UNIT TWO

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20

UNIT TWO


International Trade: Enduring Issues


CHAPTER THREE


Sources of Comparative Advantage



I. Fundamental Issues


1.

What is the factor proportions explanation of comparative advantage?

2.

What is the Heckscher
-
Ohlin theory of trade?

3.

How well does the f
actor proportions approach explain trade patterns?

4.

What is the relationship between trade and factor prices?

5.

What is the relationship between trade and real income?

6.

How does economic growth affect trade patterns?


II. Chapter Outline


1.

The Factor Proportio
ns Explanation of International Trade

a.

The Factor Proportions Approach

b.

The Heckscher
-
Ohlin Theorem and International Trade

c.

Visualizing Global Economic Issues: Factor Endowments and the Production Possibilities
Frontier

d.

Visualizing Global Economic Issues: Th
e Heckscher
-
Ohlin Theorem

2.

How Well Does the Factor Proportions Approach Explain Trade?

a.

The Leontief Paradox

b.

More Recent Tests of the Factor Proportions Approach

c.

Online Globalization: India’s Online Business Services Industry

3.

Trade, Factor Prices, and Real
Income

a.

Factor Price Equalization

b.

Visualizing Global Economic Issues: The Factor Price Equalization Theorem

c.

Trade and Real Income

4.

International Production and Comparative Advantage

a.

The Internationalization of Production

b.

Management Notebook: Do Manufacturers

Really Need a Factory?

c.

Kaleidoscopic Comparative Advantage

5.

Economic Growth and International Trade

a.

Economic Growth

b.

The Rybczynski Theorem

c.

Growth and Trade

d.

Visualizing Global Economic Issues: The Rybczynski Theorem

6.

Questions and Problems



Sources of Comparative Advantage

21



III. Chapter in

Perspective


This chapter introduces Unit Two


International Trade: Enduring Issues. The chapter uses the
Heckscher
-
Ohlin model of factor proportions and the model’s implications to explain sources of, and
changes in, comparative advantage. In particu
lar, the chapter discusses the internationalization of
production in which different stages of the value chain may optimally be located in different countries to
exploit differences in comparative advantages. The implications of the Samuelson
-
Stolper and
the
Rybczynski theorems for international trade are integrated into the discussion.


IV. Teaching Notes


1.

The Factor Proportions Explanation of International Trade


a.

The Factor Proportions Approach


The factor proportions explanation of international trade
suggests that endowments of factors of
production, and relative intensity of use of the factors in the production of goods and services, can
be used to explain comparative advantage and international trade. The simplest version of a
factor proportions mod
el assumes that labor and capital are the two factors of production and that
two countries produce two goods. Labor and capital have identical productivities in both
countries and the two countries utilize identical production technologies. Factors may m
ove
freely from industry to industry, but may not move between countries. Goods and services,
however, may move freely and costlessly between nations. Citizens of both countries are
assumed to have identical preferences for the two goods. The only diffe
rences allowed between
the two nations are
factor endowments

and the extent (
intensity of use
) to which a factor is
required to produce a given product. Endowments and intensity of use are measured relative to
each other as follows:


EXAMPLE OF DIFFERENT

FACTOR ENDOWMENTS



Country A

Country B


Labor

Capital

Labor

Capital


2000 units

1000 units

1000 units

2000 units

Capital
-
to
-
Labor ratio

½ unit capital/unit labor

2 units capital/unit labor

Labor
-
to
-
Capital ratio

2 units labor/unit capital

½ unit labor
/unit capital

Relative Abundance

Relatively Capital Abundant

Relatively Labor Abundant


Country A is a relatively capital abundant nation and Country B is a relatively labor abundant
nation.


22

Chapter 3


Suppose that the two goods under consideration are textiles a
nd machinery. Machinery requires 3
units of capital and 1 unit of labor to produce. Textiles require 4 units of labor and 1 unit of
capital to produce.


