Assignment - Agricultural Trade & Policy

Agricultural Trade and Policy – Continuous Assessment Exercise

Continuous Assessment Exercise

Prepared for Module CB9003 “Agricultural Trade and Policy” by Carlos Ferreira

Submitted on the 12th December, 2008 1

Agricultural Trade and Policy – Continuous Assessment Exercise a1. the composition of trade (in terms of categories of goods) We consider country A, with abundant low-skilled labour relative to its potential trading partners. X is the bundle of capital-intensive products and Y is the bundle of labour-intensive products. In autarky, country A must produce all products consumed, either labour-intensive or capital-intensive. Chart 1 shows this situation. Considering maximum efficiency in production, country A's citizens will only be able to consume a bundle of goods somewhere along the Production Possibility Frontier (point PA=CA). Since for this country producing capital-intensive products has a high opportunity cost, when in trade it will move some of the resources used in producing capital-intensive products into producing labourintensive products. As a result, production will move from PA (production in autarky) to PT (production with trade), and consumption will move from CA to CT. Therefore, country A will export the difference between YT and YC and import the difference between XT and XC. As a result, when in a situation of trade, the country will specialise in producing the products in which it has a comparative advantage (Y), and obtain the capital-intensive products by trade.

Good Y (L)

PT

YT

PA=CA

YA YC

CT CPFT

Production Possibility Frontier

Chart 1

XT

XA

CPFA XC

Good X (K)

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Agricultural Trade and Policy – Continuous Assessment Exercise a2. the effects on real wages for low-skilled work Considering that Country A is endowed with abundant low skilled, low-wage labour relative to its potential trade partners, by rejecting autarky and engaging in trade it will increase its demand for labour (Q1 to Q2). As a result, the nominal wages will rise (from P1 to P2).

Price Supply of Labour

P2 P1

Demand for Labour (Trade) Demand for Labour (Autarky)

Chart 2

Q1

Q2

Quantity

However, real wages also depend on inflation. Even with nominal wage increases, it is possible for real wages to drop, if the prices rise enough to undercut the gains from trade. When country A moves from autarky into trade, it experiences an increase in the cost of the factor with which it is more endowed (labour), because of the discussed increase in nominal wages, and a simultaneous reduction in the cost of the factor with which it is less endowed (capital), because capital-intensive goods can be imported at world market prices, inferior to the cost of producing them locally. The change in the prices of the two factors are shown in the tilt of the price ratio line, whose slope gives us the relative prices of labour and capital. This goes from the slope of line RA (rate of prices in Autarky) to RT (rate of prices with Trade) (Chart 2). This is partly made possible because, in trade conditions, the people from country A 3

Agricultural Trade and Policy – Continuous Assessment Exercise can shift their preferences to adapt to the new situation: by moving from CA (consumption in autarky) to CT (consumption in trade), they consume more of the products X (capitalintensive) and less of products Y (labour-intensive). Therefore, we conclude that, in the absence of any macroeconomic policies that result in increases in inflation, the real wages in country A will increase, thanks to a combination of increasing nominal wages and reduced inflation of the overall consumed bundle of goods. This is shown in Chart 3 by the fact that consumers move into a higher indifference curve (from U1 to U2).

Good Y (L)

RT YT

PT

U2

U1

YA

PA=CA

CT

YC

RA Chart 3

XT

XA

XC

Good X (K)

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Agricultural Trade and Policy – Continuous Assessment Exercise a3. the distribution of income between households We consider that country A, as described above, has in place trade barriers, and that the factors of production are capital and labour. What is normal in this situation is that the barrier is in place to protect that part of the economy at which the country does not enjoy a comparative advantage. In the case of country A, that means the barrier is protecting the income of the people who own capital, the wealthier members of society. Trade liberalisation results in domestic prices for goods to converge towards the international market prices. In this situation, the capital-intensive activities become less profitable, because cheaper foreign goods are available, shifting the economy towards labour intensive activities, increasing the demand for labour in the process, as discussed above. As a result, the price of capital decreases and the price of labour increases – factor price equalisation. Consequently, capital owners are worse-off and wage earners are better-off. Since the wage earners are usually the less well-off members of a society, trade liberalisation – in a perfectly competitive market, with undistorted labour markets and ignoring further factors as described above – would promote a shift of income from the richest members of a society and towards its poorer members.

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Agricultural Trade and Policy – Continuous Assessment Exercise b1. how the simple extensions of H-O to include human capital and to take account of natural resource differences resolve the problem. Heckscher-Ohlin predicts that a capital-rich country would export mainly capitalintensive products, and that a labour-rich country would, conversely, export mainly labourintensive products. This would be the result of specialization on both sides, with each country making the most out of the comparative advantage it possesses. However, the results from empirical testing have not confirmed the theory: this fact has been called the Leontief Paradox. Various attempts have been made at improving the model, such as to expand the factors of production considered in order to include natural resources and human capital (skilled labour). However, these attempts are not problem-free. Natural resources do not fit the model well, so resource-based industries are omitted from the analysis, which helps improve its predicting capacity. Natural resources present the problem that they can't be easily transfered between industries, one of the basic assumptions of the Heckscher-Ohlin model. As for human capital, it is an attempt to account for differences in skills among labour. Human capital (specialized skills) would be seen as a kind of physical capital. However, theory questions whether the two kinds of capital are interchangeable, and statistics seem to show that human capital is a better predictor of trade flows when treated as a third, separate factor. In the end, the extensions to Heckscher-Ohlin model do not completely solve the questions that result from the Leontief Paradox. Human capital, by not conforming to being added to capital, becomes a third factor of production. Research and development can help a country gaining advantage in the production of a certain good by increased productivity of technology, but technology is usually capital intensive, and capital has not shown to be the best predictor of agricultural trade flows. Also, natural resource endowment has proven difficult to account for, since natural resources are not directly substitutable with other inputs of production. Natural resources are a source of comparative advantage in agricultural production, and failure to account for them, although it adjusts the model to reality in a better fashion, is hardly acceptable. So, one could say that the increase of prediction capacity by the model without natural resources comes at the expense of its fit to reality.

