Since w λi is unit wage cost, (I  A)1 indicates mark-up added to wage costs to obtain prices. Kalecki, neo-Keynesians and many other economists argue that this is the way that prices are actually determined by businessmen. The practical value of this formula is whether the mark-up is relatively stable. Let the following empirical hypothesis be explored. According to (10.11), any price pj is given by pj  w Σ i λ i A ij where Σ i λ i A ij represents individual mark-up to wages. Mark-ups for individual prices differ, but on the average for the entire economy they may represent a stable relationship. p–  wλ– Σi Ai, p–  1/nΣ i pi, λ–  1/nΣ i λ i, Σ i A i  1/nΣ j Σ i A ij

(A-2)

n being the number of industries. Starting from the other end, Sidney Weintraub (1959) tried to show exactly that. He begins with the equation p Q  μ w N

(A-3)

where Q is output and N employed workers. It means: business proceeds (p Q) equal wage bill (w N) times the mark-up factor μ. Divide both sides by Q p  μ (w N / Q)  μ R

or in my notation 70

The Wage–Rental Curve p  μ (w λ)

71 (A-4)

which is identical with (A – 2). Weintraub quotes US statistics for the period 1929–1957 where μ (his k) appears to be remarkably stable. Out of 28 years, in 21 years μ does not change annually more than two index points. Computed price level p  μ R is practically equal to the actual price level (p. 27). The empirical value of the average American markup factor is μ 苲 2.

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Part IV An Alternative Theory

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12 Three Models 12.1

THE TWO RECEIVED MODELS

So far only two models of foreign trade have been developed and fully explored. The classical or Ricardian model is the older one. The neoclassical or Heckscher–Ohlin model is the contemporary one. Following the lead provided by J. Bhagwati and T.N. Srinivasan (1983, pp. 9, 50), I shall describe them in the somewhat modified fashion indicating the essential characteristics in Table 12.1. Ricardo finds comparative advantage in greater relative labour productivity. That determines the pattern of trade: a country will export commodities produced by comparatively more productive labour. For Heckscher and Ohlin, abundance of a factor determines comparative advantage. Consequently, a country will export the commodity which uses intensively its abundant factor. The neoclassical model uses much greater number of restrictive assumptions and, as we saw, its predictive value is close to zero. Therefore, it is obviously an inferior model to be discarded. There have been numerous attempts to salvage the neoclassical model. Perhaps the most interesting is the redefinition of abundance. In the neoclassical model the crucial role is played by factor proportions. Therefore, Heckscher and Ohlin defined factor abundance in terms of ratios: greater K/L ratio, called capital intensity in a process, indicates greater capital abundance in a country. The ‘Leontief paradox’ indicated that this could not be squared with facts. Leamer tried to remedy the problem by replacing ratios by absolute differences (see Appendix I-2). If net export (export minus import) of embodied factor is positive, the factor is considered to be abundant. In other words, it is assumed that an economy will export its abundant factors and import its scarce factors. The analysis showed that such a ‘common sense’ definition leads to new paradoxes. In other words, it has been empirically falsified. Besides, as Trefler observes (1995, p. 1029), ‘rich countries appear scarce in most factors and poor countries appear abundant in all factors, a fact that squares poorly with the HOV prediction that abundant factors are exported’. In conclusion, abundance-scarcity characterization 75

76

Table 12.1

Three models of foreign trades Models of Foreign Trade

Consumption: Trade:

Neoclassical (Heckscher–Ohlin)

One primary factor of production (Labour). Constant returns to scale.

Two or three primary factors given (Labour, Capital and Land). Identical production functions. Constant returns to scale. Nonreversibility of factor intensity ranking.

Two or three factors of production: two primary ones (Labour and Land) and one produced one (Capital). Three basic commodities: one consumption and two producer (capital and material) goods. (Non-) constant returns to scale.

–

Identical homothetic utility functions.

–

Systemic (Horvat)

Commodities perfectly mobile; factors mobile domestically, immobile internationally. No transaction and international transportation costs. Two countries, two traded The same. Two countries: The World (which is the goods. price setter) and the Home country. Three traded goods.

Market type:

Pure competition

Comparative advantage: More productive labour.

More abundant factor.

Lower integrated labour costs of production.

Value theory: Diachronic private labour

Utility or scarcity theory of value.

Synchronic social labour theory of value.

The Theory of International Trade

Production:

Classical (Ricardo)

Three Models

77

of economies in either ratio or absolute difference form have no place in economic theory.

12.2 AN ALTERNATIVE MODEL OF INTERNATIONAL TRADE The analysis shows that the improvement of the HO model is pointless. On the other hand, it seems possible that the Ricardian model be improved upon and developed into a relatively satisfactory theory. The basic underlying idea is that comparative advantage consists in relatively lower integrated labour costs. On inspection of Table 12.1, it will be noticed that the differentia specifica of each of the three models of foreign trade is the value theory. This need not be surprising since the theory of value is generally crucial for an economic theory. Classical theory is based on a simple labour theory theory of value: only living labour counts. It is incorrect not because its authors were unaware of its deficiences but because they did not know how to cope with them. Besides, it served as a very rough approximation to long-run equilibrium prices. The utility theory is based on subjective valuations and is therefore entirely subjective. The attempt to make it objective and measurable by linking it with material scarcity failed disastrously. The concept of scarcity is either tautological (scarcer means more valuable), and so has no explanatory value, or cannot be utilized in empirical investigations. In fact, the empirical scarcity theory is much worse than the simple labour theory of value. The concept of opportunity cost is helpful but does not explain the source of value. The systemic labour theory of value contains two main ideas: (1) Only labour inputs at the same point of time can be added up (synchronic labour costs). (2) Apart from live labour, also labour embodied in materials and synchronic capital inputs must be included. The latter are defined as those capital inputs which are necessary to keep all workers fully employed. For both reasons, not only separate activities, but the operation of the economic system as a whole must be taken into account. This consideration introduces a new concept of general equilibrium and makes economics a systemic science. The economy is a system which means that it is a whole of interdependent parts and not merely an aggregate of parts. One consequence of this fact is that all attempts ‘to build macroeconomics on microfundations’ must necessarily fail.

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The labour prices considered are full prices that include value added and material costs. Current labour produces only new value represented by the final output x. Consequently p x  w L  L if w  1

(12.1)

Notice that here w is not real wage but a numéraire. This result is easily derived from the price equations p  w λ (I  A)1 兩· (I  A)X p (I  A)X  w λ X  w(L 1  L 2  L 3)  w L

(12.2)

From the balance equations A X  x  X it follows that x  (I  A) X Using this in (12.2) we get p x  L q. e. d. The labour prices p include all costs  as shown in (10.8)  not only value added. Recall (10.9) pj  w Σ i λ i A ij  w λ*, j j  1, 2, 3 As price ratios and not absolute prices play the role of trade criteria, we may write pj λ*j  , λ*j  Σi λi A ij pi λ*i

(12.3)

Instead of Ricardian direct labour coefficients λi, we must use integrated labour coefficients λ*i which represent full labour cost and are calculated as a weighted sum of all direct labour coefficients weighted by the corresponding inversion coefficients A ij. Prices are clearly greater than direct labour coefficients, pi  λi  L i /X i, and Ricardian ratios of direct coefficients are different from price ratios pj Σi λi Aij λj  λi pi Σj λj Aji

Three Models

79

For ratios to be equal, prices would have to contain equal markups, pi  μ λi. The matrix A A 

[

a11 0 0 r κ1 r κ2 r κ3 a31 a32 a33

]

is the same matrix A from (10.8) except that the elements κ j/n are replaced by r κ j . Our method makes it possible to treat stationary and growing economy formally in the same way. That is because the synchronic calculation of inputs takes care of the time dimension.

12.3

COMPARATIVE ADVANTAGE

It has already been mentioned that by comparative advantage is meant that costs of production – integrated labour costs – are comparatively lower than elsewhere. Costs are based on the gravitational product prices. Elements of costs are not treated as factor rewards but as structural elements of the production / valuation process. Real wages represent institutionally determined remuneration of labour and their sum is equal to available amount of consumer goods. Rental represents capital outlays necessary to replace worn out capital goods plus additional outlays to equip the growing work force. The value of land is treated as capitalized rent at the ruling interest rate so that annual rent represents annual interest charged with respect to land value. Treating land as capital, we may forget it in the first approximation. Material costs represent the part of price earmarked to cover the value of material inputs. At present, comparative advantage is a normative concept in the sense that it gives a criterion for rational action. As such, it is a hypothesis. Once it is found that economic agents actually behave in the expected way, the hypothesis will be transformed into a positive theory. International trade will take place if two countries produce different products demanded in both of them. Or if costs of production differ. In that case cheaper products will be exported and comparatively expensive ones imported. The problem then boils down to ascertain the conditions under which a product will be produced more cheaply. We may enumerate them as follows: 1. Inherited climatic and production conditions that made both wine and cloth cheaper in Portugal than in England while wine was

80

2.

3.

4.

5. 6.

7.

The Theory of International Trade relatively cheaper of the two as in Ricardo’s example. Thus, wine will be exported from Portugal in exchange for cloth from England. This is a static case (in the sense that conditions do not change) which leads to interindustry trade. Economies of scale represent a dynamic case which is illustrated by intra-industry trade. Since every country is too small to produce all varieties of a product – say a private car – there will develop an international division of industrial production. One country may produce large cars (say the USA) and exchange some of them for small cars produced elsewhere (say in Korea). Economic development increases accumulated stock of capital per unit of labour employed and so increases GNP per capita. This is not because of changed factor proportions but because advanced technology, made possible by the accumulation of capital, is more efficient (embodied technological progress). That is the source of rising wages. Higher wages render labour-intensive industries unprofitable and they migrate to less developed countries with low wages (for instance, textile industry). The result is increased foreign trade. In general, technological progress represents a classic case for cost changes. It affects individual industries very unequally and so they change their positions of comparative advantage. Growth as such changes capital costs per unit of output due to replacement and employment effects. Cheap natural resources (fertile land, rich oil wells) which are abundant in the sense that the home supply is greater than the home demand, result in export of surpluses. It is the other way round with expensive and scarce resources. This is the only clear case where abundance (scarcity) generates neoclassical results. In order to avoid misleading conclusions, point 6 must be seriously qualified. Switzerland and Japan are two countries with great paucity of natural resources. Yet, Switzerland is the most developed – which means that it enjoys many industrial comparative advantages1 – country in Europe as Japan is in Asia. Due to cheap transport and the globalization of the economy, even poorly endowed countries can easily obtain the necessary resources. Moreover, although abundant resources can enhance trade, so can scarce resources by providing pressure for substitution and innovation. Michael Porter observes that ‘Japan’s natural resource disadvantages have played considerable role in

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81

the process of creating and upgrading competitive advantage’ (1990, p. 395). Apart from natural resources, simple quantities of labour and capital do not determine comparative advantages. Labour can be upgraded by education and training and capital by research creating new technologies and improved industrial organization (embodied and unembodied technological progress). 8. The chance plays also a non-negligible role. A gifted innovator – or simply an excellent businessman – located in a favourable national environment and expanding industry at the appropriate time may generate national industrial advantage. Substantial changes in international production conditions (for instance, oil shock) and demand conditions (for instance, war) will change comparative advantages. Chance events may also be caused by arbitrary (mistaken, wrong, uninformed) decisions. And, as Amendola et al. find, ‘arbitrary patterns of specialization, once established, tend to persist and extend over time’ (1992, p. 182). It may also be said that international trade is caused by the differences (a) in the technology used (different production functions) given factors of production and same preferences (inter-industry trade), (b) in the factors of production when the same technology is used and preferences are the same (inter-industry trade), (c) in the consumer preferences and the size of domestic market when the technology is the same (intra-industry trade). Ricardian theory includes (a) and (b) because factors are different (climate) and so is technology (cloth industry more advanced in Portugal than in England). Heckscher–Ohlin theory is based on (b). The systemic theory expounded in this book includes all three conditions, (a), (b) and (c).

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13 Intra-Industry Trade Intra-industry trade is trade among countries with similar factor endowments and in commodities with similar factor intensities (Davis, 1995, p. 204). According to the HO theory, such trade must be nonexistent. 2 Not so in the real world. Trade among countries in the European Union has been developing fast, and intra-industry trade much faster than the rest of the trade. Thus, countries are not only specializing in products of different industries but also in different varieties of the same commodity from within the same industry. What are the reasons for intra-industry trade? The reasons are many and they have nothing to do with factor proportions. Before answering the question posed, it may be useful to note another failure of the HO theory. The standard model yields two important predictions regarding the relation between factor endowments and the volume of trade. The first is that, ceteris paribus, the greater the difference between the factor endowment ratios, the greater the volume of trade. The second is that ‘relative country size has no effect on the volume of trade’ (Davis, 1995, p. 219). These predictions may or may not hold in the real world. In other words, the HO model proves again not to have predictive value. Economists seem to agree that empirically scale economies, product differentiation and imperfect competition are typically important (Helpman and Krugman, 1989, p. 133; Greenaway, Hine and Milner, 1995). Take again as a representative example the production of automobiles. Apart from expensive custom-made (or produced in small series) luxury cars, the production of standard cars must reach the volume of a few hundred thousand cars per year in order to be profitable. That implies three important consequences: (a) in an average country only a couple of makes can be produced as there is simply no market for more, (b) by efficient competition in the international market, the small domestic market can be enlarged (but that works in the opposite direction also) and (c) customers demand differentiated and not uniform product, and even the largest country in the world would not be able to supply all technical varieties imaginable. For instance, I drive Citroën because of its hydraulics. Yet I live on the slope of a mountain outside a city and 82

Intra-Industry Trade

83

I need four-wheel drive for the winter season. However, the car with the two characteristics mentioned is now not produced in the entire world. The Citroën managers probably guess – rightly or wrongly – that the market is too small in the entire world. In other words, even the world is too small for such a relatively simple technical combination. Where the HO theory fails completely, the theory of Ricardian comparative advantage has no difficulty. The trade criterion for exports from France is Pi /Pj  pi /pj where i is Citroën and j is another commodity. This is the familiar criterion for inter-industry trade. We now consider the trade in cars. A car is a technical package of various characteristics such as speed, acceleration, security, petrol consumption, service consumption, traction, durability, design and some others. The package has its objective costs in terms of resources used in production. But different features will be valued differently by different consumers. Consequently the sellers will confront two decision variables, price and specification, instead of taking into consideration only price. The market structure will be monopolistic competition, either perfect or imperfect (Lancaster, 1980, pp. 156–57). Some Frenchmen will prefer driving Mercedes ( j), even if it is no cheaper than Citroën, Pj Pi. Since Mercedes is not produced in France, its price is mathematically infinite, pj  . The inequality is still valid, indicating that commodity j (Mercedes) will be imported into France. This is now an intra-industry trade. Assuming that the two cars embody an equal amount of resources – whatever that means – international competition will equalize prices, Pi /Pj  1. The ratio of domestic prices, one actual ( pi for Citroën) and the other imputed ( pj for Mercedes) will be less than one, pi / pj  1. The old comparative advantage inequality re-emerges: Pj / Pi  pj / pi and Mercedes will be imported into France. If the trade in cars is not balanced in values, some other commodities will be exported / imported. The import of German Mercedes – and vice versa for Citroëns – will proceed as long as consumer budgets (given preferences) can tolerate it. When the budgets

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earmarked for Mercedeses in France and Citroëns in Germany are exhausted, intra-industry trade stops in a temporary equilibrium. It is possible to think of various complications, but the basic principle is clear. In the final analysis, intra-industry trade boils down to the simple fact that both red and blue pencils are bought because consumers have different preferences for colours. Consequently, technologically same products may be economically different products. However, differently from pencils, not all cars can be produced in one country. There is a world supply of cars, some of which are produced in France and some others in Germany. Some Frenchmen prefer German cars and they will be imported into France, some Germans prefer French cars and they will be imported into Germany. The trade is balanced by imports/exports of other commodities. Such a trade is inter-industry trade. The theory suggested predicts that large countries will engage in intra-industry trade less; so will more distant countries. Also countries with different levels of per capita incomes will participate less because consumers’ demands are different and satisfied by different industries, that is, by inter-industry trade. On the other hand, advanced economies with affluent consumers demanding differentiated and sophisticated products and industries with product differentiation will participate more. These predictions have been confirmed by empirical evidence offered by the World Bank (Kenen, 1989, p. 130). It has also been found that complexity favours intra-industry trade while foreign direct investment tends to reduce it (Caves, 1981, p. 208).

14 Four Hypotheses The mainstream trade theory revolves around the four theorems described earlier: (1) the Heckscher–Ohlin theorem determining the pattern of trade, (2) the factor–price equalization theorem, (3) the Stolper–Samuelson theorem on changes in relative factor prices depending on different factor intensities of countries starting to trade with each other and (4) the Rybczynski theorem determining output changes when the supply of a particular factor increases depending on factor intensity of output. All four theorems are deduced from a single (arbitrary) assumption on price determining factor proportions. It will be convenient to formulate corresponding theorems on the basis of labour theory. Also, it is highly desirable to derive simple explanations. Instead of focusing on factor proportions, our main criterion is labour input, as it is costs of production that determine gravitational prices. There are two primary factors of production, labour and land, while capital is produced. Land is generally not very important in modern economy and so we are concerned with just one nonproduced factor, labour. Also, we want to give the theory empirical content, so it is not purely deductive. For that reason, I prefer not to talk about theorems but to formulate a set of hypotheses.

14.1

COMPARATIVE ADVANTAGE HYPOTHESIS

This is actually the original Ricardian theory based on labour values but now correctly defined as synchronic social (systemic) labour input and not diachronic individual labour input. The criterion is to minimize labour input. That is achieved when the commodity with the lowest relative labour input is selected for export and that with the highest domestic labour input for import. We proceed then down the scale until trade is balanced. 14.1.1

Two Commodities

A closed economy will open itself to trade if it enjoys comparative advantage in the production of certain commodities. In the framework 85

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of the labour theory of value, Ricardo’s principle of comparative advantage (Ricardo, 1821) can be generalized in the following way: A country will export if it can at least recoup the labour time spent in producing the last batch of export commodities by the labour time saved in importing other commodities. In other words, it pays to export if the net saving of domestic labour time is positive. The optimum volume and structure of trade are obtained when the value of output in international prices relative to domestic prices is maximized. If pi are domestic prices and Pi are international prices, it clearly pays to export if pi  Pi and to import if pi  Pi. This is the criterion of absolute advantage. As Ricardo already noticed, such a criterion would not be precise enough and would apply only to countries at similar levels of development (and, therefore, of similar labour efficiency). It will also apply to an economic union of several countries using the same monetary unit (such as the euro in the European Union). In a backward country, most domestic prices will be higher than international prices of the same commodities and this does not mean that everything must be imported. A very developed country will face a reverse situation. Whatever the absolute prices, the general criterion is expressed in relative prices. Commodity i will be exported and j imported if Pi / pi  Pj / pj or pj / pi  Pj / Pi. The first inequality indicates that domestic prices of export commodities are relatively lower and the second that domestic prices of import commodities are relatively higher. By opening up the trade, domestic labour time will be expanded increasing the production possibilities. Balanced trade at international prices means a net import of labour at domestic productivity if Ricardo’s principle of comparative advantage is followed. Net import of labour is a free gift of the exchange. The same applies to both trading partners. This can be seen in the following way. Let e stand for export, m for import and Xe and X m for commodities exchanged and let the trade be balanced in international prices Pe Xe  Pm X m Since domestic prices of import commodities must be relatively higher pm /pe  Pm / Pe

Four Hypotheses

87

labour time that might have been spent on the production of import commodities amounts to more than the labour time actually spent on the production of export commodities pm X m  pe X e

(14.1)

The difference is labour time saved due to exchange. Labour time saved – the net import of labour – can be used to enhance production. Even this is not the end of the story. Assume that countries A and B use exactly the same technology, but that A grows faster – and therefore invests more – than B. More investment requires higher profit to finance it. Higher profit implies lower wages. Since the labour and capital intensities of individual industries are different, even the same technology and the same factor endowments will generate different prices. Different relative prices make trade profitable. Consequently, the mere difference in growth rates leads to trade. We can be even more explicit. From (10.18) we can find the ratio of prices of intermediate and capital goods: p3 r(κ3λ 2  λ 3κ 2 )  λ3  p2 λ2(1  a33)  λ3a32

(14.2)

Since a33  1, the denominator is positive. The numerator is then positive because p3 / p2  0. Let capital intensity of material production be greater then that of capital goods production, κ3 / λ3  κ2 / λ2 . Consequently, (κ3λ 2  λ 3κ 2 )  0. It follows that the ratio of prices is a positive function of r. Suppose that the initial situation is p3 / p2  P3 / P2 Reproduction material will be exported and capital goods imported. If technology remains the same, but accumulation (r) increases, at certain point the ratio of prices will be equalized and the trade will cease to be advantageous. Beyond that point, exports and imports will be reversed. Note that export or imports of capital good X2 does not influence r. The economy must change its growth rate, that is, the growth of labour force plus an increase in the productivity of labour. Differently from Ricardian times, the gold standard no longer

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automatically determines the exchange rate. A country may fully exploit comparative advantages only if foreign trade is properly guided. Individual traders are mainly stimulated to react to absolute prices and not to relative prices. The economic policy authority must design the exchange rate so as to make domestic and foreign prices comparable and that must provide information and incentives for traders so that they are induced to use proper relative prices. 14.1.2

Many commodities

Suppose we observe the following relations referring to prices of commodities X1, X2 and X3 p1/p2  P1/P2 , p2 /p3  P2 /P3 Since domestic price ratios are lower than the international ones, we can conclude that X1 will be exported and X 3 imported. Nothing can be concluded about X2: the first relation says that it is imported and the second that it enjoys comparative advantage and, consequently, will be exported. That is contradictory and our criterion must be reformulated. By simple algebraic operations we obtain p1 /P1  p2 /P2  p3 /P3

(14.3)

All commodity prices can be ordered in that way p4/P4  p5/P5  ...  pn/Pn We know that X1 will be exported and Xn imported. But what about other commodities? To settle the issue, we need additional informations. Price ratios are not sufficient, we need to know demand conditions. Since the price ratios in the sequence are decreasing, so is the relative profitability (with respect to international prices) of respective commodities. We must select more profitable commodities for exports and less profitable for imports. Suppose that demand condition is exports equal imports (balanced trade). Then the sequence has to be cut at the point when this condition is satisfied: first m exports equal last n  m imports.

Four Hypotheses 14.2

89

EQUALIZATION OF FACTOR PRICES HYPOTHESIS

Factor prices are a misnomer. Commodities are bought and sold, not factors. Their use in time is priced. Therefore commodities have prices and factors have rentals. That ought to be born in mind when we loosely speak of ‘factor prices’. Wages of labour will tend to be equalized internationally because they are positive functions of per capita income. Since the national wage bill makes for three fourth or more of national income, wages and per capita income – reflecting the degree of development – are closely correlated. It is not that marginal products determine wages, it is wages (made possible by the national economic development) that determine marginal products in a rationally organized production. A university professor in the United States is paid five to ten times more than one in Croatia, regardless of his/her productivity. That can easily be verified by observing the same (wo)man teaching alternatively in the two countries. Since in modern economies (wo)men produce in order to improve their economic welfare, they will seize every opportunity to increase their wages. And since the wealthiest nations tend to have lower rates of growth than those behind them (Horvat, 1974), there is a clear tendency for equalization of national development levels and so of per capita incomes and wages. Apart from international equalization of average wages, there is also a tendency for national reduction of wage differentials. People want to be paid equally for equal work. We may conclude that wage rates are socially determined in such a way that they converge to absolute international wage standards. Yet this convergence is a very, very long process, due to economic development and not to market competition. Money capital is quite mobile both nationally and internationally. For this reason one may assume competition that equalizes prices of capital services nationally and internationally. The price of a commodity is defined as value per unit of quantity. In this sense interest rate does not have price dimensions (dinars per kilogram of something). Interest rate is a percentage and as such a pure number. Nevertheless, for certain purposes it can be conceived as a quasi-price (the value of money stock is quantity and money interest is price. Under perfect competition, the value of money capital reflects physical capital and interest rate is the price for it use. In general, competition tends to equalize interest rates nationally and internationally.

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Land is notoriously heterogeneous and is not traded internationally. The existence of Ricardian differential rent renders the idea of rent equalization meaningless. It is still possible to argue in the following way. If commodity prices, interest rates and wages are equalized and technology is freely accessible, under competitive conditions rent differentials reflect unit cost differentials which are due to land exclusively. The value of land (V) is capitalized rent (R) and so R V



(1  i)11 (1  i)n1

(14.4)

Since the number of years of capitalization (n) and interest rate (i) are equalized by competition, the ratio of rent and the value of land (R/V) is the same for all lands and countries. If n is sufficiently large i lim R  V 1  i n→∞

(14.5)

rent is equal to the ‘discounted’ interest on capital value of land. Yet that eliminates physical land and replaces it by capital, and rent is replaced by interest. In addition, capital value does not embody labour since land is not produced. How such cases can be handled, see Horvat (1995, pp. 198–9). There is still one problem. If all profit is invested, interest rate and profit are equal, i  π. Interest rate may be equalized by international competition but profit rate is determined by the national rate of growth. If the two rates differ, economic policy measures must make them compatible. In general, for the same reason that wages tend to be equalized in the very long run, the profit rates converge as well. In the process of catching up, less advanced countries achieve higher rates of growth and, therefore, higher rates of profit. As they approach the front line of technological development, the rate of growth gets lowered and, consequently, profit rates converge.

