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Global Economics Eco 6367 Dr. Vera Adamchik


Global Economics Eco 6367 Dr. Vera Adamchik Sources of Comparative Advantage In this chapter, we will discuss the factors that ultimately determine why a country has ... – PowerPoint PPT presentation

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Title: Global Economics Eco 6367 Dr. Vera Adamchik

Global EconomicsEco 6367Dr. Vera Adamchik
  • Sources of Comparative Advantage

  • In this chapter, we will discuss the factors that
    ultimately determine why a country has a
    comparative advantage or comparative disadvantage
    in a product.

In Chapter 2 we learned
  • Trade begins as someone conducts arbitrage to
    earn profits from the price difference between
    previously separated markets.
  • With no trade, product prices differ because
  • supply conditions differ (different PPFs,
    technologies and resource endowments)
  • demand conditions differ (tastes and preferences).

Labor theory of value
  • Adam Smith viewed the determination of
    competitiveness from the supply side of the
    market (labor theory of value ? labor is the only
    factor ? the cost or price of a good depends
    exclusively on the amount of labor required to
    produce it) p. 31 in the textbook

Labor theory of value
  • Like Smith, David Ricardo emphasized the
    supply-side of the market. In his model, he
    relied on the following assumptions p. 32 in the
  • (2) In each nation, labor is the only input
  • (5) Costs are proportional to the amount of
    labor used.

In-class exercise
  • However, Smiths and Ricardos theories fail to
    explain international trade when technology is
    identical in both countries, that is, production
    functions and PPFs are the same in both
  • Exercise 1 (handout).

The Factor-Endowment Theory (a.k.a. the
Heckscher-Ohlin theory of trade) -- the basis for
the orthodox modern theory of comparative
  • The leading theory of what determines nations
    trade patterns emerged in Sweden.
  • Eli Heckscher (an economic historian) developed
    the core idea in a brief article in 1919.
  • A clear overall explanation was developed and
    publicized in the 1930s by Heckschers student
    Bertil Ohlin (a professor and politician, a Nobel
  • Ohlins arguments were later reinforced by Paul
    Samuelson (a Nobel laureate), who derived
    mathematical conditions under which the H-O
    prediction was strictly correct.

  • The H-O theory emphasizes the role of
    relative differences in resource endowments as
    the ultimate determinant of comparative
    advantage. The H-O theory explains comparative
    advantage in terms of underlying
  • differences across countries in the availability
    of factor resources (factor endowment) abundant
    vs scarce factors
  • differences across products in the use of these
    factors in producing the products
    labor-intensive, capital-intensive,
    land-intensive, etc.

Factor abundance
  • The phrase different factor endowments refers to
    different relative factor endowments, not
    different absolute endowments.
  • In other words, different factor endowments
    different factor proportions.

Relative factor abundance
  • May be defined in two ways
  • The physical definition (in terms of the physical
    units of two factors). For example, (K/L)I gt
    (K/L)II ? Country I is capital-abundant
  • The price definition (in terms of the relative
    prices. The greater the relative abundance of a
    factor, the lower its relative price). For
    example, (r/w)I lt (r/w)II ? Country I is

Commodity factor intensity
  • A commodity is said to be factor-X-intensive
    whenever the ratio of factor X to a second factor
    Y is larger when compared with a similar ratio of
    factor usage of a second commodity.

  • For example, consider labor
  • A country is relatively labor-abundant if it has
    a higher ratio of labor to other factors than
    does the rest of the world.
  • A product is relatively labor-intensive if labor
    costs are a greater share of its value than they
    are of the value of other products.

How does the relative abundance of a resource
determine comparative advantage?
  • When a resource is relatively abundant, its
    relative cost is less than in countries where it
    is relatively scarce.
  • Difference in relative resource costs causes the
    pre-trade differences in relative product prices
    between two countries.

  • The H-O theory says, in Ohlins own words
  • Commodities requiring for their production
    much of abundant factors of production and
    little of scarce factors are exported in
    exchange for goods that call for factors in the
    opposite proportions. Thus indirectly, factors in
    abundant supply are exported and factors in
    scanty supply are imported.
  • (Ohlin, Bertil. International and
    Interregional Trade, MA Harvard University
    Press, 1933)

  • Or, in other words, the H-O theory predicts
    that a country exports the product(s) that use
    its relatively abundant factor(s) intensively and
    imports the product(s) using its relatively
    scarce factor(s) intensively.

