The Ricardian Model, the Intra-Industry Trade and the Structural Adjustment Path for the Portuguese Economy 1 *

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2 The Ricardian Model, the Intra-Industry Trade and the Structural Adjustment Path for the Portuguese Economy 1 * Horacio Crespo Faustino December 1992 Introduction The analysis of intra-industry trade has gained in the last decade particularly attention due to the increasing weight of this type of trade in world trade, namely among developed countries. For Krugman (1979, 1980, 1981) and for Lancaster ( ) and Helpman (1981, 1984) the trading of similar products within the same industry, designed as intra-industry trade, may simply be the result of the exploitation of economies of scale internal to the firm and / or product differentiation. The fundamental question of economies of scale at the firm level is that its persistence puts into question the conduct "price taking" and the perfect competition equlibrium. The large firms have advantages over small firms and a few firms end up dominating the market of their product - the competition becomes imperfect and the market price is above marginal cost. Various forms of imperfect competition take place: monopoly, oligopoly and monopolistic competition. The models of Krugman and Lancaster are models of monopolistic competition - although the treatment of consumer preferences is different. In summary, the intra-industry trade can happen (and it happens more often) between countries with similar factors endowments and, therefore, the factor proportions theory of Heckscher- Olhin-Samuelson-Vanek (HOSV) could not explain the intra-industry trade. However this is not the position of Finger (1975), Neme (1982) and Chipman (1986), for example, who consider the intra-industry trade a problem of statistical aggregation: the products belonging to the same industry are not homogeneous and can be produced with different proportions of factors reflecting the difference in relative abundance of factors. Furthermore the models of imperfect competition (taken from the Industrial Economics theory) have been used by theorists of international trade for the defense (or criticism) of neo-protectionist positions (strategic trade policy) or to defend the road to intra-industry specialization as the best way to proceed to structural adjustment. So, there is a question that arises: can the traditional models of Ricardo and Heckscher-Olhin explain this kind of trade? In the models of Krugman (1979, 1980, and 1981) and Lancaster (1980) products are differentiated only by the demand side and not on the supply side: the production function considered and the production techniques are identical for all firms within the same industry. It is considered that there are economies of scale. The models of Krugman consider that there is only one factor: labor. According to Willmore (1978) if the goods are close substitutes in consumption (eg, rubber boots and leather boots) but are not close substitutes in production, then the intra-industry trade can be explained by the traditional theory of HOSV. Thus, underlying the position of Krugman and Lancaster is the hypothesis of heterogeneous goods, close substitutes in both production and consumption. Dunning and Norman (1984) distinguish four types of intra-industry trade depending on the type of goods and hence four different types of influence of multinational firms and FDI in trade and welfare. Goods type I are complementary goods in consumption. The trade in these goods is explained by the theory of HOSV, by the neotechnological theories and by economies of scale. There is intra-industry trade in such goods due to inputs that are used in various stages of production are included in the same statistical category. The type II goods are goods that are substitutes in production but not consumption. These goods are produced with the same technology and are 1 Once again we return to this theme, continuing a previous working paper (see Faustino 1992a). * This is a translation of the following working paper: Horácio Faustino (1992).O Modelo de Ricardo, o comércio intra-sectorial e a via do ajustamento para a economia portuguesa, ISEG, CEDIN-Centro de Estudos de Economia Europeia e Internacional, Documento de Trabalho Nº 7/92, p.35. (see, or and after, Publications/Working Papers) 2

3 typically associated with joint production: each firm produces many varieties of the same good. The intra-industry trade of these goods is explained by economies of scale. Type III goods are substitutes in consumption but not production. They are produced using different technologies and different proportions of factors. These goods are typically HOSV and in this case the intra-industry trade can be explained by this theory.the type IV goods are substitutes in production and consumption. Are typical products of intra-industry trade and the underlying theory is that of oligopoly. In this working paper, our concern focuses on the possibility of Ricardian model can be used as a theoretical explanation of intra-industry trade and thus as a theoretical basis for guiding policy of structural adjustment, notably in Portugal. One possibility we have is the introduction of economies of scale in the model through the consideration of fixed costs in the cost function. These fixed costs would be the cost of investment in human capital, R & D, for example, 2 or by considering the hypothesis of the labor average productivity (and marginal) may vary (increase) with the increase of production: this increased productivity, equivalent to the verification of technical progress in the neoclassical model, can be attributed to investment in R & D. If we consider that the State (Government) has a strategic policy of subsidizing for these R & D of key industry companies, then the portion relating to the cost of fixed capital investment subsidized by the State would not enter the cost function of industry which would increase the productivity, reducting the unit labor cost. So, the government subsidy for R & D firms does justify the non verification of the law of diminishing marginal productivity. In this situation the Ricardian model does not cease to be a model of perfect competition when you consider that these