Positive and Normative Analysis in International Economics

This volume draws on the research results of a joint research project initiated and led by Hiroshi Ohta and his fellow scholars, many of whom constitute the authors of various chapters in the volume. In retrospect, one key feature that has shaped the defining characteristic of the project since its inception — as Hiroshi stressed by referring to the principle of comparative advantage — would be the beauty of being ‘different’. Just as international differences in technology, factor endowments, or tastes are what drives countries to engage in welfare-improving trade, the differences among researchers’ paradigms and methods are what potentially elevate and refine our understanding of how the global economy functions. Accordingly, as the table of contents of this book reveals, the chapters in this volume span a wide range of topics in international economics from multidimensional perspectives. At the same time, the volume aims at a fine balance between positive and normative analysis as well as between theoretical and empirical research.

It is more than two hundred and fifty years since Montesquieu (1749) wrote his ‘Lettre à William Domville’. In that essay Montesquieu discussed what would now be called the welfare implications of international trade. The chief novelty of the essay lay in its focus on the well-being not of the Prince but of the People, that is, of the population at large. The central questions suggested by it concern the sense in which a country may be said to benefit from the opportunity to trade with other countries and the variety of circumstances under which trade is indeed beneficial. The first of these questions was answered, although not to everyone’s satisfaction,² by Pareto (1894), at the end of the nineteenth century. Early in the twenty-first century, the second question still awaits a complete answer. This is a somewhat alarming state of affairs for, without a reliable normative branch of our subject, we cannot evaluate the potential policy-relevance of the propositions of descriptive trade theory on the development of which we spend so much of our time and other resources.

The present inquiry revisits my past endeavours to reveal certain moral scientific aspects of the well-known Stolper–Samuelson theorem and the related less well-known proposal to ‘bribe’ for free trade. My inquiries have assumed, and so does the present one, two identical countries, identically endowed with homogeneous labour and capital (or two factors) but with internationally different tastes.

Innovation plays a key role in the theory of economic growth, but it contains different elements. These can be divided into two broad categories – process innovations and product innovations. The former may also be named ‘cost-reducing innovations’ in the sense that they take place through the discovery of new processes to produce the old products at lower costs. By contrast, the latter may be called ‘quality-improving innovations’ since they occur through the creation of new, higher- quality products. Both categories of innovations are, of course, important as engines of economic development, but their implications for economic welfare can vary enormously from time to time and from place to place. In poor economies in the early stage of development, process innovations in the daily necessities contribute significantly to the life of people. In affluent societies in the modern age, however, ‘it would be a terribly dull life if innovations only reduced costs of producing the same menu of goods and services that now populate their markets’.¹ Product innovations are crucially important in such a situation. This chapter compares the welfare implications of cost-reducing and quality-improving innovations in the context of modern international economies in which both poor and affluent countries coexist and interact.

The concept (law, principle) of comparative advantage is due to Ricardo (1817, Ch. 7) — the term is also found in Ricardo (1817, Ch. 19, p. 175), cf. Ruffin (2002, p. 743). The expression ‘what a country can do most cheaply’ needed careful examination, and it was in analysing this idea more sharply that Ricardo enunciated the principle (term) of comparative advantage. The Ricardian term means the ability to produce a good at lower cost (relative to other goods), compared with another country. With perfect market competition relative costs are also relative autarchy prices, and the law of comparative advantage (cost) says that a country exports (imports) the good with the low (high) relative autarchy price. This Law of Comparative Costs will always remain a fundamental principle of economics and international trade.

Broadly speaking, welfare economics over the past three-quarters of a century deserves credit for many signal developments in the world economy: the expansion of free trade, the extension of competition, and the deregulation of industries such as transportation, energy, communications and finance. Every world leader with a university degree now probably subscribes to the broad principles of welfare economics — in theory, if not always in practice.

Cost harmonization is said to occur when foreign firms’ (marginal) costs are brought closer or equalized to those facing domestic rivals. Cost harmonization can occur for various reasons; for example, by falling transport costs, which brings the foreign firms’ cost down to the level facing the domestic firms. As another example, suppose that the foreign government dismantles its export subsidy programs. Then, the loss of subsidies raises the foreign firms’ costs, thereby closing the cost gap between the foreign and the home firms. In this case, the cost is closed by a rise in the foreign firms’ cost.