14.3 HYPOTHESIS ABOUT THE CHANGES DUE TO THE OPENING OF TRADE Let two autarkic countries engage in mutual trade. Country U is labour-intensive and underdeveloped (lower per capita output).

Four Hypotheses

91

Country D is capital-intensive and more developed (higher per capita output). Evidence indicates that greater capital intensity is correlated with greater productivity. More formally: (K/L)U  (K/L)D Let capital-output ratios be approximately equal (which is not unlikely in the real world) (K/Y)U ~ (K/L)D Since Y is approximately proportional to K, it follows (Y/L)U  (Y/L)D

(14.6)

Labour productivity is lower in an underdeveloped country as compared with a developed country. And its reciprocal value, labour input per unit of output (L/Y), is higher. The HO theory postulates that country U, being labour-intensive, will export labour-intensive commodities in exchange for the capitalintensive commodities from country D changing, thus, factor endowment proportions (and factor prices). Empirical evidence related to the ‘Leontief paradox’ revealed that this is not so and that the postulate has no predictive value. However, another conclusion may be derived with certainty. If all labour coefficients λi in country U are higher, than from (10.11) and (12.3) pj  i λi Aij,

w  1

(14.7)

labour prices will be higher even if material input matrices A are the same for both countries. Since country U is likely to be less efficient in non-labour inputs (technical coefficients aij higher) and develop at a greater speed (rate of growth r higher), elements of A are likely to be larger and so will elements Aij of (I  A)1. Labour prices measure labour embodied in unit output and so the following theorem ( deductive hypothesis) may be formulated: When the trade opens, the labour-intensive country will export more labour than it will receive in return if trade is balanced at some international prices and labour is embodied in commodities. Since trade is following the principle of comparative advantage,

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this is the least disadvantageous result that the undeveloped country can achieve. As both countries gain from trade, their per capita incomes increase. A net export of capital goods only means that the composition of output has changed, but gives no information on the change of factor intensities. If export becomes more capital-intensive, that only indicates that capital intensity of export has increased. If the rate of growth increases – given the labour force – then the country’s endowments become more capital-intensive. Finally, increased output per capita–given the rate of growth-leads to increased wages.

14.4

INCREASED FACTOR SUPPLY SPECIFIC EFFECT

Since labour is assumed always fully employed, capital supply can increase in only three cases: (a) labour supply increases, (b) labour productivity increases and (c) capital-intensive commodities are exported in exchange for labour-intensive commodities. In the case (c) we have a simple composition effect. Since capital can always be expanded as necessary (investments), nothing important happens except in a very short run when there is a traverse from one state to the other. Much more interesting are the cases (a) and (b). If the rate of growth of effective labour supply increases, either because of physical growth of labour force or due to technological progress, the rate of growth of capital must increase also. Now we encounter effects discussed in Part II. The replacement element (ρ) of price will decrease less than the increase of net profit (π), and the net effect will be the increase of gross profits (r  ρ  π) and so the increase of all prices. Since industries are very unequally capital intensive, this will change relative prices. As a result, comparative advantages will change as well and so the pattern of trade will become different. Clearly, comparative advantage of capital intensive commodities will be reduced and that of labour intensive increased. Unless technical progress is strongly capital augmenting.

Part V The Gains from Trade

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15 The Pattern of Specialization According to (10.18), the price formation in the three industries considered in terms of p1 (divided by p1) is given by (15.1). 1. Baskets: w*λ1  p*a 3 31  p* 2 κ1r  a 11  1  p1 /p 1 2. Machines: w*λ2  p*3 a32  p*2 κ2 r

 p*2  p2 /p1

3. Material: w*λ3  p*3 a33  p*2 κ3r

 p*3  p3 /p1 (15.1)

In the analysis that follows, the reader will notice the similarities with the approach pioneered by Ian Steedman (1979, pp. 35–40). Yet my regionalization is somewhat different. The price equations (15.1) apply to an autarkic economy. Suppose it is opened up. The international exchange will take place if domestic and international prices measured in baskets differ, p*i P*i. Depending on the industry where this difference occurs, producers will be induced to specialize in production. The profit rate is given because it is determined by the requirement to equip additional workers. Consequently all gains (if any) go to the increase of wages. Input coefficients λi, aij and κi are fixed. 15.1

GIVEN AUTARKIC PRICES

For the given technology, autarkic prices are given. As far as the home economy is concerned, international prices vary and may be greater or smaller than the autarkic ones. When the economy opens up, free trade will transform equations (15.1) into inequalities until competition establishes new equilibrium with different prices and higher wages. When autarkic and international prices are equal, p*i  P*i at the point E in Fig. 15.1, everything is produced at home and nothing is either exported or imported (intra-industry trade is neglected). The sides of the box are measured by P*3 and P*2. The fixed autarkic prices p3 and p2 divide the box into four quadrants, two of which will be further subdivided into two regions. It will turn 95

96

The Theory of International Trade (P* – p*)a > (p* – P*)κ r 3 3 31 2 2 1

P*3 I

(b) X3 Produced X1, X2 imported

II X2, X3 produced X1 imported

(a) X1, X3 produced X2 imported p*3 E (b) X2 produced X1, X3 imported

X1 produced X2, X3 imported

IV

(a) X1, X2 produced X3 imported

0

p*2

Figure 15.1

(p* – P*)α > (P* – p*)κ r 3 3 31 2 2 1

III

P* 2

The pattern of specialization for Δw*  0

out that the Ricardian criterion P*i  p*i is insufficient for an unambiguous classification and must be complemented by the profitability criterion on the basis of price equations (15.1). The production and import regions for X2 and X3 are determined directly by comparing home and world prices. The same is not possible for X1 because the prices are equal by definition p*1  P*1  1. Thus, a different procedure must be used. For that purpose original equations (15.1) will be rearranged. w*λ1  (1  a11)  p*3 a31  p* 2 κ1 r w*λ2  p*2

 p*3 a32  p*2 κ2r

w*λ3  p*3

 p*3 a33  p*2 κ3r

(15.2)

If any input is obtained at a lower price, wages in all industries will increase although unequally. Actually, only the first equation

The Pattern of Specialization

97

will be needed. In a comparable equation, replace home prices by world prices: W*λ1  (1  a11)  P* 3 a 31  P* 2 κ 1r

(15.3)

To find out whether this generates an improvement, deduct (15.2) from (15.3) (W*  w*) λ1  ( p*3  P*3) a31  ( p*2  P* 2)κ 1r  0

(15.4)

For an improvement, wages must increase, Δw*  0. A reduction of wages means deterioration, Δw*  0. For Δw*  0, we have a diagonal in Fig. 15.1 Consequently, below the diagonal, the first industry generates a surplus, above it a deficit. In the surplus region baskets are produced, in the deficit region they are imported. The Ricardian criterion suffices when both international price ratios are either higher or lower than autarkic price ratios. This is the case with the second and the fourth quadrants. II Quadrants. If both P*3  p*3 and P*2  p*2 , then it is profitable to export both X3 and X2 and use the proceeds to pay for the import of X1 since the autarkic price of consumer goods is relatively unprofitable. Namely, P3/P1  p3/p1 implies p1/p3  P1/P3 and similarly for P*2  p*2. Inserting higher international prices into prices into price equations (15.2) produces smaller wages and this confirms Ricardian conclusions. IV Quadrant. Both international price ratios are lower than autarkic price ratios, P*3  p*3, P*2  p*2, and therefore X3 and X2 will be imported. That can be paid by the export of X1. The conclusion is confirmed by expanded wages for smaller P*2 and P*3. Next we consider mixed cases when one international relative price is higher and the other lower than the corresponding autarkic prices. In such cases supplementary criterion of relative profitability becomes necessary. I Quadrant. For P*3  P3/P1  p*3  p3/p1, the Ricardian criterion indicates that it is more profitable to export X3 and import X1 at world prices. For P*2  p*2 , it is more profitable to import X2 and export X1. Thus in the quadrant limited by (P*3  p*3)  (P* 2  p* 2 ), the non contradictory conclusion is to export X3 and import X 2. X1 can be either imported or exported but the Ricardian criterion does not indicate under what conditions. We already encountered this problem when discussing the case of many commodities in Section

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14.1.2. Now we shall provide an alternative solution to the problem. The first equation of (15.2) will show the surplus (deficit) if import at international prices makes costs of production lower. P*3 a31  P* 2 κ1r  p* 3 a 31  p* 2 κ 1r

(15.5)

It is more convenient to put the inequality in the following form (P*3  p*3) a31  ( p*2  P* 2)κ 1r

(15.6)

which is identical to (15.4). In (15.6) differences of international and domestic prices are weighted by technical coefficients in the price formation of the first industry. In case of an equality sign in (15.6), we have a straight line representing a diagonal which subdivides Quadrant I in two regions: (a) below the diagonal where X1 is produced (together with X3, whereas X2 is imported) and (b) above the diagonal where it is not profitable to produce X1 and therefore it is imported. The diagonal passes through the point ( p*2, p*3), denoted as E, which indicates equality of domestic and international prices, P*i  p*i , when the economy is indifferent between autarkic production of all commodities and imports or exports. The slope of the diagonal separating regions Ia and Ib is given by κ1r/a 31. III Quadrant. P*2  p*2 , P*3  p*3. The first price equation will show surplus as long as P* 3 a 31  P* 2 κ 1r  p* 3 a 31  p* 2 κ1 r which is the same condition as before. The diagonal subdivides Quadrant III into the region (a) below the diagonal and (b) above it. In IIIa, X1 is produced together with X2. In IIIb, X1 will be imported together with X3. Given constant parameters λi, aij, κj, r and constant home prices p1, p2 and p3, international prices in terms of baskets P*2 and P*3 determine regions of specialization. If home and international prices differ, trade will increase real wages above the autarky level in each region of specialization. Fig. 15.1, based on the basket industry real wage, shows a clear pattern. Production (export) of X2 and X3 are determined by simple Ricardian criteria. Above the horizontal line p*3  for P*3  p*3  X3 is produced, and is imported below that line. On the right of the vertical line p*2  for P*2  p*2  X2 is

The Pattern of Specialization

99

produced and is imported on the left from that line. The production of X1 is determined by the profitability diagonal. Above the diagonal, X1 is imported, below the diagonal it is produced (exported). At the point E  equality of domestic and international prices – all three commodities may be produced. In this sense, this is the point of autarky. Technological progress changes all technical coefficients. Thus, all lines will change positions and the diagonal will change its slope. Increases in the rate of growth (r), increases surpluses in (15.4). Since technology is not absolutely identical for all firms, lines may be replaced by bands in the real world economy. It turns out that, when Ricardian criteria are supplemented by profitability criteria and lines are replaced by bands, incomplete specializations are more likely than complete specializations and that is quite different from the usual presentation of the Ricardian model. When the number of commodities increases, complete specializations are rather exceptional.

15.2

PRIMARY AND SECONDARY SPECIALIZATIONS

When the criteria applied indicate two (or more) commodities as candidates for export or import, it makes sense to ask which one of them is the most profitable. The economy is facing two kinds of constraints: limited resources and balanced trade. It is, therefore, important to know with which commodity to start before constraints are hit. So far we were interested in the possibilities available, now we shall inquire into the order in which they should be used. Regions Ib, IIIb and IV specialize in one commodity for production and export; therefore, there is almost nothing to be changed. The same regions may import two commodities. Regions Ia, II and IIIa may produce two commodities and it is important to know which of them will be produced first. In the previous section and in Fig. 15.1, we examined regionalization by comparing international and domestic prices. Costs of production are fixed at domestic prices and international prices were allowed to vary. If the costs of production in international prices, for the same real wage, were lower, a surplus was generated that indicated higher profitability and the reason for importing inputs. Now the value of production in international prices (free trade) of the two industries is compared. Given the same real wage,

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the industry that generates (greater) surplus is more profitable and will be operated in this region. In the former case two industries might have been operated simultaneously (as against imports). Now we choose only the most profitable one. Following I. Steedman, this will be called primary specialization. When the production possibilities are exhausted, we choose second most profitable industry for operation. This will be called secondary specialization. Primary and secondary specializations make together domestic (as opposed to import specialization. These ideas form the basis for Figure 15.2. The former specialization pattern is here superimposed on the onecommodity (primary) regionalization. Given the real wage and the rental rate, the X3 industry will be more profitable than the X1 industry (will show a surplus) if the p*3 equation of (15.1) shows lower unit costs than the p*1 equation at international prices. w*1  w*3: 1/λ1[(1  a11)  P*3 a31  P* 2 κ1r]  1/λ3 [P* 3(1a33)  P* 2 κ 3r] P*3 

(λ1κ3  λ3κ1)r P*2  C1, λ1(1  a33)  λ3 a31 C1 

(1  a11)λ3  0 λ1(1  a33)  λ3a31

(15.7)

Since aij are input coefficients, (1  aij)  0. The denominator of the fraction is positive, whereas the numerator may have any sign. Since I have no strong empirical reasons to the contrary, I shall assume that the numerator is negative – for aesthetic reasons. Negative numerator really means that the consumer-good industry is more capital intensive that the industry of materials, κ1/λ1  κ3 /λ3. As only the slope is important, the equation (15.7) can be put in the form (P*3  p*3)  B1 (P*2  p*2), B1 

(λ1κ3  λ3κ1)r  0 λ1(1  a33)  λ3a31

(15.8)

and similarly for the other two cases with different values for B.

101

The Pattern of Specialization B P*3 (X1) X3

C1

X3 (X2)

X3

(X3) X1

p*3

(X2) X3 E

X2

X1

C2

X1 (X2) 0

p* 2

Figure 15.2

X2 (X1) P* 2

A –C B

Three regions of primary [X1, X2 , X3] and secondary [(X 1), (X2), (X3)] specialization

The separating line passes through the point ( p*2, p*3) with the negative slope. Above the separating line, X3 is more profitable, below the line X1 is more profitable. Next we have to separate X2 and X3 regions. w*3  w*2: 1/λ2 [1  κ2r) P*2  P3a32]  1/λ3[P*3(1  a33)  P*2 κ3r] P*3 

(λ2κ3  λ3κ2)r P  C 2, λ2(1  a33)  λ3a32 2

C2 

λ3  0 λ2(1  a33)  λ3a32

(15.9)

Again the numerator denotes relative mechanization and, again for aesthetic reasons, I shall assume that it be positive rendering the

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slope of the dividing line positive. Materials are now more capital intensive than machines, κ3/λ3  κ2/λ2. X 3 region is above the dividing line and X2 below it. The remaining region will have to be separated from X 1 region – which was already accomplished – and from the X2 region – which will be done now. w*2  w*1: 1/λ2[(1  κ2r) P*2  P3a32]  1/λ1 [(1  a11)  P*3a31  P*2κ1r] P*  3

(λ2κ1  λ1κ2)r λ1 P*2  C3, C3   0 λ2 a31  λ1a32 λ2a31  λ1a32 (15.10)

Again the relative mechanization plays the role but not decisive one because the denominator may have any sign. I shall assume that the denominator is positive and the slope is negative. In conclusion, one-commodity primary specialization depends on technical coefficients, rental rate and the relative capital intensity of the sectors compared. In Fig. 15.2, primary specialization in X1 is shown in the region C10A, that in X 2 in AP*2B and in X3 in the region BP*3C1. Each region consists of three adjacent segments. Primary and secondary specialization partly overlap. If taken together, the regions are enlarged. The X1 region is delimited by the points P*30P*2, the X2 region captures the right-hand side of the diagram, the X3 region the upper part of the diagram. Consider the price system (10.18), which may be represented in compact notation p  pA  wλ  wλ (I  A)1

(15.11)

Suppose the growth rate is increased and so the rental rate is now r. The input matrix will change to A which is the same as A except that the second column of coefficients of (10.18) is now p2κir and all prices are higher. p  wλ(I  A)1  p

(15.12)

However, an increase in absolute prices pi and pj does not indicate anything of their ratios p*i  pi /pj. If both prices increase, the ratio may increase, decrease or stay constant depending on which price

The Pattern of Specialization

103

move faster. Now price ratios are given by p*i 

pi p1



Σj λi Aji Σj λj Aj1

,

i  2, 3

(15.13)

Price ratios will change because individual prices will change differently. They will also change because of technological progress that affects individual prices differently. If r deviates from the full employment rental rate, wrong technology will be chosen (Horvat, 1995, pp. 154–55), and again prices will change. Thus there are three reasons why price ratios may change and that will change the pattern of specialization. Figure 15.1 also indicates what will happen if P*i remain constant while p*i change. If p*2 increases, vertical line passing through E will move to the right. If p*3 increases, the horizontal line will move upwards. In either case, all regions of specialization will change. The greater difference (P*3  p*3), the more will be enlarged the region of X3 specialization. This should be obvious because the lower home price p*3 is relative to P*3, the more profitable it is to export X3. The same reasoning applies to the lowering of p*2 in relation to P*2. The region of X1 will be increased if both vertical and horizontal lines move outwards, that is, both p*2  p2/p1 and p*3  p3/p1 increase. That means that p1 must be relatively lower which implies an increased profitability of X1 production. If the profitability of an economy is increased in any region of specialization, it must be possible to calculate the magnitude of that improvement. This is the subject of the next chapter.

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16 The Gains from Trade The gain from trade may be unambiguously defined in two different ways. Technological version requires more of one good and no less of the other for every set of autarkic outputs. In utilitarian version, one consumer must be better off and none of the others worse off. The latter definition is not operational and so we shall concentrate our attention on the former. Generally, it is also not operational. The problem arises when increased quantity of one good is accompanied by reduced quantity of another. Here our labour prices help to solve the problem.

16.1

AUTARKY VS. TRADE

Countries engage in trade because they benefit from it. The textbook explanation of the gain from trade is usually given in terms of indifference and transformation curves. Consider an autarkic economy producing goods X 1 and X2. Relative prices p1 and p2 are given by the transformation line. Quantities demanded are determined by the tangency of the difference curve and the transformation line as shown in Figure 16.1. After the trade is opened, the good X 2 with lower international price, given by the slope of the new transformation line, will be imported in greater quantities than was produced before. This is determined by the new point of tangency E2. If the quantity of the other good X 1 also increases, the gain from trade is obvious. If it diminishes, as shown in Fig. 16.1, the situation is not so obvious because we have to compare Δ X1 with Δ X2 which are different goods. The dilemma is resolved by the indifference curve U2 which indicates higher economic welfare. A conclusion follows: whenever domestic and international prices differ, trade will increase economic welfare. Similar welfare analysis resulted in the following propositions: (1) free trade is superior to no trade, (2) tariff restricted trade is superior to no trade, (3) lower tariff is superior to higher tariff, (4) free trade is superior to restricted trade (Bhagwati, 1964, pp. 59–61; 1968). To this list it may be added that (5) tariffs are superior to 104

105

The Gains from Trade X2

E2 ΔX2

E1

U2

U1

0

–ΔX1

Figure 16.1

X1

The gain from trade (1)

quantitative restrictions. All propositions are valid only on assumptions of perfect competition, complete markets and all profits invested. The first two propositions seem to be generally accepted. Under imperfect competition, prevailing in the real world, anything may happen (Helpman and Krugman, 1992). Besides, (1) may be contested for reasons adduced in Section 16.4. The third proposition is also not generally valid. If a country has monopoly power, it may do better than free trade by imposing the so called optimum tariff. This is because by restricting trade – which is what the tariff does – the improvements in the terms of trade may outweigh the losses in the volume of trade. There is a snag in the welfare analysis. Utility curves are psychological concepts and therefore not measurable. At best, it is only possible to order various levels of welfare, it is not possible to measure them. Given fully employed labour and capital, together with constant returns technology, the economy can produce either X 1 or X2 or some combination of them. For trade to be desirable, it must hold p1 Δ X1  p2 Δ X 2  0

(16.1)

Because prices are labour prices, this simply means that some labour will be saved as a result of exchange. Since also

106

The Theory of International Trade p2/p1  X1/X2 ⬖ p1  p2 X2 /X1

(16.2)

Inserting into (16.1), we obtain p2 (X 2 /X1) Δ X1  p2 Δ X2  0 Δ X2 /Δ X1  X 2 / X1

(16.3)

Inspection of Fig. 16.1 shows that condition (16.3) holds because the slope determined by the increments is really steeper than the slope of the original transformation line. Thus we can dispense with the unmeasurable utility.

16.2

DOMESTIC AND INTERNATIONAL PRICES

In the real world we generally cannot make comparisons of countries without trade and with trade. Trade is registered statistically and we must measure the effects implied. The comparative advantage theory makes this possible. The smaller domestic relative prices compared with international ones open the trade (and vice versa) pi / pj  Pi / Pj In this caste Xi is exported and X j is imported. Multiply domestic price by a positive constant a  1 to equalize relative prices (pi / pj) a  Pi / Pj ,

a  1

(16.4)

where a indicates purchasing power parity. Multiply both sides by X i / Xj a ( p i Xi / p j Xj)  P i Xi / P j Xj  1

(16.5)

For the trade balanced in international prices Pi Xi  Pj Xj  which is the standard case – the gain from trade in home prices is Γh  pj Xj  pi Xi  (a  1) pi Xi, a  1

(16.6)

For the same export quantity, it is possible to obtain greater import quantity evaluated at home prices. Remembering that piXi in

The Gains from Trade

107

labour prices represent embodied labour, the gain may be understood as labour saved – or available labour time augmented – by international trade. If trade is balanced in domestic prices pi Xi  Pj Xj

(16.7)

net export labour will be zero. But the gain evaluated in international (world) prices will be different form zero Γw  Pj Xj  Pi X i  (1/a  1) Pi Xi  0, a  1

(16.8)

In fact, it will be loss, which means that more goods were given away than necessary and so foreign exchange proceeds are less than possible. The trade indicator may be made positive in both cases if it is defined as a ratio instead of as a difference. In this case Γ  1 represents a gain and Γ  1 a loss. Γh  pj Xj /pi Xi  a  1, Pi X i  Pj X j Γw  Pj Xj /Pi Xi  1/a  1, pi Xi  pj Xj

(16.9)

where a  1 means an import surplus at home prices and balanced trade at international prices, whereas 1/a indicates an export surplus at international prices when trade is balanced at home prices. Clearly the gain can be repeated in the successive years, as long as structural conditions remain appropriate. Total gain from trade may be defined as the discounted value of annual gains. If the rate of production growth of all commodities remains unchanged, and the country always has net export of capital because of capital intensity of export, domestic stock of capital will increase, but its rental rate (r) will not change. If imported capital goods are cheaper than those domestically produced, wages will increase (representing gains from trade) but their rate of growth will not. If imported raw material is cheaper, the production of all three commodities can increase on account of the emerging labour surplus (given L). If imported consumption basket is cheaper, more of it can be imported and wages will increase. Each effect can be used to calculate gains from trade either in domestic or international prices or in the domestic labour saved.

108 16.3

The Theory of International Trade IMPORT AND EXPORT GAINS

The gains from trade may result from (1) cheaper import (Pj  pj) resulting in the substitution of the more expensive home-industry output; (2) expanded export which is dearer in international prices (Pi  pi). Effects (1) and (2) are direct effects. There are also indirect effects: (3) Lower import prices of inputs feed into home production costs and, as a result, all prices are lowered (in an interdependent economy). The determination of the regions of specialization (Chapter 15) is the natural introduction into the analysis of the gains from trade. Unlike in the welfare analysis, we are now able to measure the gains in either international or home prices (in terms of labour time expanded). The gain is defined as a net addition to consumption. If labour force does not change, that means an increase in real wage, w*  w/p1. It will be remembered that for w  1 we have labour time prices and real wage is w*  1/p1  x 1/L. Region IV: P*2  p*2 , P*3  p*3 , X 1 produced. Consider a semi-developed country that imports machines (X2) and materials (X3), whereas consumer goods (X1) produces at home and exports (e.g., agricultural products). In Fig. 15.1 that is the region IV. The corresponding price configuration is P2 /P1  P*2  p*2 and P3/P1  P*3  p*3. From (15.2) we see that, by importing X2 and X3 more cheaply, the country gains. Autarky:

w* a λ1  (1  a11)  p* 3 a31  p* 2 κ1r

Import of X2 and X3: w*t λ1  (1  a11)  P*3 a31  P*2 κ1r Consequently Δw*  1/λ1 [ ( p*3  P*3) a31  ( p*2  P*2) κ1r]

(16.10)

Due to reduced production costs, real wage increased by Δw* as in (16.10). Total gain is equal to the quantity of output multiplied by unit output gain

The Gains from Trade X1  λ1Δw*

109 (16.11)

Total output is now larger than before and consists of home consumption and export X1  X1h  Δ X1

(16.12)

In the same way the aggregate gain may be proportionally divided into import and export gain. In region IV only X1 is produced and so all effects emerge in the consumer goods industry, whereas home prices p*2 and p*3 remain unaffected because there is no production. Region IIIa: P*2  p*2 , P*3  p*3, X1 and X2 produced. We next select a region where two goods are produced. Let it be region IIIa. X 1 and X2 are produced and exported in exchange for the imported X3. That looks like a resource-poor advanced Japanese economy. Because two commodities are produced, cheaper input of X3 will affect two output prices but only one price ratio, p*2  p2/p1. Since X3 is not produced, we take only the first two equations from (15.2) to get w*  1/λ1 [(1  a11  P*3 a31)  p*2κ1r w*  1/λ2 [ p*2(1  κ2 r)  P*3 a32]

(16.13)

These are two straight lines which cross for equal value of w*t after trade (Figure 16.2): Since import price is P*3  p*3, cheaper import will reduce p*2 from the autarkic ap*2 to the smaller post-trade tp*2. After trade opens, real wage is greater than the autarkic one, w*t  w*a. The difference Δ*w  w*t  w*a

(16.14)

is the gain from trade due to cheaper import. This is not the whole story. Not only unit output is cheaper, but also the quantity of output has increased in order to pay for imports. So there is an additional gain due to the difference between higher international and lower pre-trade home price. For balanced trade

110

The Theory of International Trade w*

(2)

w*t w*a

(1) 0

t

Figure 16.2

p*2

a

p*2

p*2

Wage lines for P*3 and αP*3 given.