dynamic economies of scale occur at the industry level but not at the level of each firm taken separately. We can consider that remains the hypothesis of constant returns to scale, that goods are close substitutes in production are produced with the same technology and relative autarkic prices are equal-, but are not close substitutes in consumption. Thus, the trade should occur due to consumer preferences (demand for different products due to the preferences and / or marketing) and not by the difference in relative autarky costs.in this situation the specialization of the two countries is incomplete and may occur either inter-industry or intra-industry trade. Due to the existence of multiple equilibria at the level of production, the specialization is reversible and depends on consumer preferences. Moreover, we can consider that the hypothesis of constant returns to scale remains, but the goods are close substitutes in consumption (product differentiation) and are not close substitutes in production (labor productivity is different in different countries ). So, the relative costs in autarky are different. Additionally, we may consider the possibility of multilateral trade (generalization of the model to n goods and countries) and the possibility of intraindustry trade occurs because of the intermediate position occupied by certain Ricardian countries. Thus, a Ricardian country (or some Ricardian countries) can occupy a middle position: it can export products to countries that do not produce such products (inter-industry trade.), or can import products that can not produced ( we have also interindustry trade ) or can export and import these products (intra-industry trade). The consideration of these hypotheses led us to a justification for the incomplete specialization in the context of inter-industry specialization and the difficulty of explaining the occurrence of intra-industry trade within the chain of comparative advantage for n countries. 3 Note also that in this case the generalization of the comparative advantage chain for n countries is not ensured that trade increases the welfare for both countries, or at least that welfare remains (if the country is large). The possibility to adapt the Ricardo model to the explanation of intra-industry trade is important because: (i) Portugal is considered a country relatively abundant in labor (in the intermediate skill levels and low shill levels) with good ability to adapt to new technologies (capacity which has increased due to training) and the Ricardian model is a model that uses a single factor, labor;(ii) if we consider that new products are high-tech and skilled labor intensive and there is the possibility of trade pattern being determined by dynamic economies of scale, related to 2 Krugman (1979,1980) considered in their one factor model (labor), the cost of fixed capital in the abstract. This fact associated with the consideration of identical production functions for the same goods implies that the Krugman s model is a neo-hosv model (models HOSV type with economies of scale). 3 The difficulty of explaining intra-industry trade within the chain of comparative advantage for n countries and an infinite number of goods does not mean that trail this research is exhausted. The relative productivity of labor in the production of both goods is different in different countries and it is a realistic asumption the consideration of product differentiation by quality and hence the possibility of a country to export a product to countries that are below in the chain of comparative advantage (just with a level of demand for lower quality products) and import the same product in countries that occupy a top position in the chain (and therefore with higher quality standards). The difficulty is that these considerations also serve to justify the inter-industryl trade and incomplete specialization. 3

4 the effect of learning and training (subsidized by the State and, in our case, by the EEC). In this situation it is possible the occurrence of intra-industry trade without jeopardizing the hypothesis of perfect competition model of Ricardo and considering or the hypothesis of equall relative autarkic costs or the assumption of different relative autarkic costs. 4 Furthermore it is possible to link the policy of structural adjustment and strategic trade policy through subsidies to R & D, which consists of investment in human capital (highly skilled labor). In this sense there was a link between the problems of structural adjustment (including adjustment problems of labor by improving their qualifications) and strategic trade policy by subsidizing R & D industry activities. That is, the introduction of hypotheses regarding the search and qualification of labor allows the Ricardian model to explain both the intra-industry and intra-industry trade. Nowadays there is general agreement about the importance of Human Capital and intra-industry change in the pattern of trade. So, we can conclude that the Ricardian model has a political and theoretical interest. Another important result is that with the introduction of assumptions regarding the demand for skilled labor, the trade can have three origins: (i) the difference in opportunity costs in autarky determined by the difference of relative productivity in the production of both goods (or differences in relative labor costs). This difference gives rise to inter-industry trade, which is determined only by the production side (comparative advantages), (ii) the difference on the demand side: a preference for foreign products in a situation where the costs are equal in autarky (the average relative productivity are equal). In this case the trade that takes place may be inter-industryor intra-industry or both, (iii) the difference may lie in the qualification of labor due to investments in R & D supported by State: the average labor productivity is no longer going to be constant with the increase of production leading to dynamics economies of scale in the country that subsidizes R & D. In the latter case we maintain the assumption of constant returns to scale at the firm, considering that due to government intervention to reduce the unit cost is also for all firms in the industry considered strategic. 