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Agricultural Trade and Policy – Continuous Assessment Exercise b2. the applicability of the New Trade Theory to trade in these products New Trade Theory (NTT) points out several aspects that affect trade and that are unaccounted for in Heckscher-Ohlin Theorem: that most trade occurs between firms (not countries), that some of the specialisation might develop by chance instead of comparative advantage and that, once this happens, increasing returns to scale may arise, resulting in imperfect competition and maintaining the cumulative advantage. Other observations included in NTT are the fact that there is frequent intra-industry trade, and how this is accounted for by product differentiation and consumer preferences – both variables are absent from the H-O model's assumptions. Finally, the NTT also tries to account for the possible positive impacts of trade distortions for a country's industry. One advantage of the NTT for analysing agricultural trade is that it allows for intraindustry trade in situations where nations have specific and unique tastes, where economies of scale develop and the resulting product adds variety to the trading partners' choices or when seasonal factors occur (such as when the time of crop for a given products are different along the trading partners). All these possibilities violate the assumptions of Heckscher-Ohlin Theorem, but account well for some of the observations in reality. According to the New Trade Theory, specialisation in agricultural production might be a consequence of either chance or some comparative advantage, followed by imposition of a trade barrier in the right time, therefore defending an infant industry from external competitors. As a result, that industry might gain bulk and, consequently, returns to scale. The increasing returns would lock-in the cumulative advantage. However, the applicability of New Trade Theory to agricultural commodities trade remains limited. First, raising barriers to protect a national industry is appealing, but might trigger negative reactions from the trading partners, causing them to raise their own barriers in return, resulting in losses for both sides. Also, the scope for economies of scale or network effects is relatively small in agricultural production itself, although some gains might exist relatively to support industries, like transport and storage. However, the fact that little or no economies of scale develop eliminates most rationale for raising barriers. Also, the bulk of trade in agricultural products is in undifferentiated commodities, allowing little scope for product differentiation. The specific tastes, that do exist, act as isolated

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Agricultural Trade and Policy – Continuous Assessment Exercise exceptions, while most of the trade develops around standard products. As a result of these facts, for agricultural trade NTT is relatively flawed and less useful than H-O; protectionism for a country's agricultural production eventually leads to disinvestment, less productivity and a general negative outcome, possibly because there are little to no economies of scale in agriculture. The fact that trading partners might raise trade barriers as a result of protectionism, and that this way the losses are for both partners only shows the limits in applicability of this model to agricultural trade.

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Agricultural Trade and Policy – Continuous Assessment Exercise b3. where do these developments leave the trade analyst? A trade analyst working on the field of agricultural products has a difficult work. Not only the field of study has many specificities, the relevant models – especially the Heckscher-Ohlin model and the New Trade Theory model – fail to live up to the empirical observations. Reality, it seems, contradicts these models, rendering them useless or near. The problem with the Heckscher-Ohlin model, either the original formulation or its extensions, is that the assumptions on which it is based are not realistic. In reality, and even if we consider a partial equilibrium model of only two countries and two goods, free trade very rarely happens – there are trade barriers and various costs, like transportation; competition is not perfect, so not all the participants in trade are price-takers; tastes vary, even if not by much, between countries; and, especially, there are factors of production other than capital and labour, and these factors are hardly perfectly mobile between industries, although they can be partially mobile between countries. The extensions to Heckscher-Ohlin to include human capital and natural resources are a way to try going around this last set of limitations. Both manage to improve somewhat the prediction capability of the original model, but at the expense of leaving important factors for agricultural production out of the picture (natural resources), or of increasing the complexity with the analysis with a variable previously unaccounted for (human capital). As a result, none manages to provide a framework that far surpasses the original model or that overcomes the rest of the limitations (the assumptions) of it. On the other hand, New Trade Theory tries to explain trade from a different perspective, and provides some valuable insights in the process. Its focus is not on factor endowment but on the result of a combination of lucky historical coincidences, protectionist policies and economies of scale. However, because of the low scope for economies of scale in agricultural production, possible gains are wiped out by the probable trade wars that follow protectionist policies. In the end, trade analysts keep going back to Heckscher-Ohlin for a framework on trade in bulk agricultural products. It has not been possible to demonstrate empirically the basic soundness of the model because some of the assumptions fail when confronted with a varied and political economy-ridden reality. However, the model provides the most powerful insight available and, most importantly, shows that trade barriers are welfare-

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Agricultural Trade and Policy – Continuous Assessment Exercise diminishing and that trade liberalisation would achieve a higher overall welfare for all participants. It points the way to a greater efficiency in the distribution of scarce resources and, once it accounts for differences in the kinds of labour, also accounts (indirectly) for technology development and the role it can play. As a result, the Heckscher-Ohlin model is still the best model available for examining trade in agricultural products.

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