P*3 X3  P*1Δ X1  P*2Δ X2

(16.15)

where X3 is import and ΔX1 and Δ X2 are exports. Since P*1  p*1  1, only P*2 is important. The total export gain amounts to (P*2  p*2 )Δ X2

(16.16)

where p2 is pre-trade price. The total import gain is equal to Δw* (λ1X1  λ2 X 2)

(16.17)

The sum of import and export gain represents the aggregate gain from trade. Region Ib: P*2  p*2 , P*3  p*3 , X3 produced. We may imagine an oil-exporting country that imports machines and consumer goods. Now both import and export gains are present separately.

The Gains from Trade

111

Cheaper import of X2. Only X3 is produced and so insert P*2 into the price equation for material in (15.2). Δw*m  1/λ3 ( p*2  P*2) κ3r

(16.18)

Expanded export of X3. Again the value of import must be covered by expanded export, all at international prices. Δw*e  1/λ3 (P*3  p*3) a33

(16.19)

Cumulative gain is equal to Δw* mλ3 X3  Δw* e λ3Δ X3  λ 3 (Δw* m X3  Δw* e Δ X3)

(16.20)

The total wage increase consists of import and export additions (16.18) and (16.19) Δ*w  Δw* (16.21) m  Δw* e  1/λ3 [( p* 2  P* 2)κ3r  (P* 3  p* 3 a33] The reader may undertake the analysis of import and export gains in the remaining regions in a similar fashion for himself.

16.4

WAGE–RENTAL CURVE AGAIN

Free trade between two countries may not always lead to gains from trade for one or both of them. To show that, we again usewage-rental curve from chapter 11 with slight modifications. In chapter 11 wages and prices were expressed in terms of p1. w*  w/p1  x1/L,

wL  p1x1

(16.21)

Now they will be expressed in terms of p3. Because we have three goods and three prices, there are more dimensions than we can use in the graphic presentation. We can reduce one dimension by taking into account that X1 is not used in the other two industries. As a consequence, in (10.18) two last equations are sufficient for calculating p2 and p3. They can then be inserted in the first equation to calculate p1. Since there are two more variables, w and r, we have one degree of freedom which can be used to calculate the price ratio p  p2/p3. Wage rate and prices are now expressed in

112

The Theory of International Trade

terms of p3, and the relevant part of the price system (10.18) is transformed into (16.22): w*λ2  p (κ2r  1)  a32 w*λ3  pκ3r

 0,

 (a33  1)  0,

w*  w/p3

(16.22)

p  p2/p3

Eliminate p to obtain w* as a function of r. w* 

1  a33 r(λ2κ3  κ2λ3)  λ3

r

κ2(1  a33)  κ3 a32 r(λ2κ3  κ2λ3)  λ3

(16.23)

For r  0, w* takes the maximum value of W  (1  a33)/λ3. For w*  0, the maximum r is R  1/(κ2  κ3d), d  a32 /(1  a33). Since for empirical values of parameters both fractions of (16.23) are positive, w* is a falling function of r. The wage rate w*  w/p3 represents the wage equivalent of materials. This is obvious from the relations w  p1 w*1  p3w* where w*1 is real wage in terms of baskets and w*3 is real wage in terms of materials. Since we use labour prices, a wage-basket of consumer goods is equivalent to a wage-basket of materials if they contain the same quantity of embodied labour. This will be assumed, and from now on we may treat w* as the usual real wage rate. Consider two countries, A specializing in X2, and B specializing in X3. They exchange their products at the international price P  P2 /P3. They use the same technology and therefore face the same wage curve. But they grow at different rates and use different rates of profit. Therefore per capita consumption (c) and wage rates (w*) will differ. As they specialize in different commodities, relative prices in the two countries will differ except at the point of exchange. Assume that X2 is produced under such conditions that p  p2/p3 increases as the rental rate increases. These assumptions are incorporated in Figure 16.3, which I borrow, somewhat modified, from Lynn Mainwaring (1984, p. 99). Since pa is lower than the international price, pa  P, country A will specialize in the commodity X2 whose export price is P2. For similar reasons country B will specialize in X3. Internatônal price must lie between two domestic prices, pa  P  pb , for otherwise

113

The Gains from Trade w*, c

A (X2)

Δca Δw*a

Δcb Δw*b

0

g*a

ra

ro

g*b

B (X3)

rb

r, g*

pa P

pb

p p = p2 3

Figure 16.3

The gains from trade (2)

there would be no exchange (both countries would try to export or import the same commodity). Gross growth rates (gi ) determine consumption per capita (ci ), rental rates (ri ) determine prices (pi ) and wages (wi ). Usually r  g and the difference (r  g) indicates capitalist consumption out of profits. Wage equation for X2 in A is a straight line in r w*λ2  P κ2r  a32  P, P  P2 /P3  const.

(16.24)

P2 is export and P3 is import price in A and, as international prices, are given and fixed. Consumption is equal to the value of output minus the value of inputs. From (16.24) consumption per capita is

114

The Theory of International Trade c a  w/P3  1/λ2 [P(1  κ2g)  a32]

(16.25)

where g is gross (including replacement) growth rate. The wage rate is obtained by replacing g by r w*a  1/λ2 [P(1  κ2r)  a32]

(16.26)

Similarly for the industry X3 in B where X2 will be imported and X 3 exported. c b  w/P3  1/λ3 [P(1  κ3 g)  a33], P  P2/P3

(16.27)

The w* and c equations at fixed international prices are linear. Slopes of the straight lines are determined by capital intensities. Since the production of X2 is assumed more capital intensive than the production of X3, κ2 /λ2  κ3 /λ3, its slope will be steeper. The post-trade addition to consumption per capita is greater than increased wage rate in A, Δc  Δw*, and smaller in B, Δc  Δw*. A and B cross for (r, g) corresponding to P. As product minus consumption equals investment, if the wage bill differs from consumption (because wage rate is different from per capita consumption), profit will be different from investment necessary to employ additional workers. In order to make them compatible with full employment equilibrium, policy measures are necessary. However, consideration of such complications lies outside the present study and properly belongs to the theory of foreign trade policy. As the wage-rental curve and w*  c lines differ, except at the point of intersection of r0(P), surplus and deficit will arise as a result of exchange. Positive additions to consumption Δca and Δcb are trade gains. But there may be also losses. For ra  r0  rb, both countries gain in terms of wages (or profits), because they export at higher, international, price and import at lower, also international, price. This is a generally accepted conclusion: if prices differ, free trade generates gains. But these gains may be chimerical. Output is determined by full employment of resources and consists of investment and consumption. Growth rate of labout force g determines the necessary investment and so also consumption. If rb  ro , B will gain in terms of profits. If at the same time g b  ro, B will suffer loss because of reduced consumption. Even regardless of the position of g, both countries may lose

The Gains from Trade

115

from trade (negative Δc) if technologies differ (Mainwaring, 1984, p. 100). Unemployment introduces new complications. It is only when labour prices are used, i.e. ra  ga and rb  rb, that both countries always gain from trade. A general conclusion follows: any deviation from labor prices (r g) may lead to loss from trade even if trade is completely free and the other usually assumed conditions obtain. As a rule, market prices differ from labour prices (r g) and also technlogies differ, and so loss from trade in the real world appears quite likely.

116

The Theory of International Trade

17 Unequal Exchange 17.1

MARXIAN VALUES

Most of unequal exchange theorizing is based on Marxian schemes of value formation. Value (w  Wert) is composed of constant (c) and variable (v) capital and of the surplus value (m  Mehrwert) w  c  v m

(17.1)

Constant and variable capital are advanced at the beginning of the production period and are completely used in production. In the process of production, workers add to the used means of production (c) new value (v  m). The surplus value (m) is that part of value added which is not appropriated by the workers but by capitalists and so may serve as a measure of exploitation. For further analysis, is will be helpful to translate Marxian concepts into those used in the present study. Thus, variable capital is the sum of wages paid during the production period. v  wL and the surplus value is equal to profit m  πK In Marx’s view capitalists appropriate (because of competition) the same surplus per unit of their invested capital, and so the common rate of profit is π  m/c

(17.2)

if v is paid ex post. If it is paid ex ante π  m/(c  v). Workers invest their labour power and also require a common rate of surplus value μ  m/v  πK / wL

(17.3) 116

Unequal Exchange

117

Since π μ and the organic composition of capital ω  v/c varies from industry to industry and from country to country, the difference between two rates makes labour intensive production valued less than necessary (consequently, capital intensive production appears more valuable) and this is the cause of unequal exchange. This theory may be criticized on several scores. It shares with the most of the modern theory the inability to account for fixed capital. Both c and v represent circulating capital because stocks and flows could not be summed up in the value equation. Further, whatever the requirement for justice, market transactions involve ‘prices of production’ (based on common rate of profit π) and not ‘value prices’ (based on the common rate of the rate of surplus value μ). Next, since fixed capital is produced and labour is not, full employment requires sufficient production of fixed capital (investment) to equip the necessary work places. If this capital is to be allocated in an efficient way, it must generate the same surplus per (last unit) of investment in all uses. And this is the function of the common rate of profit. Finally, it is implied that Marxian values measures the labour content of commodities. This is definitely not the case as the analysis in this study demonstrates (Part II). Marxian labour theory of value is not ‘metaphysical’ as (for instance) Joan Robinson thought. It is simply a product of mistaken bourgeois ideas of ‘ownership rights’. Capitalists own capital and therefore are entitled to share in produced surplus proportionately to their invested capital. Workers own labour power and are therefore entitled to share in the surplus proportionately to invested labour. Capitalism is dominated by capitalists and therefore profit per unit of capital (π) is the pricing rule. Socialism is dominated by working people and therefore the pricing rule is surplus per unit of labour (μ). The fact of the matter is that ownership entitlements have nothing to do with rational pricing. Regardless who is the owner, investment should be made in such a way as to generate the largest surplus per invested resource. How the surplus is to be distributed and used is no longer the role of prices but of social system and prevailing values. For this reason, the old Marxian apparatus is inappropriate for judging the existence of unequal exchange and of measuring its intensity.

118 17.2

The Theory of International Trade UNEQUAL EXCHANGE I

In 1972 Arghiri Emmanuel published a book on unequal exchange which initiated lively international dabate. Emmauel was primarily interested in the consequences for underdeveloped countries. International trade is conducted at international prices and international values embody more labour in underveloped than in developed countries. Exploitation is magnified because of international monopolies and political domination and so no meaningful competition may be assumed. Typically wages in less developed countries are low and profits are high, and most of the exports to advanced countries are controlled by international monopolies located in advanced countries (Sau, 1978, p. 205). This is the second ingredient of unequal exchange determined by unequal international economic and political power. Observe also that underdeveloped countries tend to export raw materials and developed countries export final products. Without monopoly power, less developed countries cannot exploit the relatively low elasticity of demand for raw materials and are badly hurt by competition in these markets. On the other hand, the pyramiding effect of tariffs relatively increases prices of final products. Thus, less developed countries export cheaply and import dearly. In this way advanced countries tip the terms of trade in their favour. This does not mean that terms of trade are constantly deteriorating for less developed countries (although this is possible as well). It only means that at any time terms of trade are worse than they could be. If underdeveloped countries have monopoly in production of some commodities – for instance, in production of tropical products – and price elasticities are less than unity, they may recoup some of the labour lost through unequal exchange by charging appropriate export taxes that would bring national wages closer to those in advanced countries. Thus, the analysis of unequal exchange provides an argument in support of international distributive justice and OPEC demonstrates a possible empirical solution. Here, I am not interested in economic policy repercussions, but in the logic of the argument. Emmanuel defines unequal exchange as the proportion of equilibrium prices established through the equalization of profits between regions in which rates of surplus value differ (p. 64). Suppose that X D is the export product of a developed country and XU the export product of an underdeveloped country. If the trade is to be balanced, mutual exports at world prices must be equal

Unequal Exchange PXD  PXU

119 (17.4)

where P and X are vectors. Assume also that prices of developed country are also world prices. The rate of surplus value was by (17.3) defined as μ  πK/wL that is, as the ratio of profits and wages. Take the case in which the total wage bill in the two countries is equal w DL D  w U L U

(17.5)

and profit rate π is equal by definition of equilibrium prices. Developed country is endowed with more fixed capital KD  KU. It follows πKD D

w L

D



πKU

(17.6)

w ULU

the rates of surplus value are different, D  μU, and also different from the profit rate π. Developed country charges greater surplus value which makes exchange unequal to the detriment of the under developed country. It is also possible to argue in an alternative way which is probably closer to the exploitation theory. Capital transmits its value to the gross product in the form of depreciation. It does not add anything to the net value of the product, whose only source is live labour. Suppose that two countries have the same labour force LD  LU

(17.7)

Consequently, they must produce the same net product (also per worker) value price: wD(1  μ)  w U(1  μ)

(17.8)

Since the rate of surplus value μ is equal by definition in both countries, so must be wages (for equal work) to satisfy the equation (18.8) w D  wU

(17.9)

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The Theory of International Trade

As wD is higher than w U in the real world, the difference represents exploitation (of the poor working class by the worker’s elite in advanced countries). If profit prices are used, (17.8) becomes profit price: w D  πkD  wU  πkU, k  K/L

(17.10)

since w  w , k  k . D

U

D

U

Note the symmetry in the two arguments. Profit prices imply equal profit rate, πD  πU. Since KD  KU, this implies lower rate of surplus value in underdeveloped countries, μD  μU. Surplus value prices imply equal rate of surplus value, μD  μU. To achieve that, profits in advanced countries must be reduced, π D  π U. The postulates of the same rates of surplus values and value prices involve a complicated recalculation of prices and are, of course, arbitrary. It is much more convenient and straightforward to follow a different procedure developed in the next section. If labour is embodied in commodities and the exchange is carried out at world prices, underdeveloped country must export more of its labour in order to receive in return less of foreign labour. In this sense the exchange is unequal and domestic labour is exploited. The situation is completely objectively described. If we wish to remedy it, we must introduce a subjective criterion of how much the unequal exchange ought to be corrected. This is the rationale of foreign aid given to underdeveloped countries by developed countries.

17.3

UNEQUAL EXCHANGE II

Let our economy consist of three industries: production of consumer goods (X1), machine industry (X2) and raw materials production (X3). Summing up the input-output table’s columns, we may reproduce the familiar set of price equations p1a11  p2κ1r  p3a31  wλ1  p1 p2κ2r  p3a32  wλ2  p2 labour prices p2κ3r  p3a33  wλ3  p3

w  1 for exact (17.11)

Unequal Exchange

121

Remembering that consumption goods x 1  X 1(1  a11) represent net or final product of the system, p1x1  wL and p1  L / x1, w  1, so pj (j  1, 2, 3) are clearly labour prices. The difference pj  wλj  p1a1j  p2κ j r  p3a3j, j  1, 2, 3, a12  a13  0, w  1 represents labour embodied in worn out machines and raw material input. The solution of the system of three equations represents prices in terms of labour time and is given by (10.10) and (10.11) p  wλ(I  A)1, pj  w

ΣλA i

i

ij

The value of output p j X j, w  1 represents total – live and embodied – labour spent on the production of Xj during, say, one year. In other words, the value pj X j represents so many worker-years. Any set of competitive prices can be transformed into labour prices by division through the wage rate w. However, note that this is only an approximation because generally consumption differs from the wage bill and investment is different from profits

Σ

C  p1x1 wL, I rp2 κj Xj and the choice of techniques and prices will consequently be different (Horvat, 1995). Also, in reality we do not have perfect competition. If competitive prices divided through wages approximate labour time prices – which also Keynes, using this device, suspected – we get a means for computing internationally comparable absolute prices in terms of labour time. Consequently, an equal exchange in terms of international prices becomes an unequal exchange in terms of labour time (which measures the quantity of labour input). Consider again our two countries. Mirroring real world relations, developed country D has high per capita product evaluated in international prices Pj

ΣP X

D j j D

L

a

ΣP X j

L

U

U j

,a  1

(17.12)

122

The Theory of International Trade

In other words, productivity of labour is a times higher in D than in U. Assume that the same proportion holds for the goods entering international trade, xj. Balanced trade implies

ΣP x

D j j



ΣP x

U j j

(17.13)

Form (17.12) and (17.13) it follows LU  aLD

(17.14)

For balanced trade in international prices, U exports a times more embodied labour than D. We reach the following conclusion: Balanced trade in international prices means unequal exchange because international values contain less of foreign more productive labour and more of domestic less productive labour of less developed country. It follows that equal exchange in international prices implies exploitation of underdeveloped countries.1 Nevertheless, trade is still beneficial for underdeveloped countries (in the absence of monopolies) because imports make possible use of less costly commodities and so net output and consumption increase.

Part VI Tariffs

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18 Tariffs and Subsidies 18.1

EFFECTS OF A TARIFF IN A SINGLE MARKET

If tariff is imposed on the import of one commodity, we can ascertain effects as shown in Figure 18.1. price

S

E P(1 + t)

a

d

b

c

Po P

0

q2

Figure 18.1

q3

f

q4

D

quantity

Imposition of a tariff t

Price must be higher than po before domestic production becomes profitable. As shown in Fig. 18.1, world price is lower than that. In order to stimulate home production, ad valorem tariff t is imposed. The greater import price is now P(1  t), which increases domestic supply from q  0 to q2. That is still not sufficient to cover domestic demand q3  q2. Consequently import is q3  q2. The pre-tariff consumption was q4, which means that tariff-reduced consumption is Δq  q4  q3. That implies the loss of consumer surplus dcf. Yet consumption is still higher and consumer surplus loss smaller than under autarkic equilibrium price-quantity configuration. The waste of resources due to tariff is apoPb. Because of positive production effect and negative consumption effect, import is reduced 125

126

The Theory of International Trade

from q4 to (q3  q2). Increased production q2 is also called protective effect, and reduced import – which consists of production and consumption effects – measures restrictive effect. The tariff revenue of the government is tPx import quantity or abcd. It may be used for various purposes depending on the goals of economic policy. We may summarize. Tariffs raise price of the commodity and so stimulate production. They reduce domestic demand contributing further to reduced import. Reduced import – production plus consumption effects – improves balance of trade, saves foreign exchange and contributes to economic independence. Tariffs may also be used to increase military preparedness or as a bargaining instrument. If a large country imposes tariffs, it will change international prices and thus change terms of trade. Countries whose competitiveness is deteriorating move towards increased protectionism (as Great Britain did after the First World War). Tariff represents an import tax whereby the lower international price of importables is equalized with the domestic price pm  (1  t)Pm Similarly an export tax reduces domestic price of exportables pe(1  t)  Pe where m stands for importables and e for exportables. Already Abba Lerner (1934) noticed that a general export tax has the same effect as a general import tax, ceteris paribus. The ratio of domestic prices remains the same pe 1 Pe  , p  Pm(1  t) or pe (1  t)  Pe pm 1  t Pm m

(18.1)

(the conclusion is not valid when non-traded goods are included). The imposition of export tax reduces domestic export prices but leaves intact import prices. That may also be interpreted as unchanged domestic export prices and increased import prices. In the short run an export tax operates in a depressive way (for exportables) and tariff in an expansionary way (for import substitutes). The latter seems preferable for policy purposes.

Tariffs and Subsidies 18.2

127

PROHIBITIVE TARIFF AND SUBSIDY

A tariff that stops imports is called prohibitive. Imports will be stopped when the ratio of home prices is equalized with the ratio of world prices with tariffs p1 / p2  (1  t)P1 / P2

(18.2)

Tariff rate t is prohibitive. Lower than that is insufficient because X1 will continue to be imported. A higher rate is not necessary. That would mean pure revenue collecting for the government and there are more efficient instruments for that purpose (for instance, value added tax). Home and world prices may also be made equal by introducing an export subsidy. As this subsidy (for instance, in the form of tax exemptions) generates export possibilities where none existed before, it may be called an opening subsidy. Such a subsidy must not be greater than the domestic value added. A subsidy may also be called prohibitive, if former import of a commodity is arrested and replaced by subsidized home production.

18.3

THE PATTERN OF SPECIALIZATION WITH TARIFF

The need for tariff may arise when home price is higher than the international one and the home industry needs protection. Consider a less developed country that tries to increase the rate of growth in order to catch up with more advanced countries. In order to be competitive, it will try to keep wages as low as possible in the conditions of abundant labour. Therefore no tariff is imposed on wage goods X1. On the other hand, in order to develop productive capacity, it will protect X2 and X3 industries. Other combinations are also possible. Whatever combination is chosen, the main point is to show how the regions of specialization change when tariffs are imposed. Let tariffs t2 and t3 be imposed p*i  P*(1  ti), i  2, 3 i X1 specialization is described by the following equations:

128

The Theory of International Trade X 1 produced, X2 and X3 imported, T2  1  t 2, T3  1  t3 autarky:

wa*λ1  p*a 3 31  p*κ 2 1r  1  a 11

with tariffs: w*λ t 1  T 3P 3*a 31  T 2P 2*κ 1r  1  a 11

(18.3)

Import of X2 and X3 will be more profitable as long as costs are lower T3P3*a31  T2P2* κ1 r  p3*a31  p2*κ1r That at the same time means that X 1 will be produced because Pi / P1  pi / p1 implies p1 / pi  P1 / Pi Rearrange the inequality in the familiar way (T3P3*  p3*)a31  (p2*  T2P2*)κ1r

(18.4)

That is similar to (15.4) except that now international prices are increased by tariffs and the separating straight line passes through the point E2(p*2 / T2, p3* / T3). Rearrange (18.4) to get P3* as a function of P2* P3  (1 / T3a31)(p*2 κ1r  p*a 3 31  T 2P2*κ1r) The slope of the line is (1  t2) κ1r (1  t3) a31 and is equal to the former slope modified by the ratio of tariff factors. Again, below the line X 1 will be produced and exported. There is, however, a novel effect not existing before because above the line X1 will also be produced but not exported. The reason is to be found in the tariff imposed: though in this region world prices are lower than home prices, they are expanded by the imposition of tariffs and so production is still profitable for home producers but export is not. Thus, in the region demarcated by p*2 / T2  P*2  p*, 2 p* 3 / T 3  P* 3  p* 3

129

Tariffs and Subsidies P* 3 X3 produced X1, X2 imported X2, X3 produced X1 imported X1, X3 prod. X2 imported E1

A

p* 3

p3*/T3

No trade in X3 B

E2

X1 produced X2, X3 imported

X2 produced X1, X3 imported

No trade in X2

No trade in X1

X1, X2 produced X3 imported p*/T2 2

Figure 18.2

p2*

P2*

No-trade regions

there will be no trade for X 2 and X3. Besides, between the two separating lines in Fig. 18.2, there will be no trade for X1. In this way the autarkic point E1 is expanded into an autarkic region E1A  E2B. This region is the larger the higher are tariffs. A similar effect as import tariffs (or export taxes) have relatively high transport costs that render commodities non-tradeable. A cheap bulky commodity, such as bricks, will be exported only if the export price is sufficiently higher to cover transport costs. It will be imported if the import price is sufficiently lower than the home price so that transport costs can be covered. That, however, is rarely the case. As one should have expected, tariffs reduce the volume of trade. Also, one general rule must be modified. The rule that different home and world prices lead to profitable exchange is not generally valid when tariffs are imposed.