5 The paper is structured as follows: 1 - The simple model of Ricardo; 2 - The simple model of Ricardo and the explanation of intra-industry trade considering constant returns to scale and relative autarkic cost equal: the role of demand; 3 - The model of Ricardo and general explanation of intra-industry trade through the chain of comparative advantage, considering constant returns to scale and different autarkic relative prices: the role of relative wages; 4 - The Ricardian model and the introduction of the hypothesis of increasing returns increa and / or product differentiation: the R & D investment as a based for the difference in technology between countries and explanatory factor of intra-industry trade;5 - The Ricardian model and the adjustment problems of the Portuguese economy under the single market Finally, we present the main conclusions and we consider topics for future research. 1 - The simple model of Ricardo The original model of Ricardo is a production model with constant returns to scale. Assumptions of the basic model: 6 4 As we will see the occurrence of intra-industry trade with different autarky relative prioces requires a more detailed justification. 5 Here arises the question of maintaining the assumption of homogeneity of labor which would lead us to argue that in one country the labor could be highly qualified while the labor in another country would have a lower level of qualification. Or we can consider the labor being heteregenous with different levels of qualification In this case we would have to attribute the existence of intra-industry trade to the high qualified labor that allows product differentiation whereas the lowest levels of qualification would give rise to inter-industry trade. So in the same industry may coincide inter-industry and intra-industry trade, being the country relativamennte abundant in highly skilled labor that would have a higher percentage of intra-industry trade. In the latter case the Ricardian model is already a n factors model (as many factors as skill levels) and the trade can be explained by the relative abundance of factors (we have now a HOSV mode i.e., the Ricardian model would be a particular case of the HOSV model, when is considering a single factor of production). 6 The model was generalized by Dornbush, Fischer and Samuelson (1977) for an infinite number of goods and Susan Collins (1985) extended this generalization to the case of n countries. 4

5 - It is considered that in autarky the country produces and consumes two goods using labor as the only factor of production; 7 - The labor is a homogeneous factor ; 8 - The production function is different in the two countries and is homogeneous of degree one-constant returns to scale; - The opportunity cost is constant (the marginal rate of transformation is a constant), which reflects that labor is equally efficient in producing two goods; -There is labor mobility between sectors of the country but immobility between countries; -The price of labor is flexible, which ensures their full employment; - The labor supply is limited; - The labor productivity is not equal across countries so that the production function for the same product is different in different countries; 9 The goods move-up internationally in a free, no transport costs or tariff and nontariff barriers; -There is perfect competition in both labor market and in markets of both goods. Definitions: L A -labor endowment of country A; L B - allocation of work in country B; L i -amount of labor used in production of good i, with i = 1.2; Q i - the quantity produced of good i; a i - technical coefficient, gives us the amount of work required per unit of product, ie, the average cost to produce the product I, and that by definition is equal to marginal cost ( ai, is therefore the inverse of the average (marginal) productivity ); b i -has the same meaning that ai, but now only to country B w A - real wage rate in country A: give us the return for each work unit in country A and is equal to the marginal productivity of labor. As labor is homogeneous can be defined both in terms of good 1 (w A = 1/A 1 ) and in terms of good 2 (w A = 1/a 2 ); w B -real wage rate in country B; pa = (P 2 /P 1 ) A - The country's relative price or terms of trade in autarky. Gives us the price of one unit of good 2 in terms of good 1 (it is considered that the price of good 1 is equal to unity in the model without money); pb = (P 2 /P 1 ) B - autarkic relative price in country B; Y A -national income (national product) in country A; Y B -national income ( national product) in country B. Model equations: (1) a i = Li A / Qi A Give us the average (marginal) cost in terms of labor. Aso, a 1 and a 2 gives us the technology in country A (1/a i gives us labor productivity in both industires) (2) b i = L i B / Q i B 7 Some authors consider that the Ricardian model is a special case of the HOS model. In this case the other factors, notably the p hysical capital, can be transformed into labor through the equivalent in labor that incorporated in the physical capital. 8 After the Leontief paradox controversy, the concept of human capital and the existence of various labor skill levels has become a fact in the theory of international trade. Thus, labor is considered as a heterogeneous factor. This new assumption can be introduced in the Ricardian model to justify the difference in labor productivity in different countries. 9 Ricardo did not make clear where the difference in labor productivity in different countries is based : he attributed it to the innate ability of workers. This issue will be raised later regarding the Leontief paradox and the concept of human capital within the framework of the theory of HOSV. 5

