New Developments in Trade and Trade Theory

<a name=”TOP”></a> NZIIA Mini-seminar on New Zealand’s Overseas Trade:  Policies and Practices One Hundred Years Experience of Overseas Trade Development. 9 November, 2009

Keywords: Globalisation & Trade;

Three centuries ago, there was little international trade. Almost all involved ‘absolute advantage’, the exchange of products which could not be locally produced. Because the cost of transportwas high, the products had to be valuable. Thus spices from the east came to Europe from the east in exchange for silver it had seized from America.

About two centuries ago, the cost of transport – all the costs, so call them the ‘costs of distance’ – began to fall, opening up the possibility that international trade on the basis of ‘comparative advantage’. Now an economy might import a product which it could make itself – even which it could make more efficiently – because it used less resources to produce the exports which it could exchange for the import.

It is instructive that Adam Smith, who identified the significance of economic specialisation , did not support international trade, for in his day the costs of distance were high so it was not particularly relevant. Forty years later, as the costs fell, David Ricardo set out the theory of comparative advantage.

Over time, the falls in the cost of distance have been dramatic and transforming. Europeans would hardly have come to New Zealand if sailing around the world had not simplified. Refrigeration was to dramatically change New Zealand from an economy based on sheep stations in the nineteenth century to family farms in the twentieth, a change which impacted on the fundamentals of its politics and society, as well as the economy; this is a major theme in the story of New Zealand which I am writing.

Costs of distance have continued to fall. For instance our tourist industry – inbound and outbound – depends on low costs of international travel; it costs much the same in nominal dollars to fly about the world as it did forty years ago, even though prices have generally increased by twelve and more times.

Subject to one caveat, we can expect the costs of distance to continue to fall, often with surprising consequences. The introduction of the world wide web has made the cost of information flows near zero, enabling a raft of service industries to become internationally footloose. As a consequence we are seeing offshoring of parts of the service industry, just as occurs with manufacturing. Another increasing phenomenon is value chaining, where the components of a product are created in countries different from where they are assembled. Both could have considerable implications for New Zealand economy; are there opportunities here we have yet to seize?

The caveat is that it is possible that following ‘peak oil’, the price of transport fuels may rise sufficiently to reverse the falling costs of distance. When I looked it at this scenario, I concluded that the rise is likely to be offset by medium term technological improvements in energy use So we might get a period of a decade, say, in which the effective costs of distance stagnate. Even so there would be ongoing progress, because the existing possibilities have not yet been exhausted; in any case fuel costs have little impact on information flow costs.

While there are still gains to be made from international trade based on comparative advantage, competitive advantage is becoming increasingly important. Sixty years ago, trade between countries was based upon the exchange of different products, and there was hardly any intra-industry trade. Today two countries may sell the cars they make to one another. Nowadays about a quarter of internationally traded goods is based on intra-industry trade, the exchange of similar products. That probably also applies for services.

Just as David Ricardo developed a theory to explain comparative advantage trade a bit after it began, about three decades ago there evolved the New (International) Trade Theory. Last year its significance was recognised when Paul Krugman became a Nobel Laureate. At the heart of the New Trade Theory is economies of scale. To reap them one needs large markets, so the falling cost of distance is crucial. But their effect is much more complicated than in the comparative advantage case.

At the firm level economies of scale explains why a firm cannot provide unlimited variations in its products. It would be far too costly to offer you a car in any shape, size, colour and trimmings. By standardisation the firm can get the costs of the range it produces down. The consequence is that you may prefer another manufacturer’s car with a different mix of those characteristics. That manufacturer may be offshore. And so we get intra-industry trade in cars – and many other products – once production economies of scale are important.

There are also agglomeration economies of scale for industries, where industry costs are lower when they are clustered in a common area. This explains why there are concentrations of population and industries in particular locations, despite the diseconomies of congestion. A branch of the New Trade Theory is known as the New Economic Geography.

The New Trade Theory has hardly impacted on New Zealand’s economic thinking. We are so focused on classical comparative advantage that we seem unaware of the extraordinary changes in economic theory and in the international economy we live in. I can identify but one policy area where there has been some impact.

The proposals to reform Auckland’s governance were in part based on the New Economic Geography. Even so, much of the concern was to see Auckland as a gateway city, not a global city. My impression is that Aucklanders still have not faced up to all the implications of what it means to be a global city; while Christchurch, which should be our second one, is even more backward in its thinking.

We hardly care about New Zealand’s dismal intra-industry trade performance. Perhaps the national judgement of the irrelevance of the new patterns of trade is correct. Perhaps New Zealand’s destiny is to be a comparative advantage trader in the international economic regime. It has suited us well in the past, and there may remain a future for such suppliers, although the real challenge may be how to be a high income comparative advantage exporter. But I sure wish that we made a conscious decision to pursue a comparative advantage strategy and ignoring competitive advantage, rather than choosing it by inertia and default.

For even if we pursue the comparative advantage strategy we need to be aware that the international economic regime is changing under the forces which the New Trade Theory. Economic activity is relocating away from the North Atlantic economies to – especially – Asia. The European Union and the United States will remain important parts of the world economic and political order, but with the rise of China and India plus Japan, the North Atlantic will not be the hegemonic power that the US is and Britain was. But that is another seminar. <a href=article1046.html> It is the implicit theme of the one which the NZIIA is holding in 15 days on the BRICs.</a>

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