18.4

NOMINAL AND EFFECTIVE TARIFFS

The difference between the (lower) international prices and (higher) domestic prices generates differences between nominal tariff (imposed on commodities) and the effective rate of protection of value

130

The Theory of International Trade

added in the respective industry. Let the home production of consumer goods be valued at international prices P1  wλ1  P11a11  P21κ1r  P3 a33

(18.5)

or more generally Pj  wλj 

Σ Pa

(18.6)

i ij

where aij are all input coefficients including κ j r. Social accounting value added consists of wages and profits, vi  wλi  P2 κ i r. In this book, net value added consists of wages only because profits are not value addition but real cost: gross profits are equal to replacement plus new investment necessary to keep labour fully employed in the economy as a whole. In other words, they are reproduction costs incurred by the expenditures on intermediate goods. Valueadded without the just mentioned real cost component will be denoted as v*, and v will be value-added as it appears in the individual firm or industry as an imputed cost. In a competitive decentralized economy, v is important and so the social accounting value added concept will be used in order to study tariff protection of individual processes. It is easy to transform vi* into v v*i  wλi v i  wλi  P2κir  v*i  P2κi r

(18.7)

Unit value added at world prices is the difference between price and unit cost. In the first industry

ΣP a , κ r not included in a

v 1w  P1 

1 i

i

i

(18.8)

Value added in home prices is obtained if tariffs are imposed on output and inputs v 1h  (1  t1)P1  (t1P1 

Σt P a ) i

i i

Σ(1  t )P a i

i

i

 v1w  (18.9)

If the difference of values added in home and international prices is divided by vw, we obtain the effective rate of protection τ

131

Tariffs and Subsidies τ1 

v1h  v1w v1w



t 1P1  P1 

Σ tPa ΣP a i

i i

i i



t1  1 

Σt P*a ΣP*a i

i

i

i

(18.10)

i

Effective protection τi may be positive, zero or negative depending on whether the tariff rates on output are high or low relative to the tariff rate on inputs. If tariff is uniform, ti  tj, the effective rate equals the nominal rate, τi  ti. In actual practice, the difference between nominal tariff rates (levied on the purchasing value of commodities) and effective rates of protection of production processes (of the value added) may be quite large and the effective protection may be positive and negative. This may be illustrated by the American tariff rates for 1958 (Johnson, 1972, p. 316):

Rice milling Watches and clocks

Tariff rate (%) Effective protection (%) 14.3 27.9 51.9 143.1

Negative protection is the result of relatively high nominal tariff rates on inputs and very high positive protection results from relatively low rates on inputs. The latter is usually the case when tariff rates escalate with successive stages of production. Positive protection on export products is an effective subsidy. The policy textbooks suggest and common practice implements these suggestions that low or no tariffs be imposed on early stages of production and that final products be protected by higher tariffs. That produces a pyramiding effect, which can be seen from a simple example of two-stage production. In the first stage raw material is produced or imported and in the second stage final product is produced. Suppose q1 of primary products is used to produce one unit of final product q2. Since domestic prices are higher, q1 is imported and q2 is protected. P1q1  v  p2  (1  t2)P2

(16.11)

It is then decided to protect also q1. If wages and other input prices remain approximately unchanged, v will not change and we may write (1  t1)P1q1  v  p2  (1  t2 )P2

(16.12)

132

The Theory of International Trade

The new protective tariff t2 must be greater than t2. Deduct (10.11) from (10.12) to obtain t 1P1q1  (t 2  t 2)P2 (t2  t2)  t1q1P1 / P2  0 ∴ t 2  t 2, p2  p2 As a consequence, home prices must increase as well. In the later stages of production the magnifying effect of increased tariff rates and prices may be considerable. It is a positive function of the number of production stages with successive tariffs imposed.

18.5

SUBSIDIES

A tariff is added to an international price of imported commodity to make home production competitive. A subsidy is subtracted from the higher home price in order to make it equal to international price. The rates of subsidy and tariff for a given pair of prices are approximately equal. tariff: Pi(1  t)  pi subsidy: Pi  (1  s)pi Consequently, s ~ t because s t ~ 0. Although formally subsidy is no different from tariff, economically differences are important. Eight of them may be mentioned: 1. Tariffs bring money to the treasury, subsidies take it away. Thus, subsidies are politically and administratively much more cumbersome. 2. Tariffs make domestic prices different from international prices. Subsidies reduce differences between home and international prices and generate differences between producer and consumer prices because part of the supply price is paid by the treasury. 3. Subsidies decrease prices, whereas tariffs inflate prices. Industries producing intermediate goods, when subsidized, render inputs to other industries cheaper and so lower their prices. 4. Just because the effect 3, cheaper inputs may cause formerly imported commodities to be produced at home and exported.

Tariffs and Subsidies

133

5. Tariffs protect home industries but cannot enable them to export and, say, reap economies of scale. Subsidies do one and the other. 6. Subsidies may lead an economy to adapt itself to the structure of world prices and become so better prepared for customs union formation. Tariff tend to conserve domestic price structure. 7. Welfare theorists prefer direct subsidies to tariffs because they avoid the loss of consumer surplus in Fig. 18.1 (Corden 1974, p. 13; Johnson, 1972, p. 243; Cloves et al., 1993, p. 221). 8. The GATT rules do not allow explicit export subsidies in order to prevent dumping foreign markets. The proceeds from tariffs must somehow be distributed. But spending money is always easy. Expenditures caused by subsidies must somehow be financed. That can be done in various ways but two of them seem obvious: by excise taxes and tariff revenues. Subsidies may be direct or implicit such as easier credit terms, investment credit, the deduction of value added tax on export commodities and various selective benefits. In either case wages will be reduced and this is the common features of tariffs and subsidies. Subsidies can easily be incorporated into (18.1) and then regions of specialization determined. That will not be undertaken here. To prohibitive tariff, prohibitive subsidy corresponds as described in Section 18.2. The separating lines for the regions of specialization are different and no trade region is no longer present. However, the rationality of subsidized export may be questioned. Taxes on production (the extension of tariffs to domestic production), consumption and wages do not pose new problems. An import quota may be shown to be equivalent to a tariff except that the tariff revenue is collected by the holders of import licenses and not by the government. The government tries to find compensation in selling the licenses at an appropriate price.

18.6

INFANT INDUSTRY SUPPORT

Let out three-industry economy be competitive and self-sufficient in X1 and X2. That implies an equalization of absolute home and international prices at an appropriate exchange rate, p1  P1 , p2  P2. Raw material X3 is imported in exchange for, say, machinery X2. Consequently, P3 / P2  p3 / p2, where p3 is expected home

134

The Theory of International Trade

price of X3 once the production starts. Since international P3 is given, p1 and p2 can be found by solving two price equations: p1  wλ1  P3a31  p2κ1r  p1a11

(18.13)

p2  wλ2  P3a32  p2κ2r

If a tariff is imposed on any commodity, all prices will have to change, including the real wage because of w*  1 / p1. Thus, it may be profitable to grant a subsidy because then prices do not change. In either case, importation of X3 will stop and home production will begin if home and international prices are equalized. Consider a tariff support for infant industry X3, p3  (1  t3) P3. The relevant price equations are p1t  wλ1  (1  t3)P3a31  p2tκ 1r  p1ta11 p2t  wλ2  (1  t 3)P3a32  p2tκ2 r

(18.14)

(1  t3)P3  wλ3  (1  t 3)P3a33  p κ r t 2 3

The increase of price P3 to (1  t 3)P3 makes production of X1 and X2 more expensive and reduces nominal wage w. Since this is not a feasible policy politically, it will be assumed that nominal w is kept constant and real wage is reduced by inflation. In this way our data are w, P3 and r, and unknowns are t3 and tariff affected higher prices p1t and p2t. These three unknowns can be determined by solving the three equations (18.14). Since p1t  p1, the real wage will be reduced to w / p1t. Production of X1 and X2 will become uncompetitive and will need protection, p1t  (1  t1)P1, p2t  (1  t 2) P2. Since P1 and P2 are given, t1 and t2 are also determined. If formerly the economy was fully competitive, p1  P1, p2P2, now it is no longer competitive in both products but only in one, depending on the price ratio p2t / p1t  P2t / P1t The introduction of inefficient production X3 makes the whole system less efficient. With the given labour force, all three goods are now available in smaller quantities. An alternative policy is to grant subsidy to the X3 industry in order to reduce home price to the international level.

Tariffs and Subsidies

135

p3s  p3(1  s)  P3 The necessary money for subsidizing the unprofitable production can be obtained by taxing consumers which will leave nominal wage unchanged. Now we have the third set of equations. p1  wλ1  (1  s1 )p3a31  p2κ1r  p1 a11 p2  wλ2  (1  s2)p3a32  p2κ2r

(18.15)

(1  s3)p3  wλ3  (1  s 3)p3a33  p2κ3r The first two equations are the same as in (18.13) but that does not mean that the prices are the same because then the system would be overdetermined. In the system (18.13), P3 was given; in (18.15), p3 is a variable. The same was true for (18.14) and there each industry needed a different tariff protection applied to respective outputs. Now each industry needs a different subsidy applied to dearer X3 inputs. In both cases all absolute prices increase. By changing the exchange rate, in either case at least one tariff/ subsidy rate may be rendered unnecessary. The whole procedure is justified if it can be expected that within reasonable time industry X3 will improve its efficiency, and greater domestic price will converge gradually to lower international price lim τ➝n

p3(τ)  P3 , τ  time

Grounds for that are learning by doing, economies of scale, increasing skills by training and purposeful research leading to technological progress. Each time that the efficiency of X3 production improves, p3 will decline and real wages will increase. All prices will decrease and tariff protection will have to be revised. These adaptations involve considerable transaction costs. In the case of subsidies, prices will remain unchanged but subsidy rates will have to be continually revised. It is appreciably easier to administer tariffs than subsidies. On the other hand, price stability as against continual market adaptations represents an important economic gain.

136

The Theory of International Trade

19 Customs Union 19.1

DEGREES OF ECONOMIC INTEGRATION

The situation in which the independent political units, called states, and their economic agents compete on the world market, may be denoted as zero economic integration. The liberal epoch of 19th-century Europe corresponds institutionally most closely to such a state of affairs. Although various attempts at integration were made already in the last century, it is only in the second half of this century that the world began to move gradually towards economic integration. Various international agreements are the milestones on this path. Suffice it to mention the General Agreement on Tariffs and Trade (GATT), whose rules are obeyed by all important trading nations. Nevertheless, the world arrangements, just because they are so encompassing, will be taken as a basis from which the various, less general, integration schemes start. Various preferential trading agreements, in the ascending order of economic integration, are: 1. A preferential trading club, in which member countries agree to reduce import duties on the mutual trade. A paradigmatic example is the Commonwealth Preference System; similar arrangements have obtained between imperial centres and their former colonial dependencies. The problem encountered is to exclude the outside world from mutual preferential system. For that it is necessary to distinguish effectively between goods originating inside and outside the Club. Trading Clubs are no longer in existence because they are not allowed by the GATT rules. 2. A free-trade area is created when the member countries abolish all import duties and quantitative restrictions on their mutual trade. They retain their national protection schemes against the rest of the world. An obvious example is the European Free Trade Area (EFTA), created in 1960, which consisted of seven countries that did not join the European Community. The policing problem mentioned in (1) exists here too because exporters may use their national protective schemes, enter the area 136

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137

where protection is the lowest and resale the commodity in more protected markets of the area. 3. A customs union eliminates the policing problem of intra-union trade of commodities originating in other countries. The Union abolishes all import duties on the trade among member countries and establishes the common external tariff on import from the rest of the world. Duties are charged as soon as commodities enter one of the Union countries. The custom proceeds are redistributed to member countries according to an agreed upon scheme. 4. A common market is established when in addition to free movement of commodities also free movement of labour and capital is allowed. European Economic Community reached that stage of integration. 5. Economic union is the final stage of integration, now attempted by the EEC countries and intended to integrate the whole of Europe. The member countries proceed to integrate their fiscal, monetary and socioeconomic policies. Short of political integration into a federal state, the Union was established by the Benelux Treaty countries (Belgium, Netherlands and Luxembourg). The three countries formed a customs union in 1948 and converted it into an economic union in 1960. Between the trading arrangements (4) and (5), Molle (1990, p. 13) interpolates monetary union, which establishes full convertibility or common currency and undertakes the integration of macro-economic and budget policies. These various schemes are characterized by different intensities of cooperation. The lowest intensity, practised in (1) and (2), consists of co-operation, which means voluntary and unenforceable alignments of national policies in various fields. Harmonization is the second degree of co-ordination and involves agreements on how member countries will exercise policy instruments over which they retain control. This is practised in (3), Customs Union and (4), Common Market. If various policy instruments are assigned to (5), Economic Union, this is integration.

19.2

TRADE CREATION AND TRADE DIVERSION

Our 3  2  2 model has served us well so far. Now we must add the third country and consider 3 (commodities)  2 (factors)  3

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(countries). Each of the three countries has its special function. H is the home country, P is the union partner and W is the rest of the world. In order to avoid possible confusion, international price will now be denoted as pw. Although customs unions have existed for a long time – the best known example is the German Zollverein created in 1834 – the systematic theoretical study of customs union issue began with Jacob Viner’s book published in 1950. Viner distinguishes trade creation from trade diversion effects of a union. If both H and P are high cost producers protected from international competition by tariffs but P’s production costs are lower, the removal of intraunion tariff will enable P to export to H and so trade will increase on the basis of lower costs. If, however, H used to import a commodity from the low cost W, but now intra-union tariff is abolished whereas the common union tariff protects high cost producer P, import will be diverted from the low cost W to the high cost P. Viner calls the former effect trade creation and the latter trade diversion. The switch to lower prices (trade creation) is obviously desirable; the switch to higher prices (trade diversion) is generally not desirable or welfare improving but may be made so as with infant industry support or the creation of a customs union. The effects of forming a customs union are represented in Figure 19.1 which I borrow from P. Robson (1987, p. 17). The usual assumptions apply: vigorous competition, transport costs ignored, factors mobile within the country and not between countries, tariffs as the only form of trade restrictions, balanced trade and full employment of resources. The home country is a high cost producer and needs tariffs for protection. Let it be prohibitive tariff t h generating autarkic equilibrium at A. Low-case letters stand for home, customs union partner and world. Now the customs union is formed. The union, supply curve is a horizontal aggregation of supply curves of the two countries, Sh  Mp, where partner’s supply is denoted as import from the partner’s country, Mp. The common union tariff t u is set so that Su  D h. Thus, union price will be lower than in H, higher than in P, while all three prices are higher than the world price pw. In the home country output declines from q2 to q1, and consumption increases from q2 to q3. Tariff rate t p is set so as to equilibrate S and D in the partner’s country. With tu imposed, output increases to q3

and consumption declines to q1 in P. Trade creation in H consists of production effect ABC (reduction of production costs) and

Home country p

Partner country p

Dh Sh

Dp

A

Sp

Su = Sh + Mp B

pw(1 + tu)

C

D

pu

pw(1 + tp)

pp

pw

pw

0

q1

q2

q3

Figure 19.1

Customs Union

pw(1 + th)

q

b

a

0

q q

1

2

q

3

q

The effects of a customs union

139

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consumption effect ACD (consumers’ surplus), due to imports. In P, there is a loss of resources b and a consumption loss a. This is overcompensated by export earnings (q3  q1 ) (pu  pp) represented by the hatched rectangle. The union is assumed to be selfsufficient and so the partner’s export (q3  q1 ) is equal to home country import (q3  q1). Since the rest of the world remains undisturbed, there is only trade creation effect ABC. If initial tariff was not prohibitive, so that there was some import from W, and the union import from P replaced cheaper import from W, there would have been also trade diversion. In this case the starting position would not be an autarkic equilibrium at A but an excess demand calling for imports prior to the formation of union. If P’s production involves increasing or decreasing returns, its supply price will fall or increase as output expanded. In the European Economic Community of six members, trade creation appeared to be substantially higher than trade diversion. Robson (1987, p. 246) quotes estimates of six authors for the period between 1967 and 1970 indicating trade creation from 13 to 23 per cent of total imports (about 0.15 per cent of GNP) and trade diversion from 1 to 6 per cent. If this is at all representative case, trade diversion can be neglected as a problem for economic policy. A common market is one stage further along the integration path. It will not be attempted here (see, however, Appendix VI-2), but one empirical test deserves attention. Herbert Glejser compares EEC countries in 1958 – which is the year preceding the initiation of Common Market – with the same countries, now members of Common Market, in 1966. He finds that both rank correlation and regression analysis support comparative costs theory and that partner countries behave as expected (negative correlation between prices and shares of export to the home country; Glejser, 1972, pp. 247–58).

19.3 CUSTOMS UNIONS IN A MORE REALISTIC SETTING Our 3  2  3 model implies that three goods are exported or imported or neither from three different countries. This makes for 27 possible combinations. It would be cumbersome to analyze all of them. Obviously this is an exercise for applied trade analysis having in mind concrete practical problems. But we may construct

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141

a representative case which will give us the feeling for what is all about. H is a high-cost producer and all its prices are higher than in P. H produces all three commodities and P only two, while machines X2 are entirely imported at world prices. P produces materials at world prices, p3p  p3w, and since the other input X2 is also available at world prices, the price of finished goods may be lower than in H. Being entirely imported in P, X2 needs no tariff protection. X3 is also exported from P. W absorbs all surpluses and deficits. Besides, countries are small and whatever they do, the world equilibrium will not be disturbed (international prices remain constant). Before forming the union, prices in the two countries are: Home country p1h  p1w(1  t1h) p2h  p2w(1  t 2h) p3h  p3w(1  t3h)

Partner country p1p  p1w(1  t1p), t1p  t1h p2w (only for imports) p3p  p3w, t 3p  0

The union eliminates internal tariffs and retains the lowest national tariffs, protecting the already existing production: t1  t1p, t2  t2h, t3  0. Such an arrangement corresponds to the Article XXIV of GATT which stipulates that union duties must not be higher than those existing prior to the formation of union. Since H and P belong to the same cultural environment, it may be assumed that if P can have lower costs, so can H. If not immediately, costs can be lowered in stages. In the meantime, production in H can be subsidized out of proceeds from tariffs. Consequently, after customs union formation, the single set of internal prices are as follows: p1  p1w(1  t 1p)  p1p   p1h p2  p2w(1  t 2h)  p2w   p2h p3  p3w(1  t 3)  p3p   p3h Note:  substantially lower by design  slightly greater because of more expensive inputs Because of industrial interrelations, the union protection must be slightly higher than P’s tariff rates (if relevant cost changes are to be absorbed). By design, union prices p1, and p3 are substantially lower than H prices because of P’s lower protection rates. But these rates will have to be slightly increased because cheap X2 import is replaced by more expensive X2 production. Tariff t2h is

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chosen for the union tariff because X2 was not produced in P and therefore no tariff existed. Union tariff rate t 3  0 must be imposed because of increased union costs as compared with earlier P’s costs. The customs union is created by a high-cost producer H and a low-cost producer P. In reality it is not likely that all prices will be higher in H and lower in P. We consider on purpose such an extreme case to see whether the union will be beneficial for both countries even under such conditions. In the union, H prices will be substantially reduced (by design) and P prices will be somewhat increased (because of higher union prices for inputs). Protection rates will change in the same direction. The union tariff rates will be between high H and low P rates, closer to the latter. This means that the creation of the described union is a move towards free trade and the average price level is lowered. If at least some of H producers are more efficient, this move will be stronger. It is also stronger with the large number of member countries. Because of import substitution, union output will increase beyond the aggregate output of individual members before integration. The home country will gain from the union with a low-cost partner: all prices will be reduced and production increased because of import substitution. It is not immediately obvious that P will gain from the union with the high-cost country H. All its prices will increase but so will its outputs since even inflated prices pip are still lower than pih. P will replace the entire import of materials into H assuming adequate elasticity. Machines were not produced in P and so change in p2 may possibly induce P to start producing X2. Price of consumer good increased, p1  p1p, but it is still lower than p1h and so P will be able to capture a part of H’s consumer good market. There is still one effect left. The combined supply schedule of H and P has flatter slope and, therefore requires less import (Figure 19.2). At the world price p w, home production is negligible (q7) and almost all required quantities are imported. When tariff t h is imposed, supply increases to q2, demand decreases to q4, reducing import to (q4  q2). When the customs union is created including the low-cost producer P, the aggregate supply curve becomes more elastic and something is produced even at pw. Even if the union imposes much smaller common tariff t u  t h, output will increase from q2 to q3 and also import from (q4  q2) to (q6  q3). This is beneficial trade creation effect because the high cost source

143

Customs Union price Dh Sh

Su

p (1 + th)

p (1 + t) u p (1 + t ) u pw

0 q1

Figure 19.2

q2

q3 q4

q5

q6

q7

quantity

Increased elasticity of the customs union supply curve

pw(1  th) is replaced by the low-cost source pw  t u. If tariff is increased to t u, the resulting trade diversion to union products will eliminate imports altogether. In general, prices in the low-cost P will somewhat increase, in the high-cost H substantially decrease, output will expand and imports will be substituted (at least to a degree) by member countries’ production. The union supply curve (and similarly the union demand curve) becomes more elastic and this is a move towards free trade without tariff barriers. Conditions favouring the creation of a customs union are those that are lowering prices and increasing production and trade. Such conditions appear to be: 1. Much mutual trading among prospective members so that gains can be achieved by eliminating internal tariffs of formerly separated countries. 2. Overlapping of tariff protection. 3. Large volume of foreign trade in relation to total expenditures so that the elimination of trade impediments generates large gains.

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4. If two countries produce the same commodity, the gain from forming a union will be larger the larger is the difference in production costs between two countries. 5. Similar economies. The more they are alike, the more scope there is for specialization turning economies to become complementary to each other. When member countries produce completely different goods, there is little scope for further complementary specialization. 6. Different from the rest of the world. The more different they are from the outside world, the more likely it is for member countries to gain from the union because possible losses from trade diversion are smaller (Johnson, 1962, pp. 44, 57–60). 7. The larger the union, the greater its bargaining power and so, unlike a small country, may benefit from improved terms of trade or at least not suffer from imposed upon conditions for trade. 8. Large internal market, brought about by the union, makes for more efficient allocation of production and consumption (for instance, the elimination of empty stretches along former borders), more efficient transportation network, more effective competition lowering costs and prices and possibilities for exploiting economies of scale. 9. Countries at similar stages of economic development (similar GNP per capita) will find it easier to equalize tariff rates and harmonize economic policies because of similar productivity and similar organizational experience. An advanced country in a less developed environment would enjoy monopoly position and exert disruptive influences on the union. A less developed country in a developed environment would not be able to compete successfully when internal tariffs are eliminated and so would create both economic and political problems. 10. Long historical contacts and sharing cultural values facilitate cooperation even if at some earlier times countries were involved in bloody confrontation. Mutual understanding is crucial for successful communication.

19.4

DYNAMIC EFFECTS

Almost all trade theory literature is concerned with allocational effects on the welfare, although they constitute only a fraction of one per cent of GNP (Leibenstein, 1976, pp. 29–34). That is so

145

Customs Union Dp

S p

Sp

price Su S u w

p (1 + t) pw(1 + t )

pw

0

q1

Figure 19.3

q2

q3

quantity

Reduced costs of customs union

because allocational effects lend themselves easily to analytical treatment. Dynamic effects – structural changes in time – are much more important but also much more difficult to analyze rigorously. In fact, no general approach has been developed as yet. For an exception see Molle (1990, pp. 103–12). Here only the more important effects will be described. Improvement of efficiency. Greater pressure of competition will result from reduced union tariff and elimination of separate tariffs of member countries. This will stimulate intraunion specialization which will reduce costs. Because of reduced costs, supply curve will shift downwards (Figure 19.3). At world price even the low-cost partner country – and so the union too – will produce nothing. Because of increased efficiency, it will produce q1 at some later time. When high-cost producer H joins the union, tariff t will have to be imposed in order that the union produces q2 and eliminates imports. At some later day, union supply curve will shift downwards, to S u and now it will suffice to impose lower tariff t  t in order to achieve self-sufficiency and produce greater quantity q3  q2. Cost will be reduced not only because of greater competition and specialization but also because of free movement of labour and capital (in common market). Increased competition and reduced

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costs are likely to foster economic development. As a result, costs will be further reduced because of technological progress and replacement effect. At first the outside world might lose because of reduced exports. But eventually W will gain as well because of higher rate of growth of union members and consequential increase in trade. Economies of scale may be internal and external to the firm. Internal economies are best exemplified by a chemical factory. Containers used in the production process incur investment costs proportional to the surface of the container (S  6 x2 if containers are boxes), while production is proportional to the volume (V  x3). Let capacity be increased λ times V1  λV0  (λ1/3x)3 The investment cost (surface) will increase to S1  6(λ1/3x)2  S0λ2/3 where λ2/3(2/3  1) indicates economies of scale. Production costs will also decrease because of large series. Thus, internal economies of scale can be pervasive in modern industries. External economies are due to the complementarity of processes on the same area (repair shops, power generation, transport, ancillary production transferred to independent specialized firms). Next, bulk transactions are cheaper, inventories vary with the square root of output, large quantities facilitate the use of specialized equipment such as assembly lines. The main analytical characteristics of economies of scale is falling supply curve. In the upper part of Figure 19.4, the partner’s supply curve is below Home’s supply curve because the partner produces at lower cost. Imposing the tariff rate th, Home country achieves self-sufficiency producing q1. A similar prohibitive tariff in P determines q2 production. Both countries enjoy economies of scale and therefore the S curves are falling. They cannot be falling indefinitely and eventually they flatten out. It is assumed that Sp stops falling after the world price pw has been reached. Neither country can exploit economies of scale because of the lack of demand. Abstractly speaking, lack of home demand may be compensated by foreign demand (export). In reality, the precondition for substantial export is sufficiently large home demand and/or export subsidies.