6 (3) L = L i Tells us that there is full employment of labor in both A and B. (4) LA = a i Qi A It is the production possibilities frontier of country A, given by a straight line. (5) L B B = b i Q i It is the frontier of production possibilities in country B, given by a straight line. (6) = P A 1 a 1 W A tells us that the price equals marginal cost under perfect competition. (7) P A 2 = a 2 W A (8) P B 1 = b 1 WB (9) P2B = b2w B 10) p = P 2 /P 1 Give us the international relative price or the terms of trade, (11) Y A = p 1 Q A A 1 + p 2 Q 2 (12) Y B = p 1 Q B B 1 + p 2 Q 2 (13) C i = Qi -Xi, if the country exports good i (13 ') Ci = Qi + Mi, if the country imports the good i. If we consider the good 1 as a currency, we have from the division of (7) by (6): (14) p A = a 2 /a 1 Similarly to country B we have from (8) and (9): (15) p B = b 2 /b 1 Thus, according to Ricardo autarkic relative prices are given by their relative costs in labor. From (4) we have in country A: (16) = -dq 2 A /dq 1 A = a 1 /a 2 The equation above, tells us that the marginal rate of transformation of good 1 in terms of good 2 (or opportunity cost of good 1 in terms of good 2) is constant and independent of production level, reflecting constant opportunity costs. Similarly to country B, from (5): (17) -dq 2 B /dq 1 B = b 1 /b 2 Thus, combining (14) and (16) and (15) with (17), it follows that in autarky the relative price of goods is equal to its 6

7 opportunity cost and this is given by the amount of labor (working hours) required for the production of good 1, relative to the amount of labor that is needed to produce the other good. 10 For Ricardo the concept of comparative advantage includes the following elements: (i) is defined in terms of production (in autarky), (ii) is the international technology gap (the difference in labor productivity) which leads to comparative advantage, (iii) comparative advantage only materialize (is revealed) in international trade, (iv) the demand conditions are not necessary to define the comparative advantage. Thus, from (16) and (17) we have: if (18) a 1 /a 2 < b 1 /b 2 Country A has comparative advantage in good 1 and exports this good, while country B has comparative advantage in good 2 and exports this good. The only condition is that the international relative price, p = P 1 /P 2, is between the two relative autarkic prices for the exchange takes place, namely: (19) a 1 /a 2 p b 1 /b 2 where the equal sign for a country (big country) means that this country continues to produce the two goods, and got nothing from trade - because the autarky exchange ratio is equal to its international exchange ratio. Demand conditions are only required to determine the exact value of international prices, within the limits imposed by the production in autarky. 11 Even in the generalization to n goods and after the generalization to n goods and n countries, the demand conditions are only necessary to know where to cut the chain of comparative advantage, i.e. to know what goods a country exports and what goods this country imports. In this case, the only difference with the base model is that there is always a good that can be exported (imported) simultaneously by two (several countries). 12 What we said is 10 If the relative price of goods was higher than its opportunity cost (e.g. p A 2/p A 1> a 2 /a 1 would mean that the wages in sector 2, W A 2, would be higher than in sector 1, W A 1, given to (6) and (7). In this case the workers would move everyone to the second industry and the country would specialize in autarky only in the second good, which is contrary to the initial hypothesis of the country producing two goods. It is, now, better understood this hypothesis: it requires that the relative prices of goods is equal to its opportunity cost to be produced. And this is ensured by the assumptions of homogeneity and internal mobility of labor. 11 The lack of demand conditions must be understood in the sense that it relies on another assumption implicit in the model: in the autarkic situation both goods are produced and consumed and there is balance between supply and demand. In this situation the lack of international trade allows that autarkic prices are determined only by supply conditions. It is as if we had an infinitely elastic supply curve whose intercept is a 1 /a 2 in the country A and b 1 /b 2 in country B, leaving the demand curve to determine the level of production: the supply determines the price and demand determines the production. Since there are no economies of scale any level of supply is sufficient to determine the relative price in autarky.or, put it another way, the price is independent of labor endowment in the country. With international trade demand conditions determines the precise price within the range defined by the autarky prices in each country.there is, however, a "tribute" to pay for these prices: they can not be known (all known prices are determined by supply and demand). In international trade and for the country to benefit is only necessary that the autarkic relative price of the good on which the country specializes is less than that international relative price. So, we may have a plethora of autarkic relative prices and not one determined by the average labor productivity (marginal) that is differently in the two industries in the country. What remains true is that the technology (the supply conditions) determine the lower and the higher limit to the autarkic relative prices and hence the international relative price may take. 12 In this case, and considering additional assumptions relating to demand, we had a first explanation for the simultaneous existence of intra-industry trade and intra-industry trade, although the proportion of intra-industry trade allowed is clearly small relative to inter-industry trade. 7

8 commonly known as the Law of Comparative Advantage: 13 if the international relative price is between the autarkic prices, then each country specializes completely in producing the good where it has comparative advantage thus increasing world production of all goods and increasing the welfare of all countries. 14 Analytically one can prove this law from the theory of linear programming. 