EXAMPLE OF DIFFERENT

FACTOR INTENSITIES



Textiles

Machinery


Labor

Capital

Labor

Capital


4 unit
s

1 unit

1 unit

3 units

Capital
-
to
-
Labor ratio

¼ unit capital/unit labor

3 units capital/unit labor

Labor
-
to
-
Capital ratio

4 units labor/unit capital

1/3 unit labor/unit capital

Relative Intensity

Relatively Labor Intensive

Relatively Capital Intensive


Because both countries have the same production technologies, relative factor endowments and
relative factor intensities define a nation’s comparative advantage and provide a motivation for
international trade.


b.

The Heckscher
-
Ohlin Theorem and Internatio
nal Trade


The Heckscher
-
Ohlin (hereafter H
-
O) Theorem states that the country that is relatively labor
(capital) abundant will have a comparative advantage in the production of the good or service that
is relatively labor (capital) intensive in its produc
tion process.


Teaching Tip
:

This is a very simple proposition that can be related to supply and demand. The abundant
resource will tend to have a lower cost due to its greater supply. As a result, the country can
produce the product that relies more o
n its abundant resource at a cheaper price than the other
country, creating a comparative advantage in that good or service.


Recall from Chapter 2 that the good in which the country has the comparative advantage will be
the export good. It follows then t
hat the relatively labor (capital) abundant nation will export the
relatively labor (capital) intensive good.


Because advanced economies tend to be relatively capital abundant, the H
-
O theorem predicts
that advanced economies should have a comparative adv
antage in the production of relatively
capital intensive goods and should export relatively capital intensive goods, and import relatively
labor intensive goods. Text Table 3
-
1 shows international trade of goods and services for various
countries. The tr
ade patterns generally conform to the H
-
O predictions, with more advanced
economies exporting chemicals, a relatively capital intensive industry, and importing relatively
more labor intensive goods such as machinery and transport equipment and manufactured

goods.



Sources of Comparative Advantage

23



c.

Visualizing Global Economic Issues: Factor Endowments and the Production Possibilities
Frontier


For Critical Analysis: Suppose Eastisle has many fewer residents and resources as
compared to Northland. Do any of the points made above change?


W
ith less labor and capital, Eastisle’s PPF shifts inward. If the declines in labor and capital are
equal, the shift is parallel. In this case, the slope of the tangent line is the same and none of the
conclusions about comparative advantage and trade cha
nge.


d.

Visualizing Global Economic Issues: The Heckscher
-
Ohlin Theorem


For Critical Analysis: Why, in (Text) Figure 3
-
2, do residents of Northland and Eastisle
consume identical baskets of food and computers?


The model assumes that residents of each co
untry have identical tastes and preferences. Under
free trade, residents of both countries face the same price ratio. Hence, residents of both
countries consume identical baskets of food.


2.

How Well Does the Factor Proportions Approach Explain Trade?


a.

The

Leontief Paradox


Wassily Leontief used input
-
output analysis to examine how well trade data supported the H
-
O
model in 1954. Given that the U.S. was a
relatively

capital abundant nation, the H
-
O model
implied that U.S. exports should be relatively more
capital intensive than U.S. imports. Leontief
found the opposite result, hence the name Leontief Paradox. There were numerous data
problems in his study however, to name one; he could only infer factor proportions in other
countries based on U.S. data.


Teaching Tip:

Lack of empirical support does not invalidate the usefulness of a model. A model is a
simplification of reality; it is not intended to be the real thing and we should not be surprised
when results confirm this conclusion. Nevertheless, the

H
-
O model is extremely valuable for two
reasons: 1) because of what it teaches us about the motivation for international trade and
comparative advantage and 2) because it serves as a springboard for thought to help build a more
realistic model that furthe
rs our understanding even more. The results of empirical tests may help
the latter function.

24

Chapter 3


b.

More Recent Tests of the Factor Proportions Approach


The H
-
O model aggregates the inputs at a very high level. More recent models allow labor to be
broken dow
n into skilled and unskilled components based on their
human capital
, allow factor
mobility between nations, and allow different preferences for relatively labor intensive and capital
-
intensive goods in different countries. For instance, Adrian Wood found

that advanced economies
with relatively more skilled labor tend to export relatively skilled labor
-
intensive products.


c.