Customs Union

147

In the lower part of Figure 19.4 the two countries have formed a union. The combined union demand curve D u is more elastic than either Dh or Dp in isolation. The combined supply curve is identical to Sp since the partner country is more efficient of the two. This means that the entire union output will be produced by P and H will be eliminated. Since H produced originally only a small output q1, this might not be a great loss. H might also demand compensating transfers in order to remain in business until improving own efficiency (the infant industry case). Or it may benefit from the union created economies of scale in some other business by expanding output. Or its inefficient firms may be taken over by more efficient P producers. In any case, economies of scale exert additional pressure on high cost producers to reduce costs. After the union creation, consumption in H and P increases to q3 and q4. In the lower part of Figure 19.4 two possible cases are considered. First, it is assumed that P’s economies of scale are exhausted at pw and also that at this price the union self-sufficiency is achieved. Of course, the combined demand can be smaller or greater and also the Sp curve may flatten out at a different p  pw. The alternative case, represented by dashed line, assumes the same Du but somewhat less efficient S p. For self sufficiency, union imposes prohibitive tariff tu which reduces union consumption to q5. Even so, the union price is lower than either of the two pre-union prices and, consequently, more is produced at reduced cost. Tariff rates th and t p are reduced to a lower common t u. The situations described may be affected by oligopolistic and monopolitic behaviour and so not the lowest possible union cost (price) is established (Robson, pp. 39–41). To prevent such distortions, the intervention of the economic policy authority is necessary. Large market effects. Economies of scale reduce cost of additional units of output. Improved efficiency shifts supply curve downwards. Large markets are likely to generate both effects. The unification of business regulations is likely to reduce risk and transaction costs. The latter will be reduced because of eliminated border formalities, abolished internal custom duties and more rational transportation network. The transportation system in a large area can be organized more rationally than on the aggregation of transportation systems in many small, separated areas. Locational advantages tend to be more fully exploited (areas along numerous previous borders remained without productive capacities). Important technological break-throughs are likely to occur in large countries and

148

The Theory of International Trade H and P separately price

Pw(1 + th)

Sh

Pw(1 + tp)

Sp

pw Dp D n

0

q1

q2

q3 q4

q6

Union (H + P) price

S p

p(1 + tu)

Sp

pw

Du

0

q1

q2

Figure 19.4

q3 q4

q5

q6

Economics of scale

large companies. They are able to accumulate sufficient human and material resources necessary for technological progress. Most natural sciences and medicine Nobel Prize laureates come from two dozen or so universities located in a couple of countries (although the respective scientists were born in many more countries).

Customs Union

149

In a large market, local disruptions are more easily repaired, and so can full employment of labour and capital be maintained. Full employment and technological progress make for a higher rate of growth. The emergence of national markets that superseded former feudal economic atomization and local monopolies was a great advancement in macroeconomic organization. Similarly, customs unions and related forms of economic integration are second great enlargement of national markets and improvement in the macroeconomic organization. The great thing about this development is that political national states may remain preserved while reaping the benefits of international economic integration.

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Appendices to Part VI 1

EMPIRICAL EVIDENCE

There are two paradigmatic cases that may illustrate the effects of customs union creation and its dissolution. The former is the creation of the European Economic Community (now union) in 1957 (enlarged in 1973, 1980, 1986 and 1996). It will illustrate beneficial effects of the union creation. The other is the dissolution of the Soviet and Yugoslav federations which generated predictable negative consequences. The formation of the European Union has been a singular success. There is an enormous literature on it and for this reason only a few summary statements will suffice. As the name indicates, the EE passed stages of Customs Union and Common Market and is now building Monetary and fully integrated Economic Union. The empirical evidence for the first two steps is given in Table 1. The share of export in European GDP was reduced to one half in the period of trade restrictions in the 1930s as compared with the liberal 1880s. Already the first steps towards integration recovered the share in 1960 and then doubled it to 26 per cent in 1985. The message is very clear. From 1880–1910 to 1938 trade was expanding at a lower rate than output. Europe was moving towards autarkic states. From 1960 onwards, trade was expanding faster than output. Particularly fast was the expansion of intratrade. Europe has been gradually integrating and this trend continues. At the same time, trade with the rest of the world also expanded faster than output and the share of EC export in GDP increased from 9 in 1960 to 11 per cent in 1980 (Molle, 1991, p. 179). The medium-term macroeconomic consequences from market integration for the EC were estimated by Paolo Cecchini to be an increase in GNP of 3.2 to 5.7 per Table 1

The effects of European integration 1880 1890 1910 1920 1938 1960 1970

European exports as % GDP 13 Intra-trade as % of total export –

13

13

9a

6a

14a

–

–

–

–

34.6b 48.9b

a

17a

Only European Economic Community (EEC) of 12 countries. EEC 6. c EEC 9. b

Sources: Molle, 1991, pp. 42, 46, 179. Robson, 1987, p. 235.

150

1980 23a 52.8c

Appendices to Part VI

151

cent and an increase in employment by 1.3 to 2.3. million (EC, The European Challenge, 1992). While there is a great amount of literature on the benefits of integration, the costs of disintegration have hardly been discussed. In the Soviet Union in 1988, fifteen republics exported to each other on the average 52 per cent of net material product. This is a non-weighted average and the extreme individual cases are Russia with 29.3 per cent and Belorussia with 69.6 per cent (Havrylyshyn, Williamson, 1991). The reported 52 per cent of GMP is equivalent to 42 per cent of GDP. Table 1 shows that 52.8 per cent of 23 per cent share or about 12 per cent of GDP was absorbed by mutual trade of EU members. It follows that the Soviet Union was much more economically integrated than Western Europe. The disintegration of such an economy must have catastrophic consequences. Unfortunately, I do not have reliable data to document this conclusion. Therefore, I turn to Yugoslavia. Absorption of output within each republic, internal shipments to other republics and export to the rest of the world are shown in Table 2. Intrayugoslav trade (26.4 billion $) appears to be 2.5 times larger than export to foreign countries. It follows again that disintegration of the common Yugoslav market will have disastrous consequences for each of the constituent republics. This time I am in the position to ascertain these consequences. The same data are not available for the post-disintegration period for all republics. And even if they were available, they would be highly distorted. Serbia and Montenegro were badly hit by sanctions imposed by international community because of atrocities committed in slaughtering other ethnic groups. Bosnia-Herzegovina has not yet recovered from a devastating civil war. Macedonia was squeezed between Serbia under sanctions and unfriendly Greece that exercised various forms of boycott. Also, Macedonian economy is very small. Only Croatia and Slovenia remained and the relevant data are displayed in Table 3. These data are not strictly comparable because now separate states use different methodologies in their foreign trade statistics. But even so, they will serve our purpose. As soon as the former federal republics separated themselves from the federation, they closed borders, introduced mutual passports and imposed tariffs. None of the governments undertook to estimate the costs of such policies. When compared with the display of nationalist symbols, the costs looked completely unimportant. Even economists did not raise the question. In the same way as Yugoslavia was established seven decades earlier as a unitarian kingdom with complete ignorance about the consequences, so it was now dissolved with equally complete ignorance about consequences. And the consequences have been really disastrous. The mutual trade between Croatia and Slovenia was reduced 2–4 times. Exports to other Yugoslav republics were reduced even more drastically. These reductions were partly compensated by trade with the rest of the world. Slovenia reached the nominal level of 1985 exports by 1996 (Slovenian exports to other republics in 1985, shown in the table, seem to be underestimated). Croatia was unable to reach even the nominal level. In constant 1985 US dollars, both republics achieved significantly lower level of

152

Table 2 Exports in Yugoslavia in 1985 (Billions of current US dollars)

From

Croatia Slovenia Macedonia Serbia Montenegro Bosnia-Herzegovina Yugoslavia a

Croatia

Slovenia

1

2

24.6a 2.1 0.4 2.4 0.2 1.5 31.2

2.6 17.3a 0.3 2.3 0.1 0.9 23.6

Macedonia 3 0.4 0.3 5.7a 1.0 0.1 0.2 7.7

Serbia

Montenegro

4 2.2 1.5 1.0 38.2 0.6 1.8 45.4

Local absorption of shipments. b Intra-yugoslav shipments minus local absorption

Source: Courtesy of Dr Marta Bazler-Madzˇar, Institute of Economics, Belgrade.

5 0.1 0.0 0.1 0.3 1.5a 0.1 2.1

BosniaHerzegovina 6 1.2 0.7 0.2 1.6 0.1 12.9a 16.7

Yugoslavia 1–6 31.0 21.9 7.7 46.0 2.7 17.3 126.6

Rest of the world

Export to the rest of Yugoslaviab

7

8

2.4 2.2 0.5 3.6 0.2 1.6 10.5

6.4 4.6 2.0 7.8 1.2 4.4 26.4

The Theory of International Trade

To

153

Appendices to Part VI Table 3

Exports of Croatia and Slovenia in 1985 and 1996 (Billions of current US dollars)

To

Croatia

Slovenia

Former Yugoslav republics

Rest of the world

Total

1985 1996 1985 1996

– – 2.1 0.9

2.6 0.6 – –

3.8 0.6 2.5 0.5

2.4 6.6 2.2 6.9

8.8 7.8 6.8 8.3

From Croatia Solvenia

Sources: Table 1. Priopcˇenje Drzˇavnog zavoda za statistiku Hrvatske, January 1997. Statisticˇni ured Republike Slovenije.

exports in 1996 as compared with exports eleven years before. Table 3 gives a short summary of market disintegration. Yet this is only part of the story. The contraction of the internal market caused contraction of economic activity. Table 2 shows that out of total internal absorption of $126.6 billion in 1985, only $41.9 billion were generated by Croatian ($24.6 bn) and Slovenian ($17.3 bn) internal markets. Searching for alternative markets involved painful adaptations. Apart from relatively homogeneous commodities, such as wheat, coal and some other raw materials, whose sale is pricedetermined, final products are designed for particular markets and price plays a secondary role. Marketing strategy and trade organization is also market-specific. Any reorientation involves substantial costs. For lack of markets, large enterprises had to reduce their production, some even closed the door. As a result, not only total output contracted, but also unemployment increased to a degree not known at any time before. Slovenia and Croatia proclaimed their political independence in 1991. Macedonia and Bosnia-Herzegovina followed the next year. But even before political separation, market began to disintegrate due to various trade restrictions introduced by Serbia. That provoked retaliation by others. For this reason, I shall take 1986 as the base year. The following picture emerges: After eleven years, industrial output reached only 52 per cent in Croatia and 70 per cent in Slovenia of the output produced in 1986. Unemployment increased enormously. However, the eight-fold increased in unemployment in Slovenia is somewhat misleading because in 1986 there was almost no unemployment. The comparison of the estimates of GNP increase of 3.2–5.7 per cent due to the creation of the European Common Market and the actual decrease of industrial output of 30–48 per cent after the dissolution of the Yugoslav common market indicates unambiguously that market disintegration generates much stronger effect than market integration. Table 3 and 4 indicate that the life effort of at least one whole generation was wasted in Slovenia and Croatia. The two countries reached the prewar West European level of development in the early 1960s. Thus the

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The Theory of International Trade Table 4

Industrial output and total unemployment (indices) Manufacturing

Slovenia Croatia

1986 100 100

1990 86.8 89.3

Unemployment 1996 70.4 51.6

1986 100 100

1990 314 131

1996 801 203

Sources: Gospodarska gibanja, January 1997. Statisticˇki ljetopis 1996 Mjesecˇ no statisticˇko izvjes`ce, January 1997. development lag was shortened to less than one generation time and since then the two countries have been developing appreciably faster than the members of the European Union. Since 1986 they have been lagging behind and now they are close to the starting position of 1960s. The economic disaster of Croatia and Slovenia cannot be explained by the loss of markets only. At least an equally important role was played by the restoration of capitalism – euphemistically called ‘transition’ – in a labour-managed economy. But that story lies outside the scope of the present study.

Appendices to Part VI 2

155

ECONOMIC INTEGRATION OF EASTERN EUROPE

The Project Bridge This essay was published in 1992 in the Journal Economic Analysis and I have not made any changes in order to preserve its quality as a historical case study. At that time the European Community was in existence and I called the projected organization the ‘European Union’. In the meantime the European Community has been transformed into the European Union but I have not changed my appellation in the text and the two Unions should not be confused (though they may merge at some time in the future). The course of events has not followed my projected path so far. Nevertheless, several attempts at economic integration have been undertaken: the Central European Free Trade Area (CEFTA) was created in 1992 by four countries, a certain number of countries got together around the Central European Initiative and Southeast European Co-operative Initiative (SECI) was launched by the United States in 1996 (12 countries) but so far has only been lukewarmly accepted by the states concerned. The EU will begin negotiations for admittance with several countries on my list which may last another ten years. No definitive solution has been reached as yet. In the main text problems of Common Market and Monetary Union are not discussed. They are discussed in this Appendix in the form of a practical application to a contemporary situation. If the study were written today, no great revision would be necessary. True, Czechoslovakia and Yugoslavia disintegrated. But that only makes the need for integration more urgent. I would probably now include Ukraine as a candidate for the Union, thus increasing the market to 236 million consumers. With the benefit of hindsight, the predictably unsuccessful competition of individual countries for admittance to the West-European integration looks rather unfortunate. If they followed the course described in the study, they could have avoided seven years of falling output and mass unemployment and several future years of weak recovery. Yet they still have a choice of a more efficient policy. I

Introduction

Prompted by the Prague Spring in 1968, I initiated explorations of the possibilities of economic integration of Eastern Europe as a part of our research in the Institute of Economic Sciences in Belgrade. After a few months Czechoslovakia was occupied by Eastern Block forces and the initiative came to nothing. It seems that today the circumstances are more favourable. Four large markets The contemporary world knows four large economic concentrations (which also means the concentrations of economic power). They are

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The European Community The United States The ex-Soviet Union Japan

Inhabitants million

Area ‘000 km2

341 246 276 123

2366 9373 22228 372

The magnitudes of internal and external market appear to follow the same order. For our purpose of particular interest are two economic unions: the European Community and the ex-Soviet Union. In a sandwich between the two are 13 loose countries, mostly economically disintegrating and belonging to nowhere. The European Community consists of twelve countries ordered according to the size of population in Table 1. Years in parenthesis are years of joining the Community. The original six countries of the Treaty of Rome were later joined by three EFTA countries in 1973 and still later by another three countries. Thus, in the 30-year period 1957–1986 the Community increased its membership twice and at the moment several other countries are waiting to be admitted. Its present members fall into two groups: four large and dominating countries and seven small countries, with Spain in between. Three years later, in 1960, the free trade area EFTA was created. Out of its seven original members, three joined the Community in the meantime, and two additional members joined EFTA. The group is now composed of six countries, all of whom intend to join the Community. These are highly developed countries, each having a large area but a small population (Table 2). It must be borne in mind that EFTA imports from EC 60 per cent of its imports and EC from EFTA only 10 per cent (Nevin, p. 310). The main reasons why EFTA countries did not join the Community in 1957 right away were political. The countries were either neutral or socialist and being small (except for Great Britain, which presided over a commonwealth) feared the domination of large countries and the undue pressure on their sovereignty. The fifth large market Outside the two groups mentioned – in the near future, only one group – there are a number of East European countries, mostly the former communist countries. Not all of them are East European (Czechoslovakia, Malta and Cyprus are not) and not all East European countries are included (the former Soviet Union members are not). Anticipating the later analysis, I shall call this group the European Union . Its composition is shown in Table 3. The group consists of diverse countries, but in terms of size and devel-

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Appendices to Part VI Table 1

Members of the European Community in 1988 Inhabitants million

Area ‘000 km2

78.0 57.4 57.0 55.9 39.0 14.8 10.4 10.0 9.9 5.1 3.5 0.4 341.4

357 301 244 547 505 41 92 132 31 43 70 3 2366

Germany (1957) Italy (1957) Great Britain (1973) France (1957) Spain (1986) Netherlands (1957) Portugal (1986) Greece (1981) Belgium (1957) Denmark (1973) Ireland (1973) Luxemburg (1957) European Community Source: SGJ–1990 Table 2

Sweden Austria Switzerland Finland Norway Iceland EFTA

The remaining EFTA countries in 1988 Inhabitants million

Area ‘000 km 2

8.4 7.6 6.5 5.0 4.2 0.3 32.0

450 84 41 337 324 103 1339

Source: SGJ–1990 opment it is more homogeneous than the European Community. Turkey and the Balkan states belonged to a common state a century and a half ago. Besides, half of Turkish industry is state-owned, which brings its problems closer to those of ex-communist countries. The Danube states belonged to a common state until the First World War. Turkey and Yugoslavia are somewhat less developed than the group average, but they more than compensate for that drawback by their experience in market economy. The only handicapped countries are Albania and Romania which are both less developed and lack market experience. So they may be singled out for special treatment. Turkey applied for membership in the European Community in 1987, but is not likely to be admitted in this century. There are two reasons for

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Members of the prospective European Union (in 1988)

Turkey Poland Yugoslav states Rumania Czechoslovakia Hungary Bulgaria Lithuania Albania Latvia Estonia Cyprus Malta European Union

Inhabitants million

Area ‘000 km 2

52.4 38.0 23.6 22.7 15.6 10.6 9.0 3.7 3.1 2.8 1.6 0.7 0.4 184.2

781 313 256 238 128 93 111 65 29 64 45 9 0.3 2132

Source: SGJ–1990 that: considerable underdevelopment compared with other European countries and the conflict with Greece. The latter, being already a member of EC, can use its veto power to prevent Turkey joining. The same reasons apply to Cyprus. However, Turkey, Cyprus and Malta are at present the associate members of the EC. In December 1991, Czecho-Slovakia, Hungary and Poland also became associate members. The association agreements envisage a free trade area to be established over a period of up to ten years. The co-ordinating institutions are the Association Council (which has decision-making powers, the Association Committee and the Association Parliamentary Committee (composed of members of the European Parliament and of the parliaments of the associated countries). But the negotiations showed that these countries cannot hope to become members of the European Community in the next decade. In short, none of the countries in the group can expect to be admitted before the end of the century. Ex-communist countries were members of the Council on Mutual Economic Assistance, and, thus, economically tied to the Soviet Union. The collapse of trade with the Soviet Union accounts for a large drop in output. According to the IMF’s World Economic Outlook, the 1991 decrease in exports to former CMEA members is expected to be 35–45 per cent for Hungary and the Soviet Union, 50–65 per cent for Bulgaria, CzechoSlovakia and Romania and 75 per cent for Poland. Bulgaria is most vulnerable because 70 per cent of its 1990 exports went to CMEA partners. Thus we are likely to have a Europe in which the rich West European uncle will be surrounded by a number of weak and poor cousins continuously begging for help. The alternative scenario is that the cousins form

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their own Union and speed up their development, relying on their own resourcefulness. This solution is advocated in the present paper. Instead of waiting helplessly, the Union can be established right away. There can be little doubt that the interests of the EC also require that the partners be an orderly group and not a number of countries with whom the EC must deal individually. The more organized and the faster expanding a nearby market happens to be, the better. On the other hand, the EC cannot contemplate accepting new members without changing substantially its internal organization. If Presidencies rotate every six months, twelve members mean that a national member will preside every sixth year; adding six former EFTA members, this interval increases to nine years. Additional members render the institution of presidential rotation meaningless. The veto power is possible with small membership; it stifles operational efficiency if the membership is large. The European Court of Justice cannot handle the incoming cases already with the present membership of the EC and therefore in 1989 the auxiliary Court of First Instance was created. In short, a confederate organization is applicable to a small number of sovereign states. A large membership requires a federation. And, obviously, the EC and, even less, the East European countries are not ready for a federation. Geographically and economically, the candidates for the European Union find themselves in a sandwich between East and West, belonging properly nowhere. They are not ready – institutionally or otherwise – to enter the European Community and the latter is not in a position (no good will can help) to absorb them. They are not willing to join the ex-Soviet market and so recreate the CMEA and the ex-Soviet Union countries are not able to create market institutions fast enough and engage in an integration process in their present situation of great political and economic instability. Unless they are content to remain second-class Europeans, the Union candidates have only one option open to them: to create a fifth common market. Besides, this option is in the interest of all parties. Once created, the European Union can engage in a noble competition with the EC in safeguarding human rights, in establishing a modern democracy – political and economic – in developing productive forces and national cultures and also competing in ingenuity of solving the present and future social problems. When sufficiently developed, the Economic Union may incorporate the Soviet Union (as EC will do with EFTA), or may join the European Community or do both. In that sense it represents a bridge between West and East. There is even more than that. Dariusz Rosati rightly points out that ‘. . . what must be offered to the region is not a scheme for maintaining existing trade partners, but a mechanism allowing for smooth restructuring of eastern economies over a longer time horizon’ (p. 23). The region needs the creation of market institutions, replacement of obsolete technology, restructuring of distorted market structure and adjustment to a new economic environment. All this can be achieved immensely easier if production potential is preserved and the rate of growth is high. Stagnant production generates unemployment and social upheavals and renders necessary changes extremely painful. As in post-war Europe, satisfactory

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recovery and development cannot be achieved on a bilateral basis. A coordinated regional effort is needed and it should encompass institutional reforms and production programmes. Co-ordinating institutions of association agreements with the EC are a welcome first step. Yet, that is by far not sufficient. What really has to be done is to create a regional organization with an appropriate “Marshall Plan”. The former problem is discussed in the next chapter. The latter one is left for another occasion. II The Organization The Principles of Organization Different historical circumstances require that the main organizing principles be somewhat different from those of the EC. I suggest the following. 1. Since most countries in the area have only gained full political independence, the political sovereignty ought to be extolled in order to make the Union attractive. Besides, differences in cultural, political and economic experiences require a longer adjustment period. Therefore at first common political activities ought to be reduced to a minimum. 2. The countries must also be left economically independent in all matters not strictly regulated by the needs of the common market. Thus economic policy (monetary, fiscal and other aspects) remains national. This will also have educational effects. On the one hand, one learns most quickly from the own experience and the market discipline is not easy to learn. On the other hand, if you are left on your own, there is nobody to blame for failures. However, if help is asked, it must be available and forthcoming. 3. Full use must be made of the EC experience. This means that the system of standards and well functioning regulations will simply be taken over. This will not only speed up the organization process but will also make the solutions less controversial. This principle makes sure that the convergence of the two unions takes place rather quickly. 4. There is no need to insist on uniformity (as usually in the EC). The Union ought to be asymmetric in order to enhance flexibility and reduce resistance. At least three subgroups of countries may be distinguished: Czechs, Moravians and Slovaks will probably continue to live in a federation and will so join the Union; the Yugoslav states are readier for a higher level economic and cultural integration and one or two other Balkan state may join; the third separate block consists of the Baltic states. A certain minimum amount of regulations will, of course, be common for all states. Above that minimum various degrees of structuring are possible. The degree of integration may differ and some members will progress faster, the others at a slowlier pace and each member country can select some of the Union’s policies but not the others. This makes life somewhat more complicated, but the needs of various national groups will be more fully satisfied and the progress of the entire union will be faster.