15 Consider country A. The problem is to maximize the national product, Y A, subject to the restriction of limited supply of labor, L A. Max Y A = p 1 + p 2 Q 1 Q 2 s.t a 1 Q 1 + a 2 Q 2 LA Q 1, Q 2 0 The optimal solution of the problem is given by one of the endpoints of the line that defines the production possibilities frontier (PPF), L A /a 1 or L A /a 2, i.e. a point of complet specialization. The end point will be depends on the inclination given by the international relative price (P 2 /P 1 ). If we assume that the international relative price is higher than the autarkic relative price given by the slope of PPF (a 2 /a 1 ). In this case the extreme point of tangency is the point L A /a 2 meaning the country has comparative advantage in this good and should completely specialize in it. If we do the same in relation to country B, we find that the endpoint will be chosen to complete specialization in good 1, ie, the point L B /b The simple model of Ricardo and the explanation of intra-sectoral considering constant returns to scale and equal relative autarkic cost: the role of demand The main explanatory variables of the models of intra-industry trade in imperfect competition are, in most studies, the internal economies of scale, product differentiation and the variables related to market structure, namely the index of industrial concentration. The theory of international trade was asking for assistance to the industrial economy and incorporates in their analysis the market structure. This was so because the traditional theory Ricardian theory and theory of Heckscher-Olhin-Samuelson- Vanek (HOSV) was based on the assumption of constant returns to scale (the increase of production factors used in the production of goods would increase the production goods in the same proportion) which is a fundamental hypothesis of the firms price-taking behavior. However, the reality shows that in more developed countries the markets for certain products - particularly the hightech products - are dominated by a few numbers of large firms. For these goods the origin of trade is not so much the cost advantages (even though they have also their weight) but primarily the increasing returns to scale (if we consider the supply side) and / or consumer preferences for differentiated products, produced under the same technique (if we consider the demand side). It is here that the Ricardian model once again has reason to be. According to the Ricardian model, the origin of trade lies in the productivity gap, or in other words, lies in the technology difference, the difference in the production functions. The HOSV theory holds that the production function is the same for the same goods in all countries and trade is originated by the diference in relative factor endowment of countries. If we accept the hypothesis of the Ricardian model - which in its origin is a production model in which demand has no place - and adding an appropriate assumptions regarding the demand conditions we cam make the following question: Can the Ricardian model explain the intra- industry trade, when this model is a model of perfect 13 The Law of Comparative Advantage is not exclusive to the Ricardian model. When the HOS model was generalized one form of its generalization was based on a generalization of this law in case of n goods and two factors made by Jones (1956) (For a survey of the general model of HOS see Faustino (1989e )). 14 As we stated previously, if the international price is equal to the autarkic price of one country then this country still has an incomplete specialization, i.e., produce the two goods as in autarky. In this case this country- named big country - do not benefit from trade and all profits will go to another country, the small country. (On this point see Chacholiades (1990, chapter 2). 15 Similarly one can prove the theorem in the simple HO model: each country should specialize and export the good intensive in the use of relatively abundant factor in this country (i.e. the good where it has comparative advantage). Also, in those circumstances the trade is mutually advantageous and increase the global consumption of the two goods. About the demonstration of the HO theorem from the theory of linear programming see Faustino (1987, chapter 2). 8

9 competition and intra-industry trade arises, usually associated with imperfect market structures and where the autarky cost differences are not relevant? The answer is yes if we consider the question rose earlier about the substitutability of goods at production level and at the consumption level. As this trade is predominantly a trade between the developed countries, where the factor price is not relevant, if we consider that autarkic relative prices are equal (i.e. that there is no difference in relative productivity of labor between countries 16 ; i.e. when the technology is identical) the trade only occurs if preferences of consumers in both countries are different. 17 We should stress that this explanation differs from that used by the new theory of international trade 18 because it uses a Production Possibilities Frontier (PPF) convex with respect to the origin. Soon we have two ways to explain intra-industry trade using the Ricardian model: (i) one is maintaining the assumption of constant returns to scale and explaining intra-industry trade only on the demand side (in this case the PPF is a straight as in the traditional model); (ii) the other is introducing the hypothesis of increasing returns to scale in the Ricardian model (in which case the PPF is convex in relation to the origin). A question one may ask is: After international trade and keeping the incomplete specialization (each country produces the two goods as in the autarkic situation) the country will export and import the same goods, or we will continue to have verification of inter-sectoral trade where each country exports and imports a different good? Or put another way: can the Ricardian model, in this situation explain both inter-industry trade and intra-industry trade? Our response will be, as we shall see, towards the second answer: everything depends on the pattern of demand. Assuming that the relative productivity is equal in both countries we are considering that the autarkic relative prices are equal. Geometrically this is translated by the production possibility frontier (from country A and country B) with the same slope, then by two parallel lines. The consideration of this hypothesis does not mean that the autarkic equilibrium in production and consumption are the same in both countries: it all depends on consumer preferences. (Cf., Bhagwati, 1967) This additional hypothesis allows us to have two new situations: (i) the FPP of the two countries are equal and are equally the autarkic relative prices (in this case the source of the trade did not lie in the difference of prices in autarky and had to be attributed to the desire to increase production and / or product differentiation, and / or preference for foreign products), (ii) the FPP are different, but parallel, and the autarkic relative prices are equal. In any case the international relative price is equal to the autarkic relative price and in this case the welfare gains, measured in terms of consumer surplus, only exist if in autarky there was an imbalance between supply and demand and if the analysis is done in partial equilibrium. 