Online Globalization: India’s Online Business Services Industry


For Critical Analysis: Advances in telecommunications and the Interne
t enable India to
provide business services to firms in other nations. How might further advances, such as
voice
-
recognition software, affect India’s ability to remain cost competitive?


Services generally require the use of labor. India currently has a
large competitive advantage in
wages over the U.S. even among college
-
educated, English speaking workers. Low
transportation and communication costs allow India to exploit this comparative advantage and
provide medical transcription services, handling cus
tomer inquiries and providing accounting
services, etc. Further technological advances, such as voice
-
recognition software, may allow U.S.
firms to automate some of these services, reducing the need for labor (reducing relative labor
intensity). If this
happens, India’s comparative advantage in the provision of these services may
be reduced.


3.

Trade, Factor Prices, and Real Income


The distribution of income that results from free trade remains a contentious issue. Factor
proportions models can be used
to predict relative real income changes in various situations.


a.

Factor Price Equalization


The Factor Price Equalization (FPE) theorem predicts that uninterrupted trade results in
equalization of both goods’ prices and factor prices across nations. Thus,
wage rates (w) and
rental rates on capital (r) should converge and eventually become equal across nations. The
mechanism that equates factor prices is the equalization of the prices of goods and services. This
convergence has not happened yet (nor do we
have uninterrupted trade), so there is little reason to
expect wages or capital rates to have fully converged. Over the long run, there has been some
convergence of wages and convergence is greater in economies that are more open.



Sources of Comparative Advantage

25



b.

Visualizing Global Eco
nomics Issues: The Factor Price Equalization Theorem


For Critical Analysis: Suppose both nations open their borders to trade, but retain policies
that constrain trade to a level lower than under free
-
trade conditions. How would this
affect the adjustmen
t of factor prices, and how would you illustrate this situation in (Text)
Figure 3
-
3?


Logically, some convergence in goods’ prices and factor prices would occur, but equalization
would not be expected under the assumptions of the model. In the graph, the

ratios would not
equate.


c.

Trade and Real Income


The Stolper
-
Samuelson theorem states that free trade raises (lowers) the real earnings to owners
of the nation’s relatively abundant (scarce) factor. As the nations move to free trade, the good
that uses
the abundant (scarce) factor (less) intensively is exported (imported). The result is that
as nations move from autarky to free trade, the price of the good that intensively uses the
abundant factor will rise due to foreign demand for that export good. In
creased imports of the
good that intensively uses the scarce factor (increased supply) will reduce the price of that good
and will thus also reduce the earnings accruing to the scarce factor.


According to the
magnification principle
, the change in the pr
ice of a factor is greater than the
change in the price of the good or service that uses the relatively intensively in its production
process. This principle ensures that the above conclusion about real incomes holds.


Returning to the earlier example fo
r Country A and B and the production of textiles and
machinery:


EXAMPLE OF DIFFERENT

FACTOR ENDOWMENTS



Country A

Country B


Labor

Capital

Labor

Capital


2000 units

1000 units

1000 units

2000 units

Capital
-
to
-
Labor ratio

½ unit capital/unit labor

2 u
nits capital/unit labor

Labor
-
to
-
Capital ratio

2 units labor/unit capital

½ unit labor/unit capital

Relative Abundance

Relatively Capital Abundant

Relatively Labor Abundant


26

Chapter 3


EXAMPLE OF DIFFERENT

FACTOR INTENSITIES



Textiles

Machinery


Labor

Capital

L
abor

Capital


4 units

1 unit

1 unit

3 units

Capital
-
to
-
Labor ratio

¼ unit capital/unit labor

3 units capital/unit labor

Labor
-
to
-
Capital ratio

4 units labor/unit capital

1/3 unit labor/unit capital

Relative Intensity

Relatively Labor Intensive

Relative
ly Capital Intensive


Country A has a comparative advantage in producing machinery, and if free trade is allowed,
exports machinery according to the H
-
O theorem. Country B has a comparative advantage in
producing textiles and exports textiles to Country
A. The result is an increase in
aggregate
welfare

for both countries as illustrated in Chapter 2. However, the distributional effects
(
redistributive effects of trade
) differ in the two countries.