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The Main Institutions Common activities determine the profiles and the structure of institutions and they are not unlike those of the EC. Where the functions are the same, I propose to use the same names. The fourfold division of power makes the following political institutions necessary: 1. The Council of Ministers corresponds to a government and functions as the same body in the EC. The Council makes binding decisions. In principle the majority vote is used. It becomes a qualified majority for important matters and unanimity is used exceptionally, for very important matters. 2. The Commission corresponds to a civil service: it makes proposals, initiates solutions and implements the decisions. It takes care of revenues and disbursements. It is also the guardian of the legality of decisions. While the Council is a political body, the ministers being responsible to their national governments, the Commission is a professional body; the commissioners are nominated on the basis of their professional competence and are responsible to the Union. 3. The Union Court of Justice adjudicates the conflicts among the member states and also among the employees of the Union. It is proposed that the existing European Court for Human Rights extends its activities to the Union as well and so becomes the single court for the entire Europe. 4. It was suggested earlier that common policy be restricted at first and so the Union Parliament will in the beginning be primarily an advicegiving body and an instrument of communication among the member states, not a true legislative body. For this purpose it may be constituted out of delegates of national parliaments. Three economic institutions are also necessary: 5. The European Monetary Institution, in fact a bank of central banks, will at first be primarily concerned with the stable value and convertibility of the common currency. As the integration progresses, EMI will gradually assume other responsibilities of a central bank whose task is to establish and preserve the short-run economic equilibrium. 6. The European Development Bank will at first be primarily concerned with the regional balancing of employment and development. When fully developed, it will be entrusted with regulating the long run equilibrium. Like the European Investment Bank, it will have a high credit standing and therefore be able to borrow and re-lend at interest rates substantially lower than those the depressed areas are able to obtain at the market on their own account. As always, economic concentration, made possible by the formation of the EU, reduces risks. 7. Buffer stocks in agricultural and industrial raw materials. Agricultural production is (a) subject to weather shocks, (b) has a relatively long production period which always begins at the same date and (c) most of the products have low price and income elasticities. For these reasons

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cobweb cycles are likely to develop with prices and producers’ incomes wildly fluctuating. In order to achieve stabilization, an agricultural Directorate must be set up; it will take care of price regulations and buffer stocks. Similarly, another Directorate for some industrial raw materials, which experience frequent fluctuations (copper, zinc, tin, petroleum), may stabilize their prices. Directorates will buy when the world prices are low and sell at a fixed price when they are high and finance their activities out of price differences. It is well known that an increase in the volume of transactions decreases the relative volume of inventories. The same applies to the volume of buffer stocks. Of common economic interest are also transport, energy, industrial policy, tax harmonization, research and development, social and environmental policy. All these aspects of integration require adequate solutions. In the present text, I am concerned only with customs and monetary unions. III The Customs Union The levels of integration The lowest level of integration is a free trade area. EFTA is an example restricted to industrial products. Tariffs among the member countries are abolished while national tariffs against the third countries remain. If the national tariffs substantially differ, it is difficult to administer such an arrangement without inviting speculation. An importer may avoid national tariff barriers by importing over a territory with lower tariffs and re-exporting to his own country. The next level of integration is the customs union. It is free trade area plus common tariffs. Since the destination of goods does not necessarily overlap with the importing country, tariff revenues cannot accrue to the importing country but must be sent to the center. The centre then (a) either distributes the revenue to the member countries or (b) uses the revenue to finance the own budget. The latter solution is now used by the EC and the same is suggested for the EU. Some impediments to free trade are still left over. These are the socalled non-tariff barriers (licences, quotas, foreign exchange controls, customs procedures, safety regulations, indirect taxes). The elimination of such barriers is the precondition for the common market. A common market also implies the free movement of labour, the free establishment of firms on the entire territory and the free movement of capital. Until the nontariff barriers are removed, it is impossible to eliminate the internal state frontiers. It has been estimated that non-tariff barriers in the EC applied to 20.8 per cent of the imports in 1966 and to 54.1 per cent (as against to 43.5 per cent in Japan and 35.0 per cent in the USA) in 1986 (Laird and Yeats, 1989, p. 13).* * The non-tariff barriers are several times higher for agricultural goods than for manufactured ones, and that might be of great significance for countries such as Yugoslavia, Bulgaria, Hungary and Romania, i.e., for large agricultural producers. In 1985 shares of imports subject to non-tariff barriers were:

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Consequently, their significance was rising instead of falling, and this is likely to happen in the EU as well. The total cost of impediments to trade in the EC is estimated to be 3.5 per cent of value added (Kovaˇ c, 1990, p. 4) which may be compared with the administrative cost of the Community of 0.1 per cent of GDP (Nevin, 1990, p. 244). The customs union and common market are compatible with separate national currencies, inflation and changes of the exchange rates. For an orderly conduct of economic transactions it is necessary to establish a monetary union. The monetary union may be established even before the common market is fully developed. In fact, the common market cannot function well without some sort of the monetary union and vice versa and therefore the two forms of integration must be developed simultaneously. Finally, the harmonization of policies involving the flows of goods, services, labour and capital and also of monetary and fiscal policies leads to the economic union. This is the end of the integration process when the member countries cease to function as independent economic units. The European Community finds itself between common market and economic union. It is suggested that the European Union starts as a customs and monetary union. The formation of the customs union There are a number of false perceptions about the creation of the customs union. For instance, it is said that a free trade area is more beneficial to an efficiency-raising competition because the more efficient countries can retain low tariffs, while in a customs union tariffs have to be raised because the common tariff must also protect the least efficient member. Next, it is claimed that an etatist economy cannot be opened because most of the enterprises will be unprofitable and operate with losses. Also, that low tariffs require a drastic restructuring of the economy with many bankruptcies and great unemployment. It is also held that a free trade area can be established rather quickly, while a customs union will require a long period of adjustments. Let us take a closer look at the problems involved. Figure A-1 depicts the typical situation of a member of the prospective union. The distribution curve of firms according to the profitability is somewhat asymmetrical. The tail of very profitable firms is longer than the tail of those making great losses. Because of an overvalued currency, many

Agricultural goods Manufactured goods

European Community 37.8 10.1

United States 11.5 5.8

Japan 33.8 5.4

(Kenen, p. 232) Tariff rates are also higher for agricultural products, and this combined protection renders their internal prices substantially higher. In 1980–82 domestic producer prices for the weighted average of agricultural goods were higher compared with world prices 1.54, 1.16 and 2.44 times in the EC, USA and Japan resp (Kenen, p. 238).

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The Theory of International Trade Number of firms of equal size

Loss rate

S

T

Figure A-1

O’

O

Profit rate

The profitability distribution of firms

exporting firms will appear unprofitable. They will inflate domestic prices in order to finance part of export losses and will, thus, become even more unprofitable in terms of foreign currency. A devaluation will increase the profitability not only of exporting firms but also of import-substituting firms, because in both cases foreign market prices in terms of domestic currency increase. Consequently, a devaluation will shift the vertical axis to the left in Figure 1 and most firms become profitable. Not artificially but really, because it is in the nature of things that in any growing economy most of the firms must be profitable. The very profitable firms (the right tail) represent no problem. An adequate taxation of non-invested profits takes care of the problem. The devaluation rate may be determined so that the major exporting industry (e.g. tourism in Yugoslavia) becomes just profitable on the average without any customs protection. Under some circumstances an export tax may be levied. There is no unique ‘natural’ distribution of profitability. If the aggregate business saving is increased, a certain number of marginal loss-making firms will become profitable. An increase in aggregate business saving is possible if total saving remains the same and government saving is reduced by a decrease in taxes or total saving is increased by lowering wages. Under constant prices, accumulation increases in the first case and cost of production decreases in the second one and in both cases the vertical axis will shift to the left. We are left with the left branch of the distribution curve. The real tariff problem is not that the average tariff is high – a devaluation can always lower it at the desired level – but that the spread of tariff rates is great. Therefore many countries use multiple exchange rates. In Yugoslavia the market reform was initiated in 1952 and the multiple exchange rates were abolished only in 1972. For this reason common tariff will not eliminate all unprofitable firms but only TO’ of them. One must also bear in mind that relatively small nominal tariff rates

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Table 4

European Community United States Japan Nominal Effective Nominal Effective Nominal Effective Food, beverages and tobacco Apparel Footwear Furniture and fixtures Glass and glass products Iron and steel Electrical machinery

10.2 13.4 11.6

17.8 19.3 20.7

4.7 22.7 8.8

10.2 43.3 15.4

25.4 13.8 15.7

50.3 42.2 50.8

5.6

11.3

4.1

5.5

5.1

10.3

7.7 4.7

12.2 11.6

6.2 3.6

9.8 6.2

5.1 2.8

8.1 4.3

7.9

10.8

4.4

6.3

4.3

6.3

Source: Kenen, p. 166. Table 5

Average tariff rates for classes of commodities

Raw materials Semi-manufactures Finished manufactures All industrial products

European Community

All industrial countries*

0.2 4.2

0.3 4.0

6.9

6.5

6.6

7.1

* The EC, the EFTA countries, Canada, Japan and the United States Source: IMF, Table 49. may represent quite large effective protection. Table 4 indicates rates negotiated in the Tokyo Round for specific products. Differences between nominal and effective protection are due to the fact that inputs are taxed less than outputs which enlarges the share of final outputs value added protected. Here are some representative data. After the Tokyo Round (1979), tariff rates of industrial countries were lowered by one third and their structure for industrial products is given in Table 5. Consequently, there is a plenty of scope for the design of a tariff structure which, combined with a devaluation, will preserve the profitability of many enterprises. Should the firms left of T go bankrupt? Not at all! Some of them – or, perhaps, many of them – may be made profitable if the really unprofitable

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parts (public restaurants, residential houses, antiquitated shops or those based on non-existing raw materials) are eliminated and the sound parts of the firm be given an opportunity to reorganize. In principle no established firm (except those conditioned by nature) is unprofitable as such. What makes it unprofitable is (a) a wrong production programme, (b) overemployment and (c) bad management. All three deficiencies can be corrected. And the correction means the stimulation of entrepreneurship. It is therefore equally wrong to open the economy suddenly, without an adjustment period, and leave many firms go bankrupt and many workers lose their jobs in the name of ‘restructuring’ – as it is to set up a high tariff wall and do nothing. There is yet another component of the complex economic situation which must be taken into account. It may be denoted as a transient unprofitability or temporary losses. At any one time in any economy some firms suffer losses. They are larger during depressions and are greatly reduced in boom periods. Let me illustrate this observation by Italian data. According to a Mediobanka a survey of 1743 important private and public industrial and service enterprises in 1989, 16.7 per cent suffered losses which amounted to one-third of profits of profitable enterprises. In the public sector losses were greater than profits, in the private sector losses amounted to 12.7 per cent as compared with profits. In Yugoslavia, before the outbreak of civil war, about 40 per cent of all enterprises were loss-making. That was not due to their inherent unprofitability but to a prolonged deep recession. If production is reduced, unit costs increase because of contractual overheads (Horvat, 1991). Consequently, many enterprises will become automatically profitable as soon as demand increases and they are able to use full capacity. And that is exactly what the proposed Union may help to achieve. It appears that the main task is to prevent the destruction of productive forces. Or (which is the same thing) to achieve their full use. The firm must be kept operating and the workers employed. Here we encounter a great difference between the EC and the EU. The EC was concerned with competition and gradually harmonized market conditions. It does not move before the firms are in equal position. The EU is concerned with survival and it moves ahead just because the market conditions are too different. Therefore it must apply measures which sound like a heresy to the EC (cf. article 92). The profitability of the loss-making firms will be established by tax reliefs and national (not Union!) subsidies. The subsidies may be financed out of purchase tax levied on final consumption goods. The EC countries have gradually introduced the value-added tax which for administrative reasons is not practicable for the EU countries for the time being. But the purchase tax can closely approximate it. The tax cannot be too different from a similar tax elsewhere in the Union because differences in consumer prices will invite destabilizing speculation and attempts to evade the tax. The widely differing (usually more than five per cent) taxes on consumption (turnover and consumer taxes and excise duties) are reasons for tax borders: taxes must be paid where the goods are consumed and tax evasion and the diversion of trade must be prevented.

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Appendices to Part VI Production policy

F

E q0

A

D 0

Figure A-2

π0

Nominal and real exchange rate

General Equilibrium with Internal and External Balances

Granting subsidies belongs to infant industry argument. In the context of that argument, there is even some theoretical justification for giving subsidies instead of imposing tariffs. In an optimum situation, the foreign rate of transformation must be equal to the domestic rate of transformation and the latter must be equal to the domestic rate of consumer substitution. An infant industry operates at higher cost and so one equality is lacking: DRS = FRT DRT. The equality cannot be established by a tariff, but it can by a subsidy (Södersten, p. 579). The criterion of granting a subsidy may be the following one. If a firm covers its variable costs and contractual overheads and also covers a part of the wage bill (assuming unemployment), it is entitled to a subsidy which will keep it going. The criterion may be formulated in a somewhat more general way: As long as effective protection is less than 100 per cent, it is justified during severe unemployment. Naturally, subsidies are a transitional measure. They represent a financial burden for national governments which will tend to get rid of them. If the process is too slow, common measures at the level of the Union may be taken. Or it may be agreed in advance how long subsidies will be tolerated. The end result is equal competitive positions of firms. After all these measures are taken, a small number of firms making large losses will remain left of S. They may be freely left to go bankrupt because they can in no way contribute to economic development. The preservation of viable enterprises is not identical to the establishment of internal (full employment, stable prices) and external (no foreign exchange deficits or surpluses) balances. The subject deserves a separate study and there only some essential points can be mentioned. For that purpose I use a slightly modified diagram introduced by Swan (1963).

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The vertical axis represents increasing production stimulated by monetary (interest rates) and fiscal (taxation) policies. Swan and others speak of expenditure policy, but in the East European situation it is production (‘supply side’), not expenditure, which needs guidance. The horizontal axis indicates exchange rate defined as a domestic price of foreign currency. Nominal and real exchange rates are equal because domestic prices do not change when the internal balance is kept undisturbed. Along the curve D, domestic market maintains internal balance. The devaluation of currency makes domestic production cheaper, and imports more expensive. Production increases because exports increase and imported goods are partly substituted by domestic ones. Since full employment along D is assumed, increased pressures on production would produce inflation and have to be offset by more restrictive production policies which makes curve D slope downwards. Along curve F, foreign trade is kept in balance. It is assumed that the net capital inflow is zero. The same depreciation of currency improves the current-account balance. In order to prevent trade surplus to appear, production is stimulated which leads to increased import. Therefore, the F curve is upward sloping. At E the policies are such as to establish internal and external balances simultaneously. Somewhat schematically, the point E may be interpreted as the general equilibrium under normal conditions. East-European countries are far from that position having been subject to great economic and political shocks. A typical country finds itself at point A: unemployment is severe, therefore A is below the curve D, and trade deficit locates A about the curve F. In order to reach E, the country must devalue, moving thus towards the curve F. This is the same devaluation (not identical with π o.) which will move vertical axis to O in Fig. 1. The country must also have a stimulating production policy which will move it towards the curve D. This implies low interest rates, low direct taxes, a proper structure of tariff rates and subsidies (point T and S on Fig. 1). That leaves public services to be financed out of indirect taxes. The initial imbalances will be corrected by quantitative restrictions. If all member countries reach the point E, the Union as a whole will be in general equilibrium. But that is not a necessary condition. The external balance for the entire Union may be achieved while the individual countries have trade deficits and surpluses; they need to cancel out in sum. Even that condition may be relaxed. The entire trade consists of intra-country, intra-Union and extra-Union trade. It will be shown later that not only the intra-country but also the intra-Union (among the member states) trade is always balanced. Thus, in the absence of compensating capital movements, all we need is that the sum total of Union exports and imports be balanced. That provides an enormous help for a speedy recovery of individual national economies. It is obvious that there is no need to wait until the market situation become equalized. It needs to be made equal. This means that the Union can be established immediately. The average tariff may be set at a low level, preferably at that of the EC (spread of the rates 0–30 per cent, average tariff 5 per cent), and not calculated as an arithmetic mean of national tariff rates as it was done in the case of the EC. The levies on

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169

agricultural products will certainly be lower. The whole operation will last no longer than two years. In the first year national tariff rates may be lowered by 50 per cent (some may be even increased) and in the second year they may reach the prescribed level of the common tariff. In the EC it took ten years before common tariff was established, and in EFTA seven years before internal tariffs were abolished. Economic Effects Kindleberger enumerates seven effects of a tariff. They are: (1) the protective effect; (2) the consumption effect; (3) the revenue effect; (4) the redistribution effect; (5) the terms-of-trade effect; (6) the employment effect and (7) the balance of payments effect (p. 213). Naturally, all these effects will affect the tariff union as well. I leave out the last effect, which will be discussed within the context of the monetary union. The most important other effects are included in the discussion of the tariff union. Following Jacob Viner (1950), textbooks speak of trade creation, when a high cost domestic producer is replaced by a more efficient partner in the union, or trade diversion, when the former cheaper source of supply remains outside the union and the common tariff diverts trade to a more expensive source of supply inside the union. A special form of trade diversion is a trade suppression, when the total volume of trade falls as domestic output increases. Edward Nevin formulates a couple of generalizations (pp. 72–75, see also Södersten, 1970, pp. 430–43). In a low tariff union the formation of the union may benefit the group but injure individual members. The high tariff union may be trade-suppressing. A beneficial consumption effect (increase of consumption because of the fall of prices) is more likely the higher the initial external tariff (because price reduction will be greater as duty-free import is forthcoming from member states) and the higher is the price elasticity of demand. Beneficial production effects (high-cost domestic production displaced by cheaper imports) are more likely the higher the initial tariff and the greater the domestic elasticity of supply of the product. Adverse diversion effects are reduced if the number of countries increases and the more similar is their production structure (because there is less possibly to divert trade from a third country). If substitution in consumption takes place, a customs union can improve welfare even with trade diversion. It may be added that a customs union will favour trade creation if there are wide differences among union members in the cost of producing certain commodities (Hazelwood, p. 743) and if the union is large (Siebert, p. 672). The geometry of foreign trade may seem interesting, but it is concerned with static welfare effects whose magnitude is empirically largely irrelevant. It is estimated that the net trade (diversion and trade suppression losses having been deducted) creation of the EC amounts to 4–5 per cent of the growth in potential demand. Yet the welfare gain (measured crudely by consumer and producer surpluses) amounts to only 0.15 per cent of national income in 1970 (Nevin, pp. 101 and 104). That generally corresponds to the effects of price distortion so elaborately discussed in neoclassical

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textbooks (Leibenstein, 1966). And just because price distortion is so unimportant, the previously mentioned subsidies cannot do much harm. Static effects are small and once-for-all. Dynamic effects are more substantial and occur continuously (they are estimated at one per cent of the national income of the EC, Nevin, p. 108). For policy purposes, the only thing that matters is whether production increases because of changes in trade. For, the higher rate of production growth leads to full employment and the higher rate of welfare improvement for everybody. The view that trade is instrumental and not an objective in itself has been generally accepted though somewhat inoperationally formulated: ‘The normative theory of international monetary arrangements begins with discussion of the objective function, which may be called a world welfare function . . . this is generally agreed to include the usual objectives of high employment and economic growth as well as price stability. Growth of international trade, and hence reduction of trade barriers and restrictions on currency convertibility, is generally agreed to be instrumental in achieving these ends . . .’ (Black, 1181–82). However, it may be shown that, in order to maximize economic welfare it is sufficient to have a single objective, the maximization of economic growth (Horvat, 1958, 1965). The following most important effects of the formation of tariff union may be enumerated: 1. The elimination of tariffs increases mutual trade of member countries creating a large market which makes possible specialization and other effects discussed below. In the thirty years, from 1958–1988, the intraEC trade increased from 30 per cent to 59 per cent of total trade. By mid-1960s, the trade between EFTA members had risen to 40 per cent more than would have been expected in the absence of free trade arrangements (Nevin, pp. 354 and 309). Most of this increase represents trade diversion. As a federation, Yugoslavia is a sort of a customs union. Its interstate trade is almost two times larger than exports to other countries (30 against 18 in terms of shares in GNP). The exSoviet Union is much larger market and so these interdependencies are even higher. Typically Soviet republics export to each other more than 40 per cent of Net Material Product, and export abroad less than 7 per cent. The only exception is Russia – an enormous market itself with a population of 148 million – where the respective percentages are 18 and 8.6, but even here is interstate trade two times larger than exports abroad. 2. Traditional economic theories explain trade by differences in industrial structure. They cannot explain intra-industrial trade. Yet the proportion of trade within industries rather than between them has grown significantly over time. Balassa and Bauwans have examined 38 countries and 152 product groups in order to establish factors affecting levels of intraindustry trade between pairs of countries. They found out that this trade is enhanced by the membership in a common trade block, by similarities in income levels (similar tastes), by low trade barriers, by common borders (low transportation costs), and by common language (better information) (Kenen, p. 130). All these factors

Appendices to Part VI

3. 4. 5. 6.

7.

8.

9. 10. 11. 12.

171

are operative in the prospective European Union. Greater volume of intra- and extraindustry trade make for increased assortment of goods offered to consumers. Automatically balanced intra-Union trade and more easily achieved external balance in the extra-Union trade speed up recovery now and increase growth in future. As the size of the market increases many times, there is a plenty of scope for the economies of scale of all sorts. A combined bargaining power of a customs union makes possible gains from the terms of trade. Tentative estimates indicate that such gains are 0.3–0.9 per cent in the EC. A large market stimulates competition which in turn stimulates efficiency. It also makes possible more intensive research and development which foster efficiency. That may not be so important at a low level of development because those few sophisticated products needed are simply imported. At the European level of development, own research is indispensable. A larger and growing market makes it possible to solve more easily the problems of some ailing industries (shipbuilding, steel, textiles). The demand will be forthcoming and no drastic measures are necessary. Also, regional disparities can more easily be corrected if the rate of growth is sufficiently high (the transfer of resources is not felt by the consumers of developed regions). In the early 1980s in Yugoslavia almost two-thirds of all contracts with foreign partners prohibited export of products manufactured with imported technology. Once the domestic market becomes many times larger, products may be sold without the breach of contract. Larger market and trade creation stimulate the fuller use of capacity and larger investment leads to a higher rate of growth. As a consequence, unemployment will be more easily eliminated. Large market attracts foreign productive capital and reduces the brain drain. The common use may be made of scarce highly skilled professionals in designing the economic policy. It is well known that qualified economists are almost nonexisting in the ex-communist countries. Theres is also an extremely important non-economic effect. An international union is conducive to a greater international tolerance. The latter, in turn, helps in establishing greater internal democracy and political stability.

It may also be argued the other way round. In the presence of a large economic concentration, such as the EC, individual countries will suffer the twelve negative effects. These negative effects may spell economic disaster if a country remains isolated. It has been estimated that the nonexistence of the EC would have increased the Yugoslav export to the member countries by 48 per cent. As soon as a particular country joined the EC, its share in the Yugoslav export diminished (Kriz ˇani´c, pp. 41, 28).

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IV The Monetary Union A monetary union is more delicate and professionally much more difficult undertaking than the customs union. There are no cut-and-dry solutions and initial organization depends very much on the initial situation of the ex-command economies. The international trade increases faster than output, and money flows over the national borders expand faster than goods and services. The simple gold standard has been replaced by elaborate international regulations of money flows. National monetary authorities are less and less able to influence the volume of money, or the national exchange rates or to control banking systems. It would seem, therefore, that the appropriate approach is to regulate centrally the money flows for the entire Union. Bearing in mind the political will to become as independent (sovereign) as possible, that would be a misleading approach. Monetary policy – together with other macroeconomic policies – will be left to national states (which will, no doubt, be forced to cooperate, but the initiative must be forthcoming on the basis of failures experienced), and the Union will assume certain restricted responsibilities in the area of international trade, complementing, thus, the customs union. The organization must be openended so that new initiatives may be easily incorporated. The European Monetary Union The European monetary integration passed through three stages. Immediately after the Second World War, European currencies were not convertible. International payments were effected through a network of bilateral agreements that had built-in credit lines. Import–export balances were settled on a monthly basis in national central banks bilaterally by building up credits and debits until the limit of each credit line. After the limit was reached, the debtor had to pay gold or dollars to the creditor. In order to facilitate international payments, a multilateral scheme was put into operation in 1950. That was the European Payments Union which used the Bank of International Settlements to collect and consolidate monthly balances of national central banks and convert them into a single number for each member country. Thus, each country need not settle its balances with each other country but only with the EPU. Initially, cumulative deficits and surpluses were settled in decreasing proportions of credits and increasing proportions of gold until quotas were exhausted. After that all deficits were paid in gold, and 50 per cent of surplus was financed by credits. After 1954 a flat rate of 50 (later 75) per cent was used for both deficits and surpluses.1 In order to enhance international liquidity, Marshall Plan put $350 million into the EPU. 1

Peter Kenen examines how such an arrangement would work for the CMEA countries and finds that it would break down because the Soviet Union would have a permanent surplus, and almost everybody else an equally permanent deficit. He is inclined to conclude that direct convertibility of currencies may do the job better (Kenen, 1991). On the other hand O. Havrylyshyn and J. Williamson strongly recommend the creation of a payments union modeled on the EPU (1991).

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173

In 1958 West European countries achieved convertibility of currencies and that marks the beginning of the second stage of monetary integration. Exchange rates of member countries were fixed and were allowed to float mutually within a narrow band of 0.6 per cent, which was widended in 1972 to 1.125 per cent or to one half of the IMF range. The arrangement was called a snake and a credit facility was set up to assist the banks to preserve the snake. The snake survived only a couple of years. In 1979, when European Monetary System was created, a more flexible arrangement was established whereby the fluctuations were linked to a single common currency, the ECU, whose value was a weighted average of member states’ currencies. The ECU is used to only modest degree in private transactions. National central banks are obliged to intervene to keep fluctuations within 2.25 per cent (6 per cent for Ireland and Italy) of the official parity. Besides, there are (1) mutual overdraft facilities between central banks to finance day-to-day intervention operations; (2) short-term (up to six months) credit facilities to finance balance-of-payments deficits which may exert undue pressure on exchange rates and (3) a fund for medium-term assistance for long-term deficits (Nevin, 277). Official and private ECUs were left separate in the EMS. According to Commission’s own views (European Unification, p. 54), the ECU has four functions: (1) it serves as the reference unit for the exchange rate mechanism; (2) it is an indicator when one currency deviates from the others; (3) it is a unit of account for transactions under the intervention and credit arrangements and (4) serves to settle debts between national monetary authorities. Total convertibility with liberal capital movements was envisaged for 1978. That proved impossible because of different national rates of inflation and the plan was adjourned in 1983. In 1988 Delors Committee worked out a plan for monetary union in three phases: (1) by 1990 the currencies remaining outside the EMS (Greece, Portugal, Spain, and the United Kingdom), will join and all impediments for the private use of the ECU will be removed, (2) in an unspecified period central banks were to be amalgamated into a European System of Central Banks (ESCB) ending in (3) with a single currency replacing national currencies. The crucial institutional change proposed by the Committee was the creation of the ESCB. It was to have four functions: – the System would be committed to the objective of price stability; – it should support the general economic policy set at the Community level; – it would be responsible for the formulation and implementation of monetary policy, exchange-rate and reserve management and the maintainance of a payment system; – it would participate in the coordination of banking supervision policies of the supervisory authorities. In order to perform its functions, the System will conduct central banking operations in financial and foreign exchange markets and exercise regulatory powers. It will not lend to public-sector authorities but will use open market operations as a means of conducting monetary policy (The European financial Common Market, p. 50).