Criticism The Leontief paradox
  • Wassily Leontief theorized that since the U.S.
    was relatively capital-abundant (and
    labor-scarce) compared to other nations, the US
    would be an exporter of capital intensive goods
    and an importer of labor-intensive goods.
    However, he found that US exports were less
    capital intensive than US imports. Since this
    result was at variance with the predictions of
    the H-O theory, it became known as the Leontief

  • The post-Leontief studies showed that the US was
    also abundant in farm-land and highly skilled
    labor. And the US was indeed a net exporter of
    products that use these factors intensively, as
    H-O predicts.
  • The trade patterns of some other developed
    countries (Japan, Canada) and of many developing
    countries (China) are broadly consistent with
  • In general, trade patterns fit the H-O theory
    reasonably well but certainly not perfectly.

  • Who gains and who loses
  • from trade
  • within a country?

  • According to H-O, opening to trade alters
    domestic production. There is expansion in the
    export-oriented sector, and there is contraction
    in the import-competing sector.
  • The changes in production have one set of effects
    on incomes in the short run, but another in the
    long run.

  • In the short-run (when labor and capital are
    immobile / cannot move easily from one industry
    to another), the specific-factor theory predicts
    the effects of trade on factor prices and
  • In the long run (when labor and capital can move
    freely among industries), the factor-price
    equalization theorem and the Stolper-Samuelson
    theorem predict the effects of trade on factor
    prices and incomes.

Trade and the Distribution on Income in the Short
  • The types of factors that cannot move easily from
    one industry to another are called specific
  • In the short run laborers, plots of land, and
    other inputs are tied to their current lines of

In-class exercise
  • See The Specific-Factor Theorem handout.
  • Conclusions
  • for the short-run, gains and losses divide by
    output sector All groups tied to rising sectors
    gain, and all groups tied to declining sectors

  • Trade and the Distribution on Income in the Long

Factor-Price Equalization
  • By redirecting demand away from the scarce
    resource and toward the abundant resource in each
    nation, trade leads to facto-price equalization.
  • In each nation, the cheap resource becomes
    relatively more expensive, and the expensive
    resource becomes relatively cheaper, until price
    equalization occurs.

In-class exercise
  • See The Factor-Price Equalization Theorem The
    Stolper-Samuelson Theorem handout.
  • Conclusions
  • given certain conditions and assumptions, free
    trade equalizes not only product prices but also
    the prices of individual factors between the two

The Stolper-Samuelson Theorem
  • If countries gain from opening trade, why do
    free-trade policies have so many opponents year
    in and year out?
  • The answer is that trade does typically hurt some
    groups within any country.
  • Hence, a full analysis of trade requires that we
    identify the winners and losers from freer trade.

  • Wolfgang Stolper and Paul Samuelson developed the
    Stolper-Samuelson theorem in an article published
    in 1941.

The Stolper-Samuelson theorem
  • With full employment both before and after trade
    takes place, the increase in the price of the
    abundant factor and the fall in the price of the
    scarce factor because of trade imply that the
    owners of the abundant factor will find their
    real incomes rising and the owners of the scarce
    factor will find their real incomes falling.

In-class exercise
  • See The Factor-Price Equalization Theorem The
    Stolper-Samuelson Theorem handout.
  • Conclusion
  • Net gains for both countries but different
    effects on different groups
  • Winners landowners in Farmland and workers in
  • Losers workers in Farmland and landowners in

  • It is not surprising that owners of the
    relatively abundant resources tend to be free
    traders while owners of relatively scarce
    resources tend to favor trade restrictions.

  • We may not see the clear-cut income distribution
    effects with trade because relative factor prices
    in the real world do not often appear to be as
    responsive to trade as the H-O and S-S imply.
  • In addition, income distribution reflects not
    only the distribution of income between factors
    of production but also the ownership of the
    factors of production. Since individuals or
    households often own several factors of
    production, the final impact of trade on personal
    income distribution is far from clear.

The product life-cycle theory
  • The explanations of international trade presented
    so far are similar in that they presuppose a
    given and unchanging state of technology.
  • The product cycle hypothesis attempts to offer a
    dynamic theory of technology and trade.

