bernhofen inaugural

COMPARATIVE ADVANTAGE,COUNTERFACTUALS and the‘NATURAL EXPERIMENT OF JAPAN’: 

COMPARATIVE ADVANTAGE, COUNTERFACTUALS and the ‘NATURAL EXPERIMENT OF JAPAN’ Daniel M. Bernhofen Inaugural Lecture University of Nottingham April 25, 2006

Perspectives on comparative advantage (CA): 

Perspectives on comparative advantage (CA) Political dimension: CA as a justification for open markets: pro-globalists: embrace the concept. anti-globalists: take a critical position. Academic dimension: CA as a (scientific) theory of international trade.

Organization: 

Organization Intellectual history of the (scientific) theory of comparative advantage. Milllenium event: Japan’s 19th century opening up to the world. Opening up of Japan as a “natural experiment” (i) to provide the first test of the theory of comparative advantage and (ii) to assess the gains that arise from comparative advantage. analytical tool: counterfactual analysis.

What is a scientific theory ?: 

What is a scientific theory ? Three components: 1) Assumptions 2) Logic 3) Predictions Black box view of a scientific theory: Assumptions-> Black Box -> Predictions. (Logic) as the 1st organizing principle.

2nd organizing principle: “Intellectual break-throughs”. : 

2nd organizing principle: “Intellectual break-throughs”. Summary of the progress report (1817-present) Assumptions have become more general. Logic has been refined. Nature of the prediction has been preserved. -> Historical narrative.

Historical background: A response to Mercantilism.: 

Historical background: A response to Mercantilism. Perennial question : What determines the wealth of a nation? Mercantilistic answer (16th /17th/18th centuries): International Trade. “What is true for the merchant business must also be true for the nation as a whole. Trading makes you rich. And you become rich by accumulating gold. Exporting is good as it brings in gold, importing is bad as gold is flowing out of the country.” Mercantilistic policy advice to the crown: Promote exports and discourage imports.

Genesis of economics: 

Genesis of economics Scottish Enlightenment (David Hume, Adam Smith): David Hume: => Identified a flaw in mercantilistic thinking Emphasized the interdependency between exports and imports Developed his famous specie-flow mechanism (balance of payments theory). Adam Smith (1776, “An Inquiry into the Nature and Causes of the Wealth of Nations”) => The wealth of a nation is determined by its national productivity. => National productivity is governed by the division of labour, which is guided by the ‘invisible’ hand of the market mechanism.

2nd Perennial question: What governs international trade?: 

2nd Perennial question: What governs international trade? David Ricardo, 1817, Theory of comparative advantage: “The trade between countries is governed by what each country does relatively best”.

Prerequisite: A (labour) theory of value: 

Prerequisite: A (labour) theory of value “A science requires for its very existence a set of fundamental and durable problems. In economics the most fundamental of these central problems is the theory of value. The theory of value must explain how the comparative values of different goods and services are established. Until that problem is solved, it is not possible to analyze for scientific purposes what will be produced and in what quantities, how the resources will be employed…and how the resources will be valued. Without a theory of value, the economist can have no theory of international trade, nor possibly, a theory of money.” (George Stigler, 1983, Nobel Lecture on “The Process and Progress of Economics”)

Ricardo’s formulation: 

Ricardo’s formulation Ricardo’s assumptions: 2 countries, England and Portugal, are involved in trade. 2 goods: cloth and wine. Ricardo’s logic (labour theory of value): The relative value a good is determined by the labour embodied in it, i.e. the number of workers needed to produce it. “4 numbers”: England Portugal cloth 100 90 wine 120 80. Ricardo’s prediction: England will export cloth and import wine.

1817-1930: “What is value?”: 

1817-1930: “What is value?” Ricardo’s model became the dominant trade model of the 19th century. Ricardo’s labour theory of value became also the foundation of Marxian philosophy and economics. Emergence of a consumption society => Emergence of ‘utility theory’ (Jevons, Menger,Walras), 1871-74: “The value of a good is determined by the utility it provides to consumers”. Zeitgeist of the 1920s: “Labour theory of value has become old-fashioned since it ignores the other factors of production”. J.M. Keynes (1928): “The free trade case must be based in the future, not on abstract principles of laissez faire, which few now accept.”

1930: Gottfried Haberler’s reformulation of comparative advantage: 

1930: Gottfried Haberler’s reformulation of comparative advantage Reconciled the tension between the classical writers and and the utilitarians. “The value of a commodity is what you have to give up to obtain it”. Value (=Price) can now be linked to production and consumption factors.