During the global recession that began in September 2008, the world economy started to operate significantly below full capacity, and many industries around the world faced closure or else were forced to slash capacity to cope with the reduction in demand. As reported by United Press International (11 May 2009), the capacity utilization rate for industry overall in the United States fell to 69.3 per cent, a historical low since these statistics began to be compiled back in 1967. Collapsing world trade and the corresponding impact on industrial production has led the recession to spill over into export-led economies such as Bangladesh and Pakistan.¹ Such exporting countries have faced low capacity utilization caused by the global recession, and in response they have raised their export subsidy rates to promote their exports and help soften the low capacity-utilization problem. This simply indicates that export subsidy rates should increase with a fall in capacity utilization (or a demand recession).

According to Eaton and Schmitt (1994), the essence of flexible manufacturing is scope economies in the production of differentiated goods.¹ Eaton and Schmitt introduce scope economies as a device for a basic product to be modified to produce differentiated variants. They argue that firms can develop the ability to produce a basic product while incurring a sunk cost of product development. This basic product can be further modified to produce differentiated variants, albeit with an extra switching cost.

One of the recent policy concerns in the area of development is whether globalization really helps to improve standards of living in developing countries. International organizations advocate the merit of accessing the global economy via foreign direct investment. Anti-globalization movements do not necessarily agree with this view. Those opposing globalization argue that self-interested multinational companies exploit the resources of developing countries and impair development. Thus, for the purpose of long-run economic growth, it may be better to protect domestic infant industries rather than rely on foreign capital.

Two seemingly unrelated issues involving economic growth have received a great deal of attention in the development literature: the environmental Kuznets curve and the union strength hypothesis. The former explains much of the inverted U-shaped relationship between income growth and environmental degradation, while the latter touches upon the inverted U-shaped pattern between the strength of unions as income rises. In view of these two inverted U relations, regarding income growth, one naturally would conjecture the existence of link between the strength of labour unions and the environment. In particular, would the growth of labour unions precipitate environmental degradation?

As international trade and financial flows have increased, so have the so-called ‘global imbalances’, that is, the large and persistent trade and current account imbalances, including the current account deficit of the United States and the counterpart rise in the surpluses of East Asian nations (most notably, China and Japan). The natural question that arises is whether such persistent current account imbalances could pose an economic problem in themselves and whether the imbalances are sustainable. Deeply imbedded in the sustainability issue is the debate on the need for, and the feasibility of, the correction of current account positions. Some contend that the current account imbalances should and can be corrected, for instance, by way of policy-induced changes in the terms of trade (or real exchange rate) accompanied by deliberate changes in the exchange rate. Behind this view is the implicitly assumed adjustment mechanism that a decrease in the relative international price of exportables (that is, a real depreciation or devaluation) results in increased net exports.

One of the best-known events in the post-war economic history of Japan is the sharp appreciation of the yen in the mid-1980s. The dollar– yen exchange rate, which had been hovering around ¥240/$ during the early 1980s (between the inauguration of the Reagan Administration in January 1981 and the Plaza Agreement in September 1985), tumbled to ¥122/$ in December 1987, almost doubling the yen’s value in two years. (See Figure13.1.) Both the magnitude and speed of appreciation were unprecedented, whose record has not been broken until now.¹

Debates over the economic merits of free trade have surfaced recently. Trade tends to bring about what Ohta and Nakagawa (2008) called the ‘worsening terms’ of exchange, which is a more intra-national than inter national phenomenon. Yet this more intra-national, distributional conflict manifests itself as a stumbling block to international trade, as suggested seventy years ago by Stolper and Samuelson (1941) (SS).¹ An enormous amount of subsidy is reportedly poured into the adversely affected sectors in Japan, in particular agriculture. Further increased open trade will be an important factor in raising the average living standards of people in the country. However, agricultural trade liberalization has remained controversial and should be debated. Irwin (1996) and Bhagwati (2002) have discussed the economic merits of free trade. The negative effects of protectionism are well documented by Bhagwati (1988). Krugman (1987) has stated: ‘the case for free trade is currently more in doubt than at any time since the 1817 publication of Ricardo’s Principles of Political Economy…’. However, he also noted that ‘… free trade is not passe´… Its status has shifted from optimum to reasonable rule of thumb. There is still a case for free trade as a good policy, and as a useful target in the practical world of politics,…’. Herrmann (2007) discusses the linkages between agricultural support measures in developed countries and food security in developing countries. He argues that ‘A credible phasing-out of agricultural support should receive priority in multilateral trade negotiations.’ Sound agricultural policies eliminating market distortions should be based on an economic rather than a political rationale.