19 When the relative price equals the opportunity cost the country does not specialize completely, and continue to produce the two goods. In this situation there is indeterminacy at the level of output: for that price we have multiple equilibria in production. The consumption and production decisions may not coincide in the two countries. So we have several possible scenarios: (i) excess supply of X in country A and excess of supply of Y in country B, so that A exports X and imports Y, passing the reverse with country B, (ii) excess supply of Y in country A and excess supply of X in country B, so that country A exports Y and imports X; (iii) excess supply of X in country A and excess supply of X in country B. In this case, trade can only take place if occurs the intra-industry trade based on domestic consumer preference for product X, produced abroad. In this case there was still excess demand for Y in the two countries. The welfare increases due to the increased number of varieties of good X ;( iv) excess supply of Y 16 In the HOS model this hypothesis is equivalent to consider that the relative endowment of factors of the countries is igual.in the Ricardian model the absolute and relative endowment of factors is not essential for the existence of trade: the average productivity in the production of both goods determines the difference in opportunity costs and hence the difference of the frontiers of production possibilities. 17 One way of trade continue to be explained by the relative costs of labor even when they would be equal is to eliminate the assumption of zero transport costs. 18 The most widely used theoretical models to explain intra-industry trade are the model of monopolistic competition. This is the most commonly used because in admitting a large numbers of firms it allows the entry of new firms and price-competition eliminating the monopoly profit. There are two variants, Krugman and Lancaster, and two oligopoly model variants, Cournot and Bertrand. 19 The increase in consumer surplus is not originated from the fact that the consumer can consume more than one good at a lower price, but because they consume more than of the same good at the same price. In this case the supply curve remains horizontal and determines the price whereas the demand curve moves to the right. 9

10 in both countries. In this case the trade can only take place if occurs intra-industry trade in good Y, due to the bias of preference for the product produced abroad, continuing to be excess demand for X in both countries. A new question arises, now: what happens to the Law of Comparative Advantage? If we have a 1 /a 2 = b 1 /b 2, the law disappears, because comparative advantage is a relative cost advantage in production. Unless we admit that a 1 /a 2 = b 1 /b 2 and P 1 /P 2 different from a 1 /a 2 when two goods are produced, being the same true for the country B. In this case the Ricardo theory of labor value was called into question because the autarkic relative prices would not be equal to the labor relative costs. 3. The generalization of the Ricardian model and the explanation of intra-industry trade through the chain of comparative advantage, given constant returns to scale and different autarkic relative prices: the role of relative wages The generalization of the model that we will deal first is the generalization for n goods and two countries, because it is generally accepted that intra-industry trade is a bilateral trade. Then we present the generalization to n countries and an infinite number of goods because of the possible hypotheses for the existence of intra-industry trade are the existence of countries that occupy an intermediate position in the chain of comparative advantages and can import and export of any goods. The generalization to n goods and 2 countries need to calculate the relative wage W * = W B / W A R, where R is the exchange rate. 20 From the relation (18), we have: (18 ') a 1 /b 1 <a 2 /b 2 As the unit cost of good i in country A is given by W A there and in country B by W B bi, we have that country A has comparative advantage in good i if W A a i <W B b i, or, what is the same, if (20) a i / b i < W * with W* = W B / W A In the same way, the country A will have the comparative disadvantages (and country B will have comparative advantage) in the product i if: (21) a i / b i > W * Considering (20) and (21) we have the following chain of comparative advantages: (22) a 1 /b 1 <a 2 /b 2,... <aj / b j < W * <a L / b L <... <a n / b n Thus, being given a particular value for W * (determined by the conditions of demand and supply of labor in both countries) it is possible to divide the chain of comparative advantage into two groups: one group that meets the condition (20) - and that gives us products that are exported by A (and imported by B) and where this country has comparative advantage - and a group that satisfies the condition (21) - a group of products that are exported by B (and that B has a comparative advantage) and imported by A. As you can see the chain is ordered according to decreasing comparative advantage of country A, so from the relation (22) we can extract the following corollary: if good j is exported by country A we do not need any additional information to affirm that all goods chain through j are exported from A to B. In the same way, if the good L is imported by the country A (and exported by B) then all the goods from L to n are exported by the country B. 20 When w A =1 is not necessary to consider the exchange rate. In the base model the wage is calculated in the two countries in terms of the good where the country has comparative advantage. In the generalization we can not do so because we need to know the relative wage to know where countries specialize. In this case the relative wage is computed from the demand and supply of labor conditions(see, Chacholiades, 1978, pp.75-79)]. 10