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In December 1991, at the Maastricht summit, it was decided that by 1999 Europe will get a single currency. That implies a loss of national sovereignty in controlling domestic money supply and varying the foreign exchange rate. Nevin describes the initial development of monetary union as Keynesian. That implies the view that the existence of imperfect market, administered prices and limited factor mobility require to wait until growth and inflation rates of the partners are equalized and everybody achieves the equilibrium balance of payment. Unless this is done, there will be serious adjustment losses imposed on by weaker partners. The centre has to cover the balance deficit, eliminate severe deflations and conduct regional policy. The ideal of the EC was to simulate a single country using just one set of policy instruments. And, indeed, it took many years before the member states managed to equalize their economic performances sufficiently. Occasionally they failed to do so. Thus, after four years, three of the four major currencies dropped out from the snake and shortly afterward the snake was discontinued. Total convertibility and full liberalization of capital movements also proved impossible when planned. Since the 1988 Delors Report, monetarist views have prevailed. The thinking about causality was reversed. There was no need to wait for a high degree of convergence because the losses were small and transient and the gains may be great. Therefore, the union must be considered the chief instrument of convergence (Nevin, 267). The European monetary union requires that the partner currencies be convertible and that the exchange rate be fixed within a narrow target zone. The latter requirement implies a central control over the total money supply of member countries (which cannot finance budget deficit by new money since they are reduced to regions within a larger market) and a joint management of the exchange rate with third countries. Such a monetary union generates at least three gains according to Nevin (p. 258): (1) specialization and economies of scale are more fully exploited because the risks of exchange fluctuations are reduced; (2) member countries need not hold foreign exchange reserves to cover balance-of-payment deficits in mutual trade as currencies are fully convertible. Also, the foreign exchange reserve for the trade with the rest of the world is smaller than would be the sum of reserves for separate countries. Under certain conditions – as pointed out by Södersten (p. 507) – the volume of reserves, like the volume of inventories, needs to grow in proportion to the square root of the increase in the volume of trade. If trade grows at 8 per cent annually, the demand for liquidity for transaction purposes needs to grow 4 per cent per year. (3) Growth is less restrained because there are no deficits with the member countries. Monetary Union of the prospective EU There are similarities (which will not be repeated in this section) as well as differences between the existing EC monetary union and the prospective one of the EU. The theoretical difference exists in the approach: it is neither Keynesian nor monetarist but systemic. The meaning of the term is explained in Part II and the argument will not be repeated here. Besides,

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175

theoretical differences will be apparent from the design of the scheme. The main practical difference concerns money. If the exchange rates are fixed, there is in fact just a single currency although there are many national currencies which bear different names. It proved exceedingly difficult – and took many years – to simulate one country with its single currency. After all, the European Community was born in 1957 and a single currency is envisaged for 1999, or forty two years later. It is suggested here that there should be flexible exchange rates – national governments ought to be responsible for their own policies – which makes necessary parallel money: national currencies and a common currency. Call the latter the European Money (evropska moneta), EM. Its value cannot be determined by gold. Because the value of gold wildly fluctuates and, also, not enough gold is available anyhow, gold is gradually being abandoned as a monetary base, a reserve asset and a standard of value.2 There are two other possibilities. Since the main purpose of the EM is to preserve monetary stability, its value may be determined by a basket of commodities priced at constant prices. That would imply an absolute stability of prices and looks somewhat artificial. Thus, I would prefer the last possibility available: to tie the value of EM to the currency unit of a major trading partner and that is the European Community. Consequently, I suggest the parity EM1  ECU1. The value of the ECU is a weighted average of a dozen of national currencies and proved to be rather stable. (The Special Drawing Rights, created in 1967 as a reserve currency of the IMF, have also the value based on a basket of currencies, in this case of five major industrial countries). The byproduct of such an arrangement is a designed economic convergence of two European communities. The main tasks of the monetary union are the following ones: 1. To preserve the fixed exchange rate EM1  ECU1. The target zone must be narrow in order to prevent destabilizing speculation. For this purpose a central monetary facility – call it the European Monetary Institution (EMI) – ought to be created. It may display three features Delors Committee envisaged for the European System of Central Banks: the EMI ‘would be committed to the objective of price stability’ it would not be required ‘to lend to public sector authorities’ it ‘should be independent of instructions from national governments and Community authorities’ (article 2). In other words it should be an independent international professional institution. While the Union exchange rate is fixed, the national exchange rates (national currency units per unit of the EM) are flexible and the currencies may depreciate as well as appreciate. Unlike the ECU, the EM should be freely used officially as well as privately. Prices may be quoted and the goods purchased in EMs. Thus, it functions as a legal tender paralelly with national currencies. Naturally, the EM is convertible and in this way the member countries acquire a convertible currency right away. 2. To provide internal liquidity. The union functions as a clearing union, 2

Gold reserves were officially demonetized by the Jamaica agreement of 1976. They are still held by many countries, but they remain an inactive part of the international monetary system.

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The Theory of International Trade Table 6

C

E x p H o r t R s Σ m M

C

H

–

100

100

–

75 175 150

50 150 125

Export-import table Σ  x

X

150

200

100

200

100

– 150 100

125 475 –

75 – 375

R Imports 50

national surpluses and deficits are extinguished against each other and the balance left is settled in the EM using flexible national exchange rates. 3. To provide external liquidity. Surpluses are relatively easily handled, but deficits cause troubles. An individual country or the Union as a whole may have a balance-of-payments deficit. The deficit may be transient or more permanent. In either case a sufficient amount of EM and foreign exchange must be available to cover the deficit. 4. Individual countries may show a tendency to run a permanent deficit which cannot be cured by a currency devaluation. Or the Union as a whole may run a permanent deficit. An adequate mechanism must be designed to handle such cases. It will regulate accomodating capital flows. However, also short-run capital movements, caused by speculative flights of hot money, cause serious instability. As a result, flexible exchange rates widely oscillated. Double exchange rate is sometimes used in practice or proposed: one for current and the other for capital transactions. A tax on capital transactions has also been suggested. The handling of a permanent deficit and wild short-term fluctuations merit a separate study. At first, discretionary administrative interventions seem to be unavoidable. A three-country clearing union Suppose countries C, H and R belong to a union, export (x) and import (m) to and from each other and the rest of the world (X, M). Prices do not change, and there is an overall balance-of-payments equilibrium coupled with regional disequilibria. A numerical example is given in the export-import Table 6. Country C exports 100 to H and 50 to R, altogether 150 to partners and 200 to the rest of the world. At the same time it buys 100 from H, 75 from R, in sum 175 and imports from the rest of the world 150. Similar are the transactions of the other two countries. Their export balances are given in Table 7. C has an internal deficit of –25 and an external surplus of 50. It is the other way round in H, where there is an internal surplus and an external deficit, while R has both internal and external deficits. It is immediately obvious that internal Union exports and imports must be equal: if, e.g., deliveries of C to R increase by 10, the expenditures of R also increase by

177

Appendices to Part VI Table 7 Internal, external and overall net deficits Countries C H R Union Deficit

x – m

X – M

(X  x) – (M  m)

–25 50 –25 0

50 –25 –25 0

25 25 –50 0

10. The internal trade is always balanced. But the Union market differs from the national market in one important respect: sales and purchases in particular currencies need not be balanced. C has a balanced trade with H, but buys 25 more from R than it sells to R. Thus, R will be left with a surplus of 25 C money. If this is a transient surplus, no particular problem arises except that liquidity must be made available by creating appropriate reserves. If this is a permanent currency surplus for R, but only transient surplus for the Union – e.g., in the next period H sells more to C than it buys from C – H will buy C currency from R and the surplus will disappear. Instead of a direct currency trade at the stock exchange, it may be more convenient to obtain the necessary currency from the European Monetary Institution. Or to exchange currencies for EMs. C may also balance its trade with R by using part of its foreign exchange surplus. If national currencies are convertible, H may cover its foreign trade deficit by its internal trade surplus via the EMI. In this case we have a general internal and external equilibrium since the balance of payments is in equilibrium. It appears that necessary conditions for general equilibrium are: (1) the external equilibrium of the Union (convertibility of EM) and (2) the internal convertibility of national currencies. These are weaker conditions than those for isolated (insular) countries when the national currency must also be internationally convertible. If R has a permanent internal deficit with no foreign exchange surplus, a new problem arises which will be solved in a similar way as a permanent foreign exchange deficit. The following possibilities exist: (1) Devaluation. If Marshall-Lerner conditions (the sum of export and import elasticities greater than one), obtains as it normally does,3 currency devaluation will decrease the deficit in an economy with less 3

Estimated sums of long-run price elasticities for demands for exports and imports of the thirteen industrialized countries are: France United States Denmark Austria

3.11 2.57 2.33 2.25

Switzerland Germany Canada Japan

2.23 2.19 2.09 2.03

Norway Italy Belgium Sweden

2.00 1.96 1.85 1.75

United Kingdom 1.13 Source: Robert M. Stern et al. Price Elasticities in International Trade, London: Macmillan, 1976.

178

(2) (3) (4) (5) (6) (7)

The Theory of International Trade than full employment. The same applies to a full employment economy if the increase in absorption is less than in output. In other words, current account will be improved if absorption is reduced. The range of elasticities estimated by various authors is quite large but on the average import elasticities appear to be lower than 1 and export elasticities higher than 1. Long-run (longer than two years) price elasticities are about twice as high as short-run (shorter than six months) ones and about one half of final price adjustments are shorter than one year. The former means that balance of payments may first worsen after a devaluation before it improves. Further, in the shortrun, the sum of income elasticities is 2–4 times larger than the sum of price elasticities, which means that income elasticities dominate. Since income elasticities of import and export are higher than one, shares of imports and exports rise over time (Goldstein and Kahn, 1985, pp. 1076–83). Countries become more interdependent and the need for economic integration more urgent. Higher real interest rate that a currency earns will increase its attractiveness on the money market. The arbitrage by spot and forward markets will bring about the necessary currency movements. Loans which make possible capital transfers. Direct and portfolio investment. Remittances of migrant workers. Since workers normally migrate to more developed regions and countries, their remittances will be in convertible or scarce currencies. Grants, normally to less developed regions in need to cover deficits. Harmonization of national fiscal and monetary policies.

It is much easier to undertake all these measures inside a Union than on a world market. Generally, it will not be too difficult to achieve internal convertibility and for special cases special mechanism may be designed. The fixed exchange rate EM1 = ECU1 implies external convertibility. In connection with capital movements, the well-known transfer problem should also be mentioned. It consists in the fact that money and commodity flows may and do diverge. In the classical model two fully employed countries trade with each other. If C lends or grants money to R, C must create export surplus of equal size to effect real transfer. Income in C is reduced and imports will decrease depending on the marginal propensity to import, m C. R will spend part of the loan on domestic goods, and the other part on import depending on m R. C will improve its trade balance by 1  mC of decreased imports and m R of increased exports. If m C  mR  1, the full amount of loan will not be matched by real transfer and C will have a deficit in trade balance. This deficit will be eliminated by adverse change in relative prices so that terms of trade for C worsen, and this is the secondary burden of the lending country. The model may be modified by introducing the marginal propensities to save, transport cost and tariffs, but the main drift of the argument remains. In reality many more factors are operative (Kindleberger, 1958, pp. 346– 68). The experience shows that transfer is rather smooth. In particular, even if mR is not sufficiently large, the interdependencies within the Union

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179

and the increased income of all member countries may increase total imports from C more than sufficiently. Besides, the prevalent situation within Union is less than full employment. Rational incentives to give loans and grants have those countries which have excessive saving or deficit currency. In the former case excessive saving (usually in rich countries) may be absorbed by direct and portfolio investment in the member countries which need capital and where investment is likely to be more profitable. In this case, income and import are not reduced. In the latter case, the increased supply of the deficit currency will help to eliminate deficit on the EMI accounts. No worsening of the terms of trade is to be expected, and the appreciation of the currency may be avoided. All adjustments are even simpler if transactions are carried out in EMs because the Union comes close to a single market of federated regions. In order to reduce trading risks, exchange rate must be stable. If there is a relative national inflation, it cannot be stable. There are two possibilities to resolve this contradiction. One – used by the EC – is to involve the center in national monetary and fiscal policy so as to make inflation rates approximately equal in member countries. That requires a long adjustment period before the union begins to function and also generates sterile sovereignty discussions coupled with unnecessary resistance. The other is to tolerate national inflations leaving the national governments fully responsible for them, but stabilize EM prices. As long as the purchasing power of the EM remains stable, the situation may be considered satisfactory. If it changes more than ± x per cent, the EMI may intervene. The unorthodox characteristics of the monetary union Since the monetary union is not modelled as expanded single country, it will represent a highly unorthodox economic system. The member countries will therefore also behave somewhat differently. Thus, the macroeconomics of the Union must be left for a separate study. Here only some more important unorthodox features will be enumerated. 1. The initial situation is characterised by unemployment, payments’ deficits, various degrees of inflation, structural imbalances and very imperfect market, particularly the market of financial assets. 2. The Union has its separate currency, the EM, and member countries have national currencies. But member countries can also use EMs. Both the EMI and national central banks engage in open market operations. Central banks are independent in their national policies. 3. The EM is convertible and pegged to the ECU. Thus, export prices in EMs will be stable (allowing for the drift of the ECU). National currencies may be externally convertible but need not and are floating but need not. So national monetary sovereignty is preserved. National prices may experience inflation, and differential inflation and other factors will cause variability of national exchange rates. Moreover, in the countries with higher inflation rates (Latin America, Yugoslavia) there is a frequent practice to quote prices and conduct business in some key currency ($, DM). In such countries as Swaziland and Bermuda, the dollar is

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used as a parallel currency officially. National currency is exchangeable at par with the dollar and circulates simultaneously with the dollar. It may, therefore, be expected that the member countries with poor and irresponsible government policies will be the first to replace national currency by Union currency (EM) making, thus, an important step toward a single currency. That will help to stabilize their own economies. 4. More than 90 per cent of all transactions on foreign exchange market are on capital rather than current account. That makes for high volatility of capital movements. Besides, only six key currencies account for more than 90 per cent of international wealth. The former implies that capital movements will be subject to a control at first. The latter implies that capital volatility is increased if some key currency is included in the system. That is the case in the European Community (German DM, British £, French franc) but not in the European Union which on that score may experience more stability. Namely, if a revaluation of the German mark is expected against the American dollar, speculators will sell dollars and buy marks in large quantities. If the mark appreciates against Hungarian forint, which is not a key currency, non-Hungarian speculators will have first to borrow or buy forints and than sell them. That takes time, and large quantities of forints are not available anyhow. Besides, since the national exchange rates are not pegged, central banks are not forced to sell other currencies to support own exchange rate and so monetary equilibrium in other member countries will not be disturbed. 5. The Union does not produce anything directly. Consequently, it will be subject primarily to monetary shocks. The best policy to deal with them is a pegged exchange rate. National economies are directly productive and so subject to real shocks. They react best by floating exchange rates. But they also suffer monetary shocks. Consequently, the best national policy seems to be managed float. That strengthens the argument of the preceding point. The Union with its pegged exchange rate and the absence of fiscal policy and member countries with floating exchange rates and independent central banks represent an interdependent system whose macroeconomics must display novel features, particularly empirically. Foreign exchange market If the foreign currency can be freely bought and sold, like any commodity, market will be cleared when demand and supply are equal. The domestic price for foreign currency is exchange rate π  Din/EM at C, and N quantity of EMs will be demanded and supplied. (Figure A3). Suppose, first, that the exchange rate is pegged at πO. For some reason that makes the dinar overvalued. As a result, demand for EMs will be larger than supply. The excess demand (MO  NO) corresponds to a trade deficit which must be covered by an outflow of reserves or an inflow of capital or both. Suppose, next, that the exchange rate is made flexible. Now π will simply increase until the market is cleared at C. Trade (or balance-of-payments) deficit disappears. These are essential differences

181

Appendices to Part VI Din EM S

C

π πo

D

0

Fig. A-3

No

N

Mo

Number of EMs

Demand and Supply of Reserve Currency

between the two mechanisms. In practice, of course, processes are much more complicated. It may only be noted that the market clearing point C depends on the policy pursued. To simplify the matters, it is assumed that the pegged rate with, say, an autonomous inflow of capital, determines the same C as a float without it. Let us analyse problems in some more detail. In order to simplify the analysis maximaly, it will be somewhat schematic. The intention is to establish characteristic effects and not to study all the intricacies of possible economic policies. Two pure foreign exchange regimes are distinguished: pegged and floating exchange rates. In the former case, foreign currency reserves must change during the adjustment process, in the latter they do not change. Two alternative pure policies are considered: monetary policy varies the money supply and fiscal policy varies the taxation rate for government spending. These policies are alternatively applied to the initial disequilibrium. (a) The pegged exchange rate. Most of the countries apply pegged rates. The resulting typical process of adjustment to disturbances may be described as follows. Suppose unemployment coexists with external balance and monetary policy is assigned the task to restore internal balance. By open market purchase of bonds, central bank will increase money supply and reduce interest rate. The aggregate demand expands increasing imports which will drive balance of payments into deficit. Central bank sells foreign currency and buys domestic currency. Cash reserves of commercial banks decrease. The resulting reduction of money supply increases interest rate, depresses aggregate domestic demand and reduces imports. Demand for foreign currency falls, demand for domestic one increases. External balance is restored but unemployment is not cured. The effects of monetary policy wear off unless the outflow of reserves is sterilized by open market operations indefinitely. Capital mobility makes monetary policy even less effective. But there is slight improvement in current-account balance: by selling more

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valuable domestic bonds, foreigners forfeit their interest-income. It follows that a pegged exchange rate renders monetary policy less effective for national economies. The Union is not subject to direct interdependencies between aggregate demand and money supply and so monetary policy may be effectively used to stabilize exchange rate of EM. If in the same situation fiscal policy is assigned the task of eliminating unemployment, tax cut will be used to expand aggregate demand. Interest rate increases because money supply remains constant. Increased imports generate payments deficit and an outflow of reserves. With no mobility of capital, reduced money supply will depress aggregate demand and restore initial income flows with higher interest rate which must offset the tax cut. Sterilization of reserve flow has as a consequence that we now have reduced unemployment but external deficit. If there is some capital mobility, increased interest rate will cause capital inflow. The trade deficit remains but is now covered by capital inflow. As a consequence, reserves and money supply are stabilized. Naturally, the end result is achieved faster if – apart from using fiscal policy to increase employment – monetary policy simultaneously reduces money supply. This may be considered a typical case for East-European countries after an initial organization of financial markets. If, however, capital mobility is high, the rise of the interest rate will encourage capital inflow which is more than necessary to cover trade deficit. The resulting balance-of-payments surplus increases monetary supply and reduces somewhat the interest rate. Trade deficit remains, but increase in employment is higher than in the previous case. In general, while increased capital mobility reduces the effectiveness of otherwise already less effective monetary policy, it increases the effectiveness of fiscal policy. However, this is a somewhat academic discussion because the Union will not engage in fiscal policy and national states are not likely to peg their exchange rates. (b) Flexible exchange rate. The prewar experience with floating exchange rates was not favourable. Therefore, the postwar Bretton Woods arrangements opted for pegged rates without much disagreements. Nurkse (1944, pp. 210–211) formulated well the three main objections raised: (1) exchange rate fluctuations increase risks which tend to discourage international trade; (2) the same fluctuations involve constant shifts of resources between production of traded and non-traded goods which are costly and wasteful if only temporary and cause frictional unemployment; (3) any considerable and/or continuous movement in the exchange rate generates expectations of further movement in the same direction. As a result, speculative capital movements are destabilizing. Later empirical research has shown that (2) is not important. Exchange rate fluctuations do not seem to influence trade flows and, consequently, shifts of domestic production (Black, 1985, p. 1183). As to (1), riskiness is undoubtedly increased, but that apparently does not discourage international trade. Destabilizing speculation of (3) is present and therefore capital flows are everywhere subject to some control, occasionally to very stringent control. Because of the enormous volume of financial transactions and the fact already mentioned that almost all world financial wealth is denominated in only a couple of key currencies, small changes in ac-

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183

tual or expected interest rates or risk involved may induce asset holders to change composition of their portfolios so as to affect significantly the prices of other currencies. There seems to be yet another effect which Nurkse did not mention and it is a consequence of the difference between the adjustment lags in monetary and real spheres. Monetary adjustment is almost instantaneous due to the modern communication technology; prices of financial assets respond promptly to new information. On the other hand, adjustments in goods prices and production last considerably longer. As a result, movements in exchange rates tend to overshoot the mark; wrong signals generate other wrong signals and that is destabilizing. The response to this effect is some stabilizing interventions, i.e., managed float. After the foregoing introductory remarks we are back to our comparisons. Let the initial conditions be the same, unemployment coexisting with external balance, and let first apply only monetary policy. In order to increase aggregate demand, the central bank lowers interest rate and increases monetary supply. Imports increase, payments deficit appears and domestic currency depreciates. That increases export demand and decreases import demand by substituting part of imports by domestic production. On both scores employment and output increase. Capital mobility makes possible an outflow of capital because of lower interest rate. Currency depreciates even further reinforcing initial devaluation effects while the interest rate somewhat increases. Monetary policy proves to be effective and its effectiveness is further increased by capital mobility. Consequently, flexible exchange rates can provide significant autonomy in national macroeconomic policies and such an autonomy is very desirable for East-European countries in the present political and economic situation. Fiscal policy does not fare so well under the regime of floating rates. A tax cut increases aggregate demand and imports. Interest rate increases, but the inflow of capital will probably not cover the trade deficit. The currency depreciates, that establishes external balance and further improves the initial output effect. Thus, in the East-European situation fiscal policy will be effective. However, if capital mobility is high, capital inflow will more than cover trade deficit and currency will appreciate. Trade deficit increases but less than surplus on capital account. Income increases, but less than before making fiscal policy less effective. It may be added that the interest-income on bonds acquired by foreigners will somewhat deteriorate current-account balance additionally. The above considerations provide final theoretical justifications for the suggested option of the pegged exchange rate for the Union and the floating rates for the member states. The functioning of the monetary union In the present text no detailed design of the necessary mechanisms will be undertaken. The purpose of this section is only to make clear what is the main idea and that it is workable. After all, the scheme is open – ended and all sorts of modifications are possible and will be undertaken under the guidance of experience.

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We find ourselves in a fortunate position that we do not need to start from scratch. There is a rich experience of the International Monetary Fund and of the European Community. Three additional schemes – though not for a regional market but for the world as a whole – have also been proposed. The respective authors are Keynes, Bernstein and Triffin (Södersten, pp. 526–34). I shall make a liberal use of all schemes mentioned. The European Monetary Institution is an embryonic international central reserve bank and so represents a central bank of national central banks. It serves as a clearing union for the member states (as in Keynes Plan) and provides internal and external liquidity (not unlike the International Monetary Fund). International liquidity represents a stock of financial means available to cover payments imbalances and to influence exchange rates. It consists of reserves enlarged by a free access to the borrowing facilities which are unconditional or mildly conditional. Like any central bank, the EMI creates new international money, the EM. The ability to create new money for the entire Union has an important consequence: out of this monopoly, the EMI extracts a profit, called seignorage. The seignorage has two forms. In open market operations the interest bearing securities are bought in the market for EMs. The economic agents get a fully liquid means of payment and for that pay a price in the form of interest rate. EMs may also be lent to the European Development Bank at zero interest and unlimited repayment period. As the volume of money transactions increases all the time, the need for additional liquidity, given the velocity of circulation, is great and permanent and so seignorage is a source of substantial revenues. Out of these revenues, the EMI may finance its own operations and also operations of the EDB. In its role of a clearing union, the EMI functions in the following way. All member states are allotted EMs at their accounts with the EMI proportional to their volume of trade. At the end of the year, the net balances of sales and purchases in national currencies are converted into EMs drawn upon the EMI accounts. For example, in Table 7 the deficit countries C and R will transfer EM 25 and 25 to the account of H. As H now has EM 50 above its quota, it is entitled to interest on that account which is paid by C and R. As with SDRs in IMF, countries whose holdings exceed their allocation receive and interest paid by countries whose holdings are less than their allocation. National quotas are divided into, say, four tranches. The first tranche will be used unconditionally, while for other tranches successively more stringent conditions will be imposed, including the increasing interest rate. Thus the last three tranches are in fact credit tranches. Next year the distribution of net balances will be different and national deficits and surpluses will change places. Between accounting periods, national central banks extend unlimited amounts of very shortterm credit to each other in order to combat speculation (as in the EC). As just described, the clearing union is also a source of internal liquidity (not unlike the SDR of the IMF). Apart from that, the EMI is responsible for external liquidity too. All member banks deposit gold and foreign exchange with the EMI amounting to, say, 25 per cent of their allocations of EMs. These deposits bear the usual international interest rate. Since it is desirable to concentrate as much of foreign exchange reserves as possible, the EMI will slightly raise the interest rate for all additional reserves

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Union reserves Czecho-Slovakia: reserves quota Hungary: reserves quota Romania: reserves quota

Currency

EM

Percentage of reserves and quotas

foreign exchange

175

100

foreign exchange EM

100 400

100 100

foreign exchange EM

50 200

100 100

foreign exchange EM

25 100

100 100

to make deposits with the EMI attractive. In both cases the source of finance is seignorage. Own foreign exchange reserves, deposited with the EMI, may be used automatically when national resources are exhausted, i.e., when they fall below x per cent of trade. Now we may continue the liquidity story. Since the EM is both an internal and an external money, internal and external balances will be consolidated. Thus C in Table 7 appears to earn an overall surplus of 25, the surplus of H is reduced to 25 and only R adds external deficit to internal deficit so that its total deficit of 50 is equal to combined surpluses of C and H. R is obviously the case that merits a special consideration of the EMI. In order to differentiate between the risks involved, the interest rate on foreign exchange reserves may be higher than that on above – quota holdings of EM. Let me describe the transactions involved by using the numerical example of Table 7. It will become apparent that the flexibility of the scheme is even greater than described hitherto. In order to have some names, let C stand for Czecho-Slovakia, H for Hungary and R for Romania. The respective currencies are koruna, forint and lei. Since it is more difficult to settle foreign exchange imbalances than internal payments imbalances, the foreign exchange tranche must be separated from credit tranches and higher interest rate must be applied. One fifth of the entire deposit will be deposited by the member countries themselves and four fifth represent additional liquidity created by the Union. All tranches are denominated in EMs. Initial allocations of quotas are as follows. It is assumed that no national currency is convertible; the only convertible currencies are foreign exchange and EM. It is possible to use national reserve of foreign exchange automatically and borrow 100 per cent more conditionally. First credit tranche may be used automatically, and the other three conditionally. Transactions of Table 7 may be conducted with the EMI in various ways. Suppose Czecho-Slovakia compensates her internal deficit of EM 25 by an equal amount of surplus of foreign exchange. The rest of foreign trade surplus exchange leaves with her national central bank. It may also be used for the repayment of foreign debt. Hungary finances her foreign trade deficit out of internal surplus and the rest de-