  • Technology-based comparative advantage can arise
    over time as technological change occurs at
    different rates in different sectors and
  • Hence, a country can develop a comparative
    advantage based on its technological improvements
    or innovations (that mainly come from RD).

  • In some ways this technology-based explanation is
    an alternative that competes with the H-O theory.
  • However, there is also a link to the H-O theory
    the suitable location of RD matches the factor
    proportions of production using the new
    technology to the factor endowments (that is,
    availability of highly skilled labor and venture
    capital) of the national locations.

  • The product life-cycle theory, proposed by
    Raymond Vernon in the mid-1960s, suggested that
    as products mature both the optimal production
    location and the location of sales will change
    affecting the flow and direction of trade
  • Initially, RD, production and consumption are
    likely to be in an advanced developed country.
  • Later, as demand grows in other developed
    countries, the innovating country begins to

  • Over time, demand for the new product will grow
    in other advanced countries making it worthwhile
    for foreign producers to begin producing for
    their home markets.
  • The innovating country might also set up
    production facilities in those advanced countries
    where demand is growing, limiting the exports
    from the innovating country.

  • Over time, the product and its production
    technology become more standardized and familiar
    (mature). Factor intensity in production tends to
    shift away from skilled labor and toward
    less-skilled labor.
  • The technology diffuses and production locations
    shift into other countries, eventually into
    developing countries that are abundant in cheap
    less-skilled labor.

  • Trade patterns change in the manner consistent
    with shifting production locations. The location
    of production of a product shifts from the
    leading developed countries to developing
    countries as the product moves from its
    introduction to maturity and standardization.
  • The innovating country is initially the exporter
    of the new product, but it eventually becomes an

  • The product life cycle theory accurately
    explains what happened with a number of high
    technology products developed in the US in the
    1960s and 1970s. For example,
  • Pocket calculators were pioneered by Texas
    Instruments and Hewlett-Packard in the US in the
    early 1970s.
  • Soon Sharp and other Japanese firms began to
    dominate a product whose characteristics had
    begun to stabilize.
  • More recently, assembly production shifted into
    the developing countries.

The product life-cycle theory
  • Nonetheless, the usefulness of the product
    cycle hypothesis is limited due to the
    difficulties in determining the phases of the
  • 1. In many industries especially high-tech
    product and production technologies are
    continually evolving because of ongoing RD.
  • 2. International diffusion often occurs within
    multinational (global) corporations. In this
    case, the cycle can essentially disappear. New
    technology can be transferred within the
    corporation for its first production to other
    countries, including developing countries.

Alternative models of tradeNew trade theory
  • Standard theories of international trade
    (developed by Adam Smith, David Ricardo, and
    Heckscher-Ohlin) focus on production-side
    differences as the basis for comparative
    advantage. According to these theories, the
    sources of production-side differences are
    differences in technologies, differences in
    factor productivities, differences in factor
    endowments, and differences across products in
    the use of productive factors in producing the

  • Hence, according to these theories, the more
    different the countries are regarding
    productivity, technology, or capital-to-labor
    ratio the greater the economic gain from
    specialization and trade. Thus, we may expect
    that the predominant portion of international
    trade will occur between countries that are
    different in these regards. In other words, we
    may expect that developed countries
    (capital-abundant, high productivity, advanced
    technologies) will trade with developing
    countries (labor-abundant, low-productivity,
    outdated technology).

In-class exercise
  • Conduct a simple test of the standard theories of
    international trade. Go to the U.S. Census Bureau
    webpage http//
    tics/highlights/index.html click on the Top
    trading partners linkclick on December of the
    previous year (because the December data show the
    annual values for each year).What countries
    were the top 10 purchasers of U.S. exports? What
    countries were the top 10 suppliers of U.S.
    imports? Compare these lists. Does the overall
    pattern of the U.S. trade partners appear to
    match well with the predictions of the standard
    trade theories? Why or why not? Are there any
    features of the data that appear to violate
    strongly these predictions?

In-class exercise
  • Conclusions
  • Industrialized countries (which are similar in
    many aspects in their technologies, technological
    capabilities, and factor endowment) trade
    extensively with each other.
  • Trade between industrialized countries is nearly
    half of all world trade.
  • These facts appear to be inconsistent with
    comparative-advantage theory.