11 I f the following equality occurs (23) a i / b i = W * then both countries produce good i. However the fact that the two countries produce the same goods does not mean that both countries can export it (which always implies a third country). The conclusion to be drawn is that there is incomplete specialization in this type of good and is more likely that consumption of this good in autarky is so great that the other country would be insufficient to supply the consumers in both countries. Only additional assumptions regarding the consumption pattern in the two countries could justify the simultaneous export and import of the same goods. But the question we may raise now is: if we consider the multilateral trade rather than bilateral trade, i.e. n countries, it will be able to verify the occurrence of intra-industry trade? The first step is the generalization to n goods and n countries and this was done by Dornbush, Fisher and Samuelson (1977) - which generalized the chain of comparative advantage for an infinite number of goods- and by S. Collins (1985) who extended the generalization made by DFS to the case of n countries. Dornbush, Fischer and Samuelson (DFS) defined the following relationship: (24) b (z) / a (z) = A (z) where A (z) gives the average labor productivity in country A relatively to the average productivity in country B, for the product z. As A (z) = f (z) with f '(z) <0, whereas the number of goods is very large, we have a curve, which can be considered continuous for the purposes of geometric representation, downward sloping. So, when z increases the comparative advantage of country A decreases. Again the chain is broken at the point where we have: (25) b (z) / a (z) = W A / W B or, (25 ') a (z) / b (z) = W * The generalization to n countries made by Collins brought a result that calls into question the conclusions of the Ricardian model with regard to welfare gains. So far both countries gained if the international price was between the autarkic opportunity costs and in the limits only one country gains with the trade (the small country). In this case and in terms of normative analysis, the conclusions enjoyed the Ricardian model: this extreme situation it was determined if a country is large enough in relation to others that aftert trade this big country would continue to produce the two goods (incomplete specialization) while the small country is completely specialized collecting all the gains from trade. Collins brings precisely the opposite conclusion when considering the multilateral trade and infinity of goods. So, considering a less developed country, where there is an increase in labor productivity, reducing the unit cost of labor, this will induce a change in the terms of trade that will be favorable to the most developed country and at the expense of other countries. 21 However as the conclusions of the generalization made by DFS remain valid, this leads us to conclude that the consideration of n countries allows for the emergence of countries in an intermediate situation: countries that have lower productivity ratios relative to more developed countries and countries where these same ratios are higher than the less developed countries. In this intermediate situation these countries could, according to the law of comparative advantage, export a product i for the least developed countries and import it from the more developed countries. However, we would have to admit, again, that consumers of these intermediate would have a preference bias for the product I produced in developed countries. In this case, the intra-industry trade would arise due to the intermediate positions of the countries and due to the bias of the preferences of domestic consumers by foreign 21 The increase in labor productivity in less developed country is such that would lead to a big increase in the wage in labor market, changing dramatically the relative wage, w *, and decreasing the number of products where the country had comparative advantages. 11

12 products. 22 Accordingly to the assumptions, the global trade (inter-industry and intra-industry trade) will benefit the most developed countries. 4 - The Ricardian model and the introduction of the hypothesis of increasing returns and / or product differentiation: the R & D investment as source of the technology gap between countries and explanatory factor of intra-industry trade Let's say, hypothetically, that there is investment in research and development (R & D) in only one industry (let it be industry 1), but that this investment is fully subsidized by the State, and therefore not considered as a cost by industry. This investment is made in prior to the start of production activity in this industry. This investment in R & D in industry 1 will have as consequence a learning effect, which results in a decrease in unit labor cost when the production increases. 23 We will consider that this improvement in labor productivity (and therefore a reduction in unit labor cost) is directly proportional to the increase of production. Definitions: a 1 = L 1 /Q 1, the unit cost of labor in industry 1; a 2 = L 2 /Q 2, the unit cost of labor in industry 2; L - the limited supply of labor in the economy. As the industry 1 incorporates the learning by doing effect this lead to the following relationship: (26) L 2 = L 1 / (Q 1 2 ) from (26) and substituting L 1 and L 2 for their values, we have: (27) Q 2 = (a 1 / a 2 ) / Q 1 which defines the frontier of production possibilities. From (27) and since the opportunity cost of good 1 in terms of good 2 (CO 1,2 ) is given by - dq 2 /dq 1, we have: (28) CO 1,2 = -dq 2 /dq 1 = (a 1 /a 2 ) / Q 1 2 i.e., CO 1,2 decreases as the production of good 1 increases (decreasing opportunity cost). If we consider that there are no endogenous distortions (difference between the opportunity cost and market price) we have that the price of good 1 in terms of good 2 (P 1 /P 2 ) decreases as the production of good 1 increase. 