186

Union reserves Czecho-Slovakia: reserves quota Hungary: reserves quota Romania: reserves quota

The Theory of International Trade

Currency

EM

foreign exchange

150

foreign exchange EM

100 400

100 100

foreign exchange EM

50 225

100 112.5

25 75 25

0 75 25

lei EM lei

Percentage of reserves and quotas 85.7

posits as an above-quota surplus with the EMI. Romania uses lei to buy her reserves – which are depleted – and to buy EMs from her quota. The EMI records these transactions in the following way. Initially member countries deposited EM 175 of foreign exchange reserves with the Union. At the same time the Union created liquidity of EM 700 as member countries quotas. Although Czecho-Slovakia and Hungary had various internal and external deficits and surpluses, debts and credits are netted through the clearing union and eventually all their positions remain the same except that Hungary accumulated EMs to 112.5 per cent of her quota. If insulated, Romania would be in an awkward position because her reserves were depleted and on top of that a debt of equal magnitudes was created. As it stands she can rely on reserves of the Union and she can use the first tranche of her quota free of charge. She is, however, obliged, to purchase back lei by means of EM or other foreign exchange within say, five years. A flexible exchange rate enables Romania, which has no external debt, to eliminate payments deficit rather quickly. The Union reserves are reduced by 14.3 per cent. But there is nothing to worry about because the sum total of national reserves remained unchanged as Czecho-Slovakia increased her reserves by an equal amount at her national central bank. As long as non-convertible national currency appears on an account with the EMI, the respective country is obliged to pay interest. On foreign exchange and above-quota EMs, the respective country is entitled to receive interest.4 The EMI may engage in various other transactions. Thus, i.e., the price of foreign debt in secondary markets has often fallen to 50 per cent or 4 In his unsigned contribution to the Economic Survey of Europe in 1989–1990, Jozef von Brabant writes (p. 148): ‘A foremost concern is that any clearing scheme suffers from a fundamental theoretical weakness. To require in principle that all countries balance their current account within the clearing system is tantamount to assuming that they balance at the same time their accounts with the countries

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187

less of the nominal price. The EMI, aided e.g. by a loan in ECUs, may buy the debts of its members at 50 per cent price and then collect full or renegotiated annuities. All member countries will benefit from financial economies of scale. Conclusion A common criticism of the existing and proposed plans consists in the observation that they provide no rule for liquidity creation (the Keynes Plan does not even bother about liquidity). Either mechanical or arbitrary rules are suggested. Triffin’s proposal to regulate international liquidity by open market operations has been criticized that it will have inflationary consequences. The present plan avoids both objections. The EM will be stabilized at the parity of EM1  ECU1 by insuring that demand and supply of EMs be equal. (It may be noted that in a dynamic setting S  D is not sufficient condition for stability – an inflated D may induce an inflationary S or vice versa – but coupled with the requirement of parity, it is; within the limits of own inflation of the ECU, of course). A number of instruments have been described that can be used to achieve this objective. Thus the rule is clear and objective. As for inflation, the flexible exchange rates make possible to have a stable EM coexisting with national inflations. However, since there is no separation between the official and private use of the EM – EM is simply a parallel money, a legal tender as national money – prices may be quoted in EMs and goods bought by EMs which guarantees the overall stability. Parallel currency has been criticized as well. In the Delors Report two objections were raised: ‘Firstly, an additional source of money creation could jeopardise price stability. Secondly, the addition of a new currency, with its own independent monetary implications, would rather complicate the already difficult endeavour of coordinating different national policies’ (article 47). As far as our scheme is concerned, the first argument is obviously irrelevant, and the second implies such a degree of coordination which is not feasible at present among the various EU countries. Finally, the plan is designed so as to speed up the convergence of the EU towards the EC – hopefully a reverse process will also take place – and so provides a bridge between two integration processes of our time. The gains from the monetary union are considerable: (1) Risks are reduced and that generally promotes production and trade. In particular, complementing the customs union, the monetary union helps to create a large common market in which practically full specialization and economics of scale can be realized. Exchange rate and

outside the system. Without this, participants will be tempted to use their surplus with clearing partners to offset their deficits with outside trade partners; countries in deficit vis-a-vis the clearing partner will not want to repatriate their surpluses with outside partners into the clearing arrangement.’ It is obvious that the proposed monetary union does not suffer from the weakness described.

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convertibility risks being reduced (if the EM is used in transactions), the costs of protecting against them are eliminated as well. (2) Adequate internal and external liquidities are provided. As a result (a) internal Union trade expands because the clearing function of the EMI eliminates almost all obstacles, (b) international trade expands because of full convertibility of EM and combined foreign exchange reserves and (c) the costs of otherwise forced adjustments are avoided. (3) Necessary foreign exchange reserves are greatly reduced and so the main current obstacle for the expansion of foreign trade is eliminated. If the approximate square root rule applies, the following effects may be expected. Suppose that an average country in the Union has the population of ten million, has an average per capita income and average characteristics of foreign trade. Then the Union population of 184 million indicates an expansion of transactions by 18.4 times. Foreign exchange reserves need to increase only 5.2 times or 3.5 times less. In other words, the present volume of transactions requires only one third of normal reserves or, by mere enlargement of the market, present reserves of foreign exchange will effectively increase 3.5 times. The smaller the country, the greater are the foreign exchange savings by integration. (4) The replacement of dollars and other key currencies with EMs represents an appropriation of the seignorage which previously went to foreign countries. The once-and-for-all costs of acquiring the initial stock of foreign currency are large, on the average about 8 percent of GNP (Fischer, 1982, p. 305). The use of EMs does not give rise to such costs, because EMs are simply allocated as national quotas. But there will be a division of seignorage between the Union and the member countries. The empirical evidence indicates that the seignorage, measured by the ratio of a change in the high-powered money and GNP, is two percent or more of GNP.5 The higher the rate of inflation, the higher the seignorage. The dollarization of the country, corresponding to the use of EMs, indicates seignorage flows between 0.75 percent and 1 percent of GNP (Fischer, loc. cit.). Thus, it may be expected that seignorage will be divided in the proportion 1:2 between the Union 5

Data exist for the following three comparable countries and one prospective Union member: Change in High-Powered Money Divided by GNP 1960–73 1973–78 Greece Ireland Portugal Turkey Nonweighted average

Rate of Inflation 1960–73

1973–78

0.20 0.17 0.21 0.19

0.30 0.27 0.43 0.37

3.3 5.9 6.1 N.A.

15.5 15.3 21.6 24.5

0.19

0.34

5.1

19.2

Source: Fischer, 1982, p. 309.

Appendices to Part VI

(5) (6)

(7)

(8)

6

189

and the member countries. The Union seignorage (and custom duties) replace tax contributions (for administration and the activities of the EDB) and so the functioning of the Union imposes no tax burden on the member countries. Direct and portfolio investments in particular, and capital movements in general, do not represent serious problems any longer and so capital movement can be liberalized to a great extent. Stable EM guarantees stable prices even if national inflations exist and their rates differ. Thus, production and capacity expanding investment risks are considerably reduced and are separated from the risks in the volatile capital market in which hot-money flights of shortterm funds may cause great instability. In addition, consumers may hold their savings in EMs and link their insurance premiums and pensions to the EM. In this way they are able to reduce economic uncertainties in their private lives. The decision to establish a single currency for the EC by 1999 stimulated many discussions about costs and benefits of a single currency. The main cost is, of course, the loss of national sovereignty as far as monetary policy (i.e., a large part of macro-economic policy) is concerned. Also, ‘(A)s long as central banks in the EMS are obliged to support each other currencies . . . competition among the suppliers of money is restricted’ (Vaubel, 1990, p. 940). These costs are largely avoided by the present proposal. As for the benefits, most of them are equal for both, parallel and single6 currency and differ only in size of the effects. They are: The elimination of information costs and of incentives for price discrimination. Consumers and producers will simply compare prices in EMs. Gross and Thygesen believe that 2% of the EC’s GDP can be saved by using a single currency. Additional 0.25–0.50% can be saved by eliminating all exchange-rate related transaction costs. To the extent that the EM is directly used in transactions, the same applies to it as well (cost of changing money, passing exchange controls). Idle money balances, otherwise needed in a variety of currencies, will be greatly reduced. Comparability and stability will stimulate financial integration (transparency of pension schemes, insurance contracts and various national financial instruments). The last advantage can be judged in the light of the EC experience. ‘When crises have erupted in the past in the EMS, they have been related either to bilateral conflicts – who should adjust to whom? – or to instances of interest-rate escalation which left the relative positions of currencies unchanged’ (Gross and Thygesen, 1990, p. 934). If not eliminated, such conflicts will be greatly reduced. In short, the European Union, whose two main pillars are customs and monetary unions, is a move towards economic growth and prosperity.

For the single currency cost and benefits see Gross and Thygesen (1990, pp. 926– 28, and Britton and Mayes (1990).

190

Notes

Notes Chapter 9 1. I used synchronic capital costs, without calling them so, in a mimeographed essay which won the university prize in 1950. The first paper of mine on the subject was published in The Manchester School, 1958, 136–59. The first to describe systemic labour cost, which they called ‘synchronic labour cost’, were Ch. Weizsäcker and P. Samuelson (1971). They used it to show the falsity of Marx’s labour theory of value and the correctness of ‘bourgeois prices calculated as dated labour requirements, marked-up by compound interest, at a profit or interest rate equal to the system’s rate of exponential growth . . .’ (p. 1192). Samuelson believed that he ‘proved the following theorem: If labour grows at exponential rate 1  g and goods are priced at their ‘synchronized labour costs’, than the bourgeois pricing formula A o(g)  a o (1  g) [I  a(1  g)]1 must be charged by rational planners’ (1971, p. 429). The formula is not correct. The error is explained in Horvat (1995, pp. 261–3). Samuelson unconsciously applied ‘bourgeois’ reasoning that labour may be remunerated either ex post or ex ante (and then cost is ao (1  g)). For a correct (i.e. synchronic) theory, it is irrelevant when labour is paid but when it is expended. The methods of payment are irrelevant, as are methods of depreciation (see Note 3). 2. For the full treatment see my theory book (Horvat, 1995, pp. 54–70). 3. The algebra is similar to the one in Domar (1953). The difference is in economic interpretation. Evsey Domar thought that the effect – the surplus of depreciation over replacement in his analysis – was a matter of depreciation methods (which is true) and would disappear in the case of linear decay when linear depreciation is applied (which is false). I proved that the effect was a real one independent of depreciation methods (1958). The simplest way to see that is to disregard depreciation altogether, as I did in the present essay. With Domar we encounter the same ‘bourgeois’ arbitrariness as with Samuelson mentioned earlier (Note 1). 4. That was the case in former Yugoslavia when the rate of technological progress was higher than four percent (Horvat, 1970, p. 218). Chapter 14 1. This seems intuitively obvious but has also been empirically documented. In their empirical study ‘International Patterns of Technological Accumulation’ (JOICE, 3/1992, p. 173), Amendola, Guerrieri and Padoan find that ‘the empirical evidence points to the linkage between a country’s technological capacity and its ability to penetrate foreign markets.’ 2. There is a dissenting view by J.S. Chipman. He constructs a case of

190

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two countries whose factor endowments are ‘mirror images of one another’, produce commodities whose production functions are also ‘mirror immages’, the export price is the same but production techniques are different. He adds a couple of other arbitrary assumptions and concludes that ‘the HLS model would predict intra-industry trade, contrary to received opinion’ (1987, p. 940). Chipman, of course, does not hint where in reality such a case exists and also the construct does not correspond to the usual definition of intra-industry trade. But it is a good example of the futility of contemporary theorizing. Chapter 17 1. As far as I know, the first to pose the problem in this way was the Yugoslav statesman Milentije Popovic´ (1949). He also drew practical implication for the relations with the more developed Soviet Union (trade at international prices) and less developed Albania (trade at each country’s home prices). In the state of the postrevolutionary idealism, it was considered that poor, socialism building, Albania should be helped by an equivalent (in labour time) exchange and that more developed Soviet Union must not exploit Yugoslavia. Popovic´ lacked modern economic tools and so his analysis lacked necessary rigour.

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Name Index Amendola, G., 81, 190 Backer, S., 33 Balassa, Bela, 170 Bazler-Madz ˇar, Marta, 152 Bernstein E.M., 184 Bhagwati, Jagdish, 14, 32, 75, 104 Black S., 170, 182 Bliss, Christopher, X, XI Bowen, H.P., 32 Brabant, Jozef van, 186 Brecher, Richard A., 34 Britton A., 189 Caves, R.E., 29, 33, 84 Cecchini, Paolo, 150 Chacholiades, M., 11, 14, 26, 32 Chipman, John S., 15, 19, 30, 190 Choudhri, Ehsan U., 34 Corden, Max W., 133 Davis, Donald R., 82 De Marchi, N., 32 Domar, Evsey, 190 Elmslie, Bruce T., 33 Emmanuel, Arghiri, 118 Ethier, Wilfred J., 1 Fischer, Stanley, 188, 189 Glejser, Herbert, 140 Goldstein, M., 178 Greenaway, David, 82 Gros, Daniel, 189 Guerrieri, P., 190 Haberler, G., 25 Harrod, Roy, 18, 25 Havrylyshyn, O., 151, 172 Hazlewood, A., 169 Heckscher, Eli Filip, 10, 75 Heffernan, Sh., 11

Helpman, E., 82, 105 Hicks, John R., 16 Hine, Robert, 82 Horvat, Branko, X, XII, XIII, 20, 26, 27, 29 36, 46, 55, 64, 67, 76, 89, 90, 103, 121, 166, 190 James, Antoinette M., 33 Johnson, Harry G., 23, 131, 133, 144 Jones, Ronald W., 30, 32 Kalecki, Mihal, 70 Kemp, Murray, 21, 22 Kenen, Peter B., 84, 163, 165, 170, 172 Keynes, John Maynard, 184, 187 Khan, M., 178 Kindleberger, Charles P., 169, 178 Kovac ˇ, Oskar, 163 Krizˇanicˇ, F., 171 Krugman, Paul, 82, 105 Laird, S.A., 162 Lancaster, Kelvin, 83 Land, A.H., 15, 18, 19 Leamer, Edward, 33, 75 Leibenstein, Harvey, 4, 144, 170 Leontief, Wassily, 28–9, 32, 63 Lerner, Abba, 126 Marx, Karl, XI, 39, 40, 116, 117, 190 Mainwaring, Lynn, 28, 115 Mayers, D., 189 Metcalfe, J.S., 26, 28 Mikic ´, Mia, XIII Mill, John Stuart, 39 Milner, Chris, 82 Minhas, Bagicha S., 20, 25, 32 Molle, W., 137, 145, 150

197

198

Name Index

Neary, P., 32 Nevin, Edward, 156, 163, 169, 170 173 Nurkse, Ragnar, 182, 183 Ohlin, Bertil, 10, 75 Olson, Mancur, 25 O’Rourke, Kevin H., 17, 18 Padoan, P.C., 190 Pierce, I.F., 15, 18 Popovic ˇ, Milentije, 191 Porter, Michael E., 33, 80 Ricardo, David, IX, 7, 8, 13, 17, 32, 39, 43, 44, 75, 76, 80, 85, 86, Robson, P., 138, 147, 150 Rosati, Dariusz, 159 Rybczynski, T.M., 23 Samuelson, Paul A., 15, 17, 19, 190 Sau, R., 118 Schumpeter, Joseph, IX

Siebert, H., 169 Sinclair, P., 11 Smith, Adam, 39 Södersten, Bo, 167, 174, Sraffa, Piero, 67 Srinivasan, T.N., 75 Steedman, Ian, 26, 27, 28, 30, 95 Stern, Robert M., 32, 177 Stiglitz, Joseph, 26 Stolper, Wolfgang F., 32 Swan, T.W., 167, 168 Thygesen, Niels, 189 Torrens, Robert, 7 Trefler, Daniel, 33, 75 Triffin, Robert, 184, 187 Tsang, H., 32 Weintraub, Sidney, 70 Weizsäcker, Christian, 190 Williamson, J., 151, 172 Yeats, A., 162 Yeung, P., 32

Subject Index Albania, 157, 158, 191 Austria, 157, 177 autarky, 104 Bank of International Settlements, 172 Belgium, 157, 177 Bermuda, 180 Bosnia-Herzegovina, 151, 152, 153 buffer stocks, 161, 162 Bulgaria, 158, 162 business cycles, XII–XIII Canada, 165, 177 contractual overheads, 166, 167 convertibility, 178 Council of Mutual Economic Assistance (CMEA), 158, 159, 172 canonical model, 1 capital 20, 80, 85, 107, 162 abundant, 26 circulating, 60 cost, 41, 46, 52, 190 dynamic vs static c. cost, 47 fixed c., 40, 46, 49, 60, 117 intensity, 24, 27, 28, 35 money c., 89 neoclassical, 14 productive c., 25 synchronic c. cost, 52, 54 value of c., 30 Central European Free Trade Area, CEFTA, 155 classical economics, IX, X, 8 common market, 137, 140, 150, 155, 162, 163 comparative advantage, 7, 11, 15, 16, 75, 77, 79, 81, 91, 106 competition, 3, 11, 16 direct, 20 imperfect, 105 indirect, 20

perfect, 10, 25, 105 strong, 13, 15, 24 composition effect, 24, 36, 92 cone of diversification, 18, 19, 25 consumer surplus, 125 convergence in per capita GNP, 20 costs material c., 18 of disintegration, 151 of production, 7, 8, 19, 85 opportunity c., 2 transaction c., 3, 147 Croatia, 151, 152, 153, 154 customs (tariff) union, 137, 149, 150, 162, 163, 170, 171, 187 Cyprus, 158 Czechoslovakia Delors Committee, 173, 174, 175, 187 demand reversal, 10 Denmark, 157, 177 dilatation of economic time, 46 dynamic vs static time, 50 economic integration, 136, 155 economies of scale, 80, 135, 146, 170, 171, 187 economic union, 150, 163 efficiency allocational e., 4 production e., 4 employment effect, 41, 43, 64 Estonia, 158 European Common Market, 153 European Economic Community (EEC), 137, 140, 150, 155, 156, 157, 159, 169, 170, 175, 180, 184 European Free Trade Area (EFTA), 136, 156, 157, 159, 162, 165, 169, 170

199

200

Subject Index

European Monetary Institution (EMI), 175, 177, 179, 184, 185 European Monetary System (EMS), 173 European Payments Union (EPU), 172 European Union (EU), 150, 154, 155, 156, 158, 171 exchange rates, 168, 174, 176, 179, 181, 182, 183, 188 exploitation, 68, 69, 116, 119, 120, 122 factors (of production), 13, 18, 25 abundance, 14, 27, 75 endowments, 10, 11, 13, 14, 24, 34, 82 input, 9 intensity, 14, 63 intensity reversal, 10, 13, 15, 19, 25, 27, 32 price, 89 proportions, 11, 14, 19, 28 specificity of f., 19 factor price equalization theorem, 11, 15, 23 Finland, 157 France, 157, 177 free trade area, 136, 163 General Agreement on Tariffs and Trade (GATT), 136, 141 Germany, 157, 177 goods capital g., 59 consumer g., 1, 50, 55, 59, 79 intermediate g., 47 investment g., 55 producer g., 1 Great Britain (United Kingdom), 156, 157, 173 Greece, 151, 157, 173, 188 growth rate of g., 27, 65, 87, 113, 114, 149 steady state g., 64

Heckscher-Ohlin theorem, 10, 11, 13, 29–30, 75, 76, 85 Hungary, 158, 162 Iceland, 157 infant industry, 134, 147, 167 Institute of Economic Sciences, 155 Ireland, 157, 173, 188 Italy, 157, 173, 177 Interest rate, 15, 17, 20, 28, 40, 41, 42, 89, 90, 178 International Monetary Fund, 184 inventories, XIII investment, 28, 45, 54, 64, 114, 178 demographic i., 50, 51, 52 gross i., 64 new i., 64 portfolio i., 189 real, 55 replacement i., 64 isoquants, 10, 19, 25 Jamaica Agreement, 175 Japan, 156, 165, 177 joint production, 21, 25 labour, 2, 13, 20, 39, 42, 60, 85, 92, 177, 162 intensive, 11, 13, 35 productivity, 30, 70, 75 supply, 27 time, 50, 59 labour embodied, 107 labour input diachronic vs synchronic, 39, 40, 41, 42, 44, 85 labour saved, 107 labour-managed economy, XI, 154 labour-managed firm, X land, 17, 18, 20, 27, 79, 85, 91 Latvia, 158 Leontief Paradox, X, 32, 36, 75, 91 liquidity, 176, 177, 184, 185, 188 Lithuania, 158 Luxemburg, 157

Subject Index Maastricht Summit, 174 Macedonia, 152, 153 Market factor m., 13 product m., 13 mark-up, 70 Malta, 158 Marshall-Lerner conditions, 177 material cost, 79 input, 79 misallocation, 69 monetary union, 137, 150, 155, 163, 172, 187 Montenegro, 151, 152

201

p. ratio, 11, 16 production effect, 125, 126 production function, 11, 12, 13, 16, 32 productive capacity, 3 profit, 64, 67, 114 profit rate, 3, 22, 28, 42, 44, 69 gross p. r., 46 protective effect, 126 quasi-rents, 55

neoclassical aporiae, 27 neoclassical economics, IX, XI, 20, 21, 30 neoclassical postulates, 27–8 Neo-Ricardians, X, XI Netherlands, 157 Norway, 157, 177 no-trade regions, 129

relative mechanization, 101 rental rate, 27, 68, 79, 89, 100, 113 rents, 15, 16, 17, 19, 79, 90, 91 replacement effect, 41, 45, 46, 47, 64 replacement cost, 54 replacement period, 1 restoration (of capitalism), 154 restrictive effect, 126 returns to scale, 3, 10, 11, 13, 24 Romania, 157, 158, 162 Rybczynski theorem, 11, 22, 85

Pareto optimality, 42 planning, theory of, XII, 2 Poland, 158 policy fiscal, 182, 183 monetary, 182, 183, 189 Portugal, 157, 173, 188 preferential trading club, 136 prices domestic, 7 gravitational, 1, 3, 62, 79, 85 international, 3, 7 labour p., 107, 115, 121 long-run, 2 of production, 117 short-run, 2 value p., 117 prices autarkic p., 95 commodity p., 11, 15, 90 competitive, 121 factor p., 11 full p., 18 market p., 18

seignorage, 185, 188, 189 Serbia, 151, 152, 153 Slovenia, 151, 152, 153, 154 Southeast European Co-operative Initiative (SECI), 155 Spain, 157, 173 Special Drawing Rights, 184 specialization complete s., 15 incomplete s., 16, 23 pattern of s., 81, 92, 100, 103 primary s., 100 regions of s., 133 secondary s., 100 Soviet Union, 150, 151, 156, 158, 170, 172, 191 Stolper-Samuelson theorem, 11, 21, 22, 85 structure of the economy, 29 subsidy, 127, 132, 133, 167 surplus value, 40 Swaziland, 180 Sweden, 157, 177 Switzerland, 157, 177

202

Subject Index

tariffs, 104, 105, 118, 125, 126, 132, 133, 138, 151, 162, 163, 164, 165, 167, 169 nominal, 129 prohibitive, 127 technological progress, XII, 3, 42, 52, 53, 80, 92, 149 terms of trade, 7, 23, 105, 118, 126, 171, 179 theory, pure, 4 Tokyo Round, 165 trade, 104 creation, 138, 169 diversion, 138, 166, 169 free t., 11, 15, 104 gain from t., 104, 107, 108, 114; export g., 110; import g., 110 inter-industry, 28, 81, 83, 84 intra-industry, 28, 80, 81, 82, 83, 84, 170, 191 loss from t., 115 pattern of t., 10, 75 Treaty of Rome, 156 Turkey, 157, 158, 188 Ukraine, 155 unemployment 2, 3, 4, 11, 167, 181

unequal exchange, 188 United States, 156, 165, 177 value, 116 use v., 39 value added, 18 value theory, IX, 9, 30, 76, 77 labour theory, IX, X, XI, 8, 9, 39, 40, 41, 44, 53, 117, 190 neoclassical scarcity t., IX, 9, 24 systemic t., IX, X, 77 utility t., IX, 8 Verdoorn effect, 53 wages, 3, 15, 20, 25, 60, 62, 68, 107, 113, 114, 121, 133 real w., 21, 27, 61, 67, 79, 89, 90, 99, 100, 108, 112, 134 wage-basket, 112 wage cost, 70 wage–profit (rental) curve, 28, 67, 111 Yugoslavia, 150, 151, 152, 155, 157, 158, 162, 164, 166, 170, 171 179, 190, 191