Intra-industry trade
  • An increasing fraction of world trade consists of
    intra-industry trade, in which a country both
    exports and imports the same or very similar
    products (products in the same product category /
  • Even very subtle production-side (i.e.,
    technology-based) comparative advantages seem to
    be unable to explain the phenomenon of
    intra-industry trade.

In-class exercise
  • Go to http//
    cs/highlights/index.html, click on
    Country/Product Data, then on NAICS web
    application, then choose World in the lower
    window, then choose December of the previous
    year to get cumulative annual data. Analyze
    intra-industry trade of the US with the ROW.

Spread of technology
  • Furthermore, technology quickly spreads
    internationally because it is difficult for a
    country to keep its technology secret.
  • Hence, many countries usually have access to the
    same technologies for production and are capable
    of achieving similar levels of resource

Global industries dominated by a few large firms
  • Boeing and Airbus commercial aircraft.
  • Sony, Nintendo, and Microsoft videogame

Trade facts in search of better theory
  • Substantial trade among industrialized countries,
    much of which is intra-industry trade.
  • The dominance of a few large firms in some world
  • We turn next to the theories that focus not
    only on the supply side differences (technology,
    endowment, etc.) but also on the demand side
    differences as the source of trade.

The Linder Theory
  • The theory was proposed by the Swedish economist
    Staffan Burenstam Linder in 1961.
  • The Linder theory is a dramatic departure from
    the H-O model because it is almost exclusively
    demand oriented.

  • The Linder theory postulates that tastes of
    consumers are conditioned strongly by their
    income levels the per capita income level of a
    country will yield a particular pattern of
  • Trade will occur in goods that have overlapping
    demand, meaning that consumers in both countries
    are demanding the particular item.

In-class exercise
  • Figure 2 (handout).
  • Exercise 2 (handout).

  • The important implication is that international
    trade in manufactured goods will be more intense
    between countries with similar per capita income
    levels than between countries with dissimilar per
    capita income levels.

  • The Linder theory identifies the goods that would
    be traded between any pair of countries. However,
    the theory does not identify the direction in
    which any given good will flow. Linder made it
    clear that a good might be sent in both
    directions both imported and exported by the
    same country! (That is, intra-industry trade.)

  • The Krugman Model

  • The Krugman theory of trade focuses on
  • product differentiation monopolistic
  • substantial internal scale economies and global
  • external scale economies (industries that
    concentrate in a few places).
  • The major alternative theories of international
    trade relax assumptions 4, 5, and 6 (p. 32) and
    use the existence of economies of scale as a
    major departure from the standard theory.

  • Increasing returns to scale (IRS), or economies
    of scale, exist if increasing expenditures on all
    inputs (with input prices constant) increases the
    output quantity by a larger percentage.
  • Therefore, the average cost of producing each
    unit of output declines, as output increases.

The PPF with decreasing opportunity costs /
increasing returns
  • The PPF is bowed inward rather than outward
    that is, opportunity costs decrease the higher
    the level of production in an industry.

Internal economies of scale
  • Scale economies are internal if the expansion of
    the size of the firm itself is the basis for the
    decline in its average cost.
  • Ways to reduce the average cost
  • greater specialization of workers
  • more specialized machines
  • spreading of up-front fixed costs (RD or
    production setup costs) over more units of output.

External economies of scale
  • Scale economies external to the individual firm
    relate to the size of the entire industry within
    a specific geographic area.
  • The average cost of the typical firm declines as
    the output of the industry in the area is larger.
    (Better input markets specialized services and
    labor swift diffusion of new knowledge about
    product and technology through direct contacts
    among the firms or as skilled workers transfer
    from firm to firm).

Demand Product differentiation
  • Growth in intra-industry trade over time and
    higher intra-industry trade for higher-income
    countries can be understood partly from the
    demand side.
  • Income growth shifts demand toward luxuries, and
    product variety is a luxury. Affluent people vary
    their choices of wines, beers, automobiles,
    music, clothing, travel expenses, and so on.

  • Full customization of production in a single
    country would be too costly.
  • Hence, some varieties will be imported, while the
    varieties produced in the country can be exported
    to affluent consumers in other countries.
  • When all firms face similar downward-sloping
    average cost curves, so there may be no
    comparative advantage.
  • Rather, a countrys trade is based on product

  • The basis for exporting is the domestic
    production of unique models (or varieties)
    demanded by some consumers in foreign markets.
  • The basis for importing is the demand by some
    domestic consumers for unique models produced by
    foreign firms.
  • Intra-industry trade in different products can be
    large, even between countries that are similar in
    their general production capabilities.