24 This decrease in the relative price of good 1 (due to economies of scale) is due, by hypothesis, to the learning effect (that improves the quality of labor). This learning effect was only possible because the industry was considered strategic 22 Was Leontief (1956) who first raised the possibility of multilateral trade hide these intermediate positions, leading, in practice, to the invalidation of the HO theorem. These countries were exporting labor-intensive products to countries relatively abundant in capital (located at the top of comparative advantage chain ) and export capital-intensive products to countries that are relatively abundant in labor (located at the bottom of the chain of comparative advantage). Likewise, these intermediate countries imported capital-intensive products from the rich countries and labor-intensive products from the poor countries. 23 Increasing productivity in a sector could also be considered an effect of increasing the qualifications of the labor, but in this case we would have to consider the heterogeneity of this factor. In the sector 2 we have unskilled labor while in a sector 1 we have qualified labor. 24 Assuming that the economies of scale are due to the effect of learning by doing, and that this was made possible by the investment in R & D - dynamic economies of scale - we maintain the assumption of perfect competition. These economies of scale have a common point with the external economies: there were at the industry level and not at the firm level.. 12

13 by the Government and therefore subsidized at a 100% level. Note that this result implies very restrictive assumptions on the production sector that is not considered strategic (not subsidized). Thus, and considering that the labor supply is limited, we have: (29) L = L 1 + L 2 = (L 1 /Q 1 2 ) + L 1 = (a1 / Q 1 ) + L 1 so, if Q 1 = 1 we have L 1 = L 2 and a 2 = a 1 ; if Q 1 > 1 then L 2 > L 1 and L 2 <a 1 ; if 0 <q 1 <1, then L 2 > L 1 and a 1 <L 2. Moreover, consideration of decreasing costs implies that not only labor left to be equally efficient in both industries (hypothesis of the Ricardo base model that makes the curve of production possibilities frontier to be a straight line and the opportunity cost to be constant) but, it is considered, by hypothesis, that the work efficiency increases when moving from one sector to another. While in sector, and due to R&D investment, is easy to assume the increased efficiency of workers who move from sector 2, in relation to the transfer of industrial workers 1 to industry 2 will have to admit that the efficiency gains in the production of a good 1 is not lost when these workers are allocated to the production of good 2. Or,the workers of industry 1 are always more efficient than workers who were already in the industry 2. This is a realistic hypothesis. We can conclude that although the model is a model with only one factor (labor) the introduction of decreasing costs and the hypothesis of R & D investment that increases labor qualification and labor productivity, leads us to the field of models explaining the trade by the difference in relative abundance of factors ( HOSV models). We should also stress that the various levels of qualification of labor can be considered as different factors, so that trade ceases to be originated in the difference in labor productivity, and may occurs due to the differences in labor qualifications (differences in factors supply). 5 - The Ricardian model and the adjustment problems of the Portuguese economy from the single market of 1993 As mentioned before, in the first models of international trade that explain intra-industry trade (Krugman models, for example) the products are differentiated only by the demand side and not on the supply side: the production function and the production techniques are identical for all firms within the same industry. So, these models can be considered Neo-Heckscher-Samuelson-Olhin models and do not raise problems of structural adjustment because all factors are mobile within the same industry. When we consider that the differentiation operates both on the demand side and supply side the production processes are different and the way of intra-industry specialization raises structural adjustment problems and the quality and mobility of factors should be taken into account. Lundberg and Hansson (1986, p.131) consider that the difference in the problems of structural adjustment depending on the answer to three questions: (i) the degree of homogeneity of industries (in the aggregation level considered to measure intra-industry trade) in terms of three key productive factors: Physical Capital, Human Capital and Labour (unskilled), (ii) the degree of intra-industry mobility for these three factors of production; (iii) the greater or lesser homogeneity of Physical Capital, Human Capital and Labour. Thus the degree of mobility of these three factors of production between different industries and within the same industry depends on their skill level: the human capital (highly qualified and skilled labor) can be of little use outside of the small number of firms that are able to utilize its services. In this case the factor is a specific factor to the oligopolistic industry or even a specific factor to a particular firm. On the other hand while there is a limited supply of workers with higher skill levels there is excess supply of unskilled workers. If the unions do not negotiate agreements and if there is not social dialogue, may arise rigidity in wages and low mobility across industries,and have problems of structural unemployment accompanied by social conflict. Adding to these problems the interindustry adjustment is harder than the intra-industry adjustment since the former often requires internal migration between different regions while in the intra-industry adjustment the interregional mobility is lower (industries are usually concentrated by geographical areas, as is the case of textiles in Portugal.) Another aspect to consider is the relationship between intra-industry and intra-firm trade (i.e. intra-industry trade through intra-firm trade done by large multinational firms) and the structural adjustment In paragraph 5.3 of his doctoral thesis, A. Guerra (1990, pp ) discusses "The intra-firm trade as a manifestation of intra-industry trade." Also, Taveira (1985, pp.9-48) relates the IDE with market imperfections 13