’Legacy’ of the Austrian School (Haberler, Hayek):: 

’Legacy’ of the Austrian School (Haberler, Hayek): The dispute about the theory of value has been settled by adopting the opportunity cost formulation of value. (this resolves the famous ‘water-diamond value paradox’) Comparative advantage is about the reallocation of resources =>set the agenda for the development of modern general equilibrium price and trade theory. Hayek (1945): “Prices carry information about economic fundamentals (tastes, endowments, preferences)”. Haberler’s (1930) trade-off diagram: “The trade economist’s most favourite diagram”. Used by other disciplines, e.g. Rawls (1971), “Theory of Justice”.

The opportunity cost formulation: 

The opportunity cost formulation

1930-1980: Development of general equilibrium price and trade theory: 

1930-1980: Development of general equilibrium price and trade theory Refinement of the “gains from trade” => revealed preference theory (Samuelson) ‘Fundamental’ existence and welfare theorems (McKenzie, Arrow, Debreu) Trade theory separates from ‘economic theory’ as a separate field. Dilemma in the late 1970s: What can we say in higher dimensions? The theory of CA appears to break down.

1980: Alan Deardorff’s general equilibrium formulation: 

1980: Alan Deardorff’s general equilibrium formulation The spirit of the law can be preserved in a fully specified general equilibrium model. Although there is no prediction for each good, there is an “average” prediction”. The prediction holds with a minimum of ‘critical’ assumptions.

Logic of the general prediction: 

Logic of the general prediction Data on two regimes: autarky and free trade Autarky price data: p=(p1,…,pn) Trade data T=(T1,…,Tn) (if Ti>0 the good is imported; if Ti<0, the good is exported) Prediction: p1T1+…+ pnTn>0. Zeitgeist of the 1990s (empirical age): “When the law of comparative advantage is expressed in terms of a comparison of price vectors in autarky and trade, and when autarky prices are completely unobservable, we must ask what the theory is all about.” (Leamer and Levinsohn, 1995)

Our research contributions(Bernhofen and Brown, 2004 & 2005): 

Our research contributions (Bernhofen and Brown, 2004 & 2005) There is a refutable hypothesis about comparative advantage that can be tested with a ‘natural experiment’. One can identify a probability statement about rejecting the ‘alternative hypothesis’, defined as ‘chance’. One can provide a theory-based counterfactual calculation about the magnitude of the comparative advantage gains from trade.

Slide19: 

THE ECONOMIST (The world this Millenium, December 31, 1999): … “Japan cut itself off in 1639 from outside the world to reopen only in 1853- and catch up on three centuries of western technology in one.” …

The tale of Japan: 

The tale of Japan 1542: “Discovery” by the Portugese. 1639-1853: Policy of seclusion. 1851-1853, “Experimental autarky window”. 1853: US Commodore Perry arrives in Tokyo Bay. 1858: Signing of Treaties. 1868-1918: Period of Modernization. “1868-1875: Experimental free trade window”. 1918-present: Japan emerges as a major economic power.

1542: “Accidental discovery”: 

1542: “Accidental discovery”

Incentives for seclusion: Avoid foreign threats and prevent growing allegiance to a foreign pope : 

Incentives for seclusion: Avoid foreign threats and prevent growing allegiance to a foreign pope

Only contact point with the west: Dutch trading settlement on an artificial island in Nagasaki harbour: 

Only contact point with the west: Dutch trading settlement on an artificial island in Nagasaki harbour

Life on the trading post: Preservation of Dutch fashion from the 1640s : 

Life on the trading post: Preservation of Dutch fashion from the 1640s

A Japanese view of Perry’s fleet and the meeting on the Shore of Tokyo Bay, 1853.: 

A Japanese view of Perry’s fleet and the meeting on the Shore of Tokyo Bay, 1853.

Technologically backwards, but market based: 

Technologically backwards, but market based An English steam powered spinning “mule” of about 400-500 spindles. A Japanese woman turns the spinning wheel with her right hand and winds cotton (1840s).

Traded Products: 

Traded Products Major Exports, 1860s Silk Silkworm eggs Tea Copper Seaweed Seashells Major Imports, 1860s   Cotton Cloth Cotton Yarn Woolens Rice Sugar Beans and Peas

Japan as a ‘natural experiment’: 

Japan as a ‘natural experiment’ Market based economy in isolation. Excellent environment and data that justify combining price data from “1851-53” with trade data from “1868-1875”. 2 Major findings: I) We can reject the hypothesis that Japan’s trade was governed by “chance” with 99%. II) Counterfactual gains from trade calculation.

Causality and Counterfactuals: 

Causality and Counterfactuals Q: What causes the soccer ball to fall? Q: What is the contribution of trade to a nation’s wealth? Counterfactual answer for Japan: “If Japan were engaged in international trade during its final years of isolation, the average Japanese worker would have gained about 15 days of production per year: a two-week paid holiday!”

Conclusion: Why do we care?: 

Conclusion: Why do we care? Impact on Teaching of CA. Trade policy advice: Intellectual justification for doing calibration. Warning: Justification of trade liberalization on the grounds of (static) comparative advantage arguments.