Economies of scale
  • Yet, demand effects cannot be the whole story.
  • Economies of scale play a supporting role, by
    encouraging production specialization for
    different varieties.
  • With trade, firms in each country produce only a
    limited number of varieties of the basic product,
    but in greater quantities (domestic market
    exports), which leads to a lower unit production

  • If internal scale economies are modest or
    moderate, then there is room in the industry for
    a large number of firms. If, in addition,
    products are differentiated, then we have a mild
    form of imperfect competition called monopolistic

  • If internal scale economies are substantial over
    a large range of output, then it is likely that a
    few firms will grow to be large in order to reap
    the scale economies. If a few large firms
    dominate the global industry, then we have an
  • The countries in which these firms are located
    will then tend to be net exporters of the
    product, while other countries are importers.

  • External scale economies appear to explain the
    clustering of some industries
  • Silicon Valley high-tech semiconductor,
    computer, and related producers.
  • New York City banking and finance.
  • Hollywood (Bollywood in Bombay) filmmaking.
  • Italy stylish clothing, shoes, and accessories.
  • Switzerland watches.

Gains from trade
  • A major additional source of national gains from
    trade is the increase in the number of varieties
    of products that become available to consumers
    through imports.
  • Without trade, nations might not be able to
    produce those products where economies of scale
    are important. With trade, markets are large
    enough to support the production necessary to
    achieve economies of scale.

Implications of new trade theory
  • Nations may benefit from trade even when they do
    not differ in resource endowments or technology.
  • The theory does not contradict comparative
    advantage theory, but instead identifies a source
    of comparative advantage.
  • Governments should consider strategic trade
    policies that nurture and protect firms and
    industries where first mover advantages and
    economies of scale are important.

Criticism of new trade theory
  • 1. The monopolistic-competition model suggests
    that product differentiation can be a basis for
    successful exporting, although it does not
    predict which specific varieties of a
    differentiated product will be produced by which

Criticism of new trade theory
  • 2. The models based on substantial scale
    economies (internal or external) indicate that
    production tends to be concentrated at a small
    number of locations, but they do not precisely
    identify which specific countries will be the
    production locations. History, luck, and perhaps
    early government policy can have a major impact
    on the actual production locations.

The gravity model of trade
  • The analysis of the major trade partners has led
    to the development of the gravity model of trade,
    so called because it has similarity to the
    Newtons law of gravity, which states that the
    force of gravity between two objects is larger as
    the sizes of the two objects are larger, and as
    the distance between them is smaller.

  • The gravity model of trade posits that trade
    flows between two countries will be larger as
  • the economic sizes of the two countries are
  • the geographic distance between them is smaller
  • other impediments to trade are smaller.

Economic size
  • Economic size is usually measured by a countrys
    GDP, which represents both its production
    capability and the income that is generated by
    its production.
  • In statistical analysis, the elasticity of trade
    values with respect to GDP is usually found be
    about 1.

  • In statistical analysis, a typical finding is
    that a doubling of distance between partner
    countries tend to reduce the trade between them
    by one-third to one-half. This is actually a
    surprisingly large effect, one that cannot be
    explained by the monetary costs of transport
    alone, because these costs are not that high.

Other impediments
  • Government policies like tariffs can place
    impediments to trade.
  • However, perhaps the most remarkable finding from
    statistical analysis using the gravity model is
    that national borders matter much more than can
    be explained by government policy barriers.
  • Even for trade between the US and Canada (where
    government barriers are generally very low), this
    border effect is very large.

  • A series of studies (McCallum, 1995 Anderson and
    van Wincoop, 2003) examined trade between the US
    and Canada and show that GDP and distance are
  • The key finding is that there is also an
    astounding 44 less international trade than
    there would be if the provinces and states were
    part of the same country.
  • Hence, there is something about the national

  • Other kinds of impediments (or removal of
    impediments) to trade
  • Countries that share a common language trade more
    with each other.
  • Countries that have historical links (for
    example, colonial) trade more with each other.
  • Countries that are members of a preferential
    trade area trade more with each other.
  • Countries that have a common currency trade more
    with each other.

  • A country with a higher degree of government
    corruption, or with weaker legal enforcement of
    business contracts, trade less with other
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