International Economics Mordecai E. Kreinin Copyright ©2002 South-Western/Thomson Learning. All rights reserved. Copyright ©2002 South-Western/Thomson Learning. All rights reserved. Part I International Trade Relations Part I International Trade Relations

C3-2 CHAPTER 3 The Commodity Composition of Trade

C3-3 OVERVIEW Factor Proportions Theory Alternative Theories Sector-Specific Factors An Emerging Consensus? Economic Adjustment to Changing Circumstances Factor Proportions Theory Alternative Theories Sector-Specific Factors An Emerging Consensus? Economic Adjustment to Changing Circumstances

C3-4 Important Concepts Factor proportions (endowment) theory Capital-intensive products Capital-abundant country Direct foreign investment Product cycle Monopolistic competition Factor price equalization Leontief scarce-factor paradox Factor proportions (endowment) theory Capital-intensive products Capital-abundant country Direct foreign investment Product cycle Monopolistic competition Factor price equalization Leontief scarce-factor paradox Sector-specific model Labor-intensive products Labor-abundant country Inter-industry trade Intra-industry trade Product variety Dynamic changes in comparative advantage Export-biased growth Import-biased growth

C3-5 Factor Proportions Theory Production functions (isoquants) Labor- and capital-intensive commodities Resource endowment ratios, factor endowment model Direct foreign investment Rise in U.S. income inequity over the past 20 years Concentrates solely on most elementary properties of trading countries Employs the country’s economic structure to explain trade, and can be reversed to inquire about the effect of international trade on the economic structure With incomplete specialization, trade leads to equalization of factor prices between trading nations. Mixed results of empirical testing Leontief scarce-factor paradox contradicts factor-endowment model. Production functions (isoquants) Labor- and capital-intensive commodities Resource endowment ratios, factor endowment model Direct foreign investment Rise in U.S. income inequity over the past 20 years Concentrates solely on most elementary properties of trading countries Employs the country’s economic structure to explain trade, and can be reversed to inquire about the effect of international trade on the economic structure With incomplete specialization, trade leads to equalization of factor prices between trading nations. Mixed results of empirical testing Leontief scarce-factor paradox contradicts factor-endowment model.

C3-6 Additional Insights: Consequences of Factor Price Equalization Internal income distribution in each country changes, with relatively abundant factor gaining, relatively scarce factor losing (Stolper-Samuelson theory). Losses to scarce factor outweighed by gains to abundant factor Introduction of trade lowers price of capital in UK and raises it in U.S.; similar labor price convergence also occurs. In absence of other real-world factors, complete factor-price equalization occurs only when specialization is incomplete Inequality of technologies, transport costs, etc., prohibit complete price convergence. Hence, there is only a tendency in this direction. Internal income distribution in each country changes, with relatively abundant factor gaining, relatively scarce factor losing (Stolper-Samuelson theory). Losses to scarce factor outweighed by gains to abundant factor Introduction of trade lowers price of capital in UK and raises it in U.S.; similar labor price convergence also occurs. In absence of other real-world factors, complete factor-price equalization occurs only when specialization is incomplete Inequality of technologies, transport costs, etc., prohibit complete price convergence. Hence, there is only a tendency in this direction.

Effect of Trade on Factor Prices FIGURE 3.1 C3-7

C3-8 Alternative Theories One simple theory cannot account for complex trade phenomena Especially intraindustry trade expansion Alternative explanations of 1970s and 1980s One simple theory cannot account for complex trade phenomena Especially intraindustry trade expansion Alternative explanations of 1970s and 1980s

C3-9 Sector-Specific Factors Assumes two-sector economy (agriculture and manufacturing) Product Cycle (standardization process) Monopolistic Competition and Intra-Industry Trade Economies of scale allow intraindustry trade of specialized varieties. The greater similarities in countries’ technologies and factor endowments, the less interindustry trade and the greater intraindustry trade occurs. Assumes two-sector economy (agriculture and manufacturing) Product Cycle (standardization process) Monopolistic Competition and Intra-Industry Trade Economies of scale allow intraindustry trade of specialized varieties. The greater similarities in countries’ technologies and factor endowments, the less interindustry trade and the greater intraindustry trade occurs.

C3-10 An Emerging Consensus? Interindustry trade Intraindustry trade Trade benefits: Reallocation of resources Economies of scale Greater competition Larger product variety All productive factors gain Interindustry trade Intraindustry trade Trade benefits: Reallocation of resources Economies of scale Greater competition Larger product variety All productive factors gain

C3-11 Economic Adjustment to Changing Circumstances Dynamic Changes: Comparative advantage changes with shifts in factor endowment, technology. Example: Japan’s postwar economy changed from labor- to capital- to technology-intensive. Human hardships arise from resource shifts. Protectionism hampers consumer gains and excludes LDCs from trade. Government can maintain high level of aggregate production, so labor and capital released from declining industries will find alternative employment, provide direct assistance. Dynamic Changes: Comparative advantage changes with shifts in factor endowment, technology. Example: Japan’s postwar economy changed from labor- to capital- to technology-intensive. Human hardships arise from resource shifts. Protectionism hampers consumer gains and excludes LDCs from trade. Government can maintain high level of aggregate production, so labor and capital released from declining industries will find alternative employment, provide direct assistance.

Two Patterns of U.S. Economic Growth FIGURE 3.2 C3-12

C3-13 Summary Causes of comparative advantage/disadvantage Factor proportions theory Leontief paradox Monopolistic competition and economies of scale Efficient allocation of resources and consumer benefits Dynamic changes Asymmetrical growth Causes of comparative advantage/disadvantage Factor proportions theory Leontief paradox Monopolistic competition and economies of scale Efficient allocation of resources and consumer benefits Dynamic changes Asymmetrical growth

Constant Cost Transformation, or Production Possibilities Curve FIGURE A3-1.1 C3-14

UK and U.S. Transformation Curves Based on Equation 3 FIGURE A3-1.2 C3-15

Edgeworth-Bowley Box Diagrams FIGURE A3-2.1 C3-16

Post-Trade Production Equilibrium FIGURE A3-2.2 C3-17

Wage Rate Determination FIGURE A3-2.3 C3-18