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 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 textbook]: (2) In each nation, labor is the only input; (5) Costs … are proportional to the amount of labor used.

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

The Factor-Endowment Theory (a. k. a The Factor-Endowment Theory (a.k.a. the Heckscher-Ohlin theory of trade) -- the basis for the orthodox modern theory of comparative advantage

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 Heckscher’s student Bertil Ohlin (a professor and politician, a Nobel laureate). Ohlin’s 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 > (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 < (r/w)II  Country I is capital-abundant.

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 Ohlin’s 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 Paradox.

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 H-O. 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 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 incomes. 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 Run The types of factors that cannot move easily from one industry to another are called specific factors. In the short run laborers, plots of land, and other inputs are tied to their current lines of production.

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 lose.

Trade and the Distribution on Income in the Long Run

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 countries.

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 Peopleland. Losers: workers in Farmland and landowners in Peopleland.

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.

Criticism 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 countries. Hence, a country can develop a comparative advantage based on its technological improvements or innovations (that mainly come from R&D).

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 R&D 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, R&D, 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 export.

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 importer.

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 cycle: 1. In many industries – especially high-tech – product and production technologies are continually evolving because of ongoing R&D. 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 trade: New 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 products.

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://www.census.gov/foreign-trade/statistics/highlights/index.html ; click on the “Top trading partners” link; click 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 / industry). 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://www.census.gov/foreign-trade/statistics/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 productivity.

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

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 industries. 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 tastes. 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 competition; substantial internal scale economies and global oligopoly; 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 (R&D 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 country’s trade is based on product differentiation.

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 costs.

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 competition.

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 oligopoly. 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 country.

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 Newton’s 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 larger; the geographic distance between them is smaller; other impediments to trade are smaller.

Economic size Economic size is usually measured by a country’s 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.

Distance 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 important. 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 border.

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 countries.