With autarky, labor in Country A is relatively scarce an
d can command relatively higher wages
than returns on capital, R. The opposite holds in Country B so
W
A
/R
A

> W
B
/R
B
. If free trade is
allowed, Country A shifts production to produce more machinery and fewer textiles. This uses
relatively more capital and

less labor, increasing R
A

relative to W
A
, reducing the ratio. The
opposite occurs in Country B and
W
B
/R
B

begins to rise, and the relative ratios converge.


Teaching Tip
:

Here is an alternative version of the same explanation: Under free trade, the price

of textiles in
Country A falls as textile imports become available from Country B. The value of the marginal
product of labor declines, resulting in a decline in relative wage rates in Country A. Similarly,
the price of machinery in Country B falls as
machinery imports become available from Country
A, and as a result, relative returns to capital fall in Country B.


Teaching Tip
:

This example assumes that citizens are either workers or owners of capital, but not both.
Interestingly, it also implies tha
t all workers are affected equally, regardless of whether they are
involved in the import or export sectors; likewise for capital owners.


Because of the real income changes depicted above, the model predicts that owners of capital in
the capital abundant
nation will be proponents of free trade and the same nation’s workers will be
against free trade. Likewise, workers in the labor abundant nation will be proponents of free
trade and that nation’s owners of capital (the scarce resource) will be against fr
ee trade.



Sources of Comparative Advantage

27



4.

International Production and Comparative Advantage


a.

The Internationalization of Production


The production of a good or service can be thought of as a series of activities that add value at
each step. Typical stages might include design, man
ufacturing, assembly, marketing and
transportation or delivery. This process is sometimes called the
value chain.

Some stages in the
value chain tend to be more capital intensive, such as design, marketing and delivery, while
manufacturing and assembly m
ay be more labor intensive. The theory of factor proportions
suggests that different countries may have a comparative advantage in producing a given step in
the value chain. South Korea, for example, is relatively more labor abundant than the United
State
s and may be expected to have a comparative advantage in manufacturing certain goods.
Competitive firms may improve their margins by
outsourcing

certain parts of the production
process to firms with a comparative advantage in that step. Similarly, a U.S.

firm may hire a
foreign firm to manufacture the U.S. firm’s product using specifications provided by the U.S.
firm. The product may then be marketed by the U.S. firm using its brand name around the world.
This process is termed
contract manufacturing
.


b.

Management Notebook: Do Manufacturers Really Need a Factory?


For Critical Analysis: The Internet plays a very important role in the relationship between
electronics firms and contract manufacturers. How do you suppose the Internet facilitates
the relati
onship between the firm that innovates and the firm that produces the actual
product?


The Internet is a low cost method of communicating information that allows tighter inventory
control, better communications between distant operations and makes incredib
le amounts of
information available to users. Reductions in information and transportation costs have allowed
the internationalization of production to become cost feasible. For instance, a computer system
can use the Internet to identify an increase in
sales of a given item at multiple outlets in the U.S.,
quickly analyze the data and transmit an order to an overseas manufacturer which produces more
of the item and ships it back to the U.S. for distribution. Customer inquiries and service needs
can quic
kly be addressed, and technicians in the production factory can be involved if necessary.
The more rapid the innovations and the greater the demand for customer service, the more
important the Internet will become. Note that the Internet will also put pr
essure on contract
manufacturers’ profit margins to decline, because it will make it easier and cheaper for the hiring
firm to locate competing manufacturers.


c.

Kaleidoscopic Comparative Advantage


The term
kaleidoscopic comparative advantage

refers to the
tendency for comparative advantage
to change rapidly over time, requiring firms to respond to changing circumstances and
competition in order to remain profitable.


28

Chapter 3


5.

Economic Growth and International Trade


a.

Economic Growth


Economic growth in the context o
f a factor proportions model is evidenced by an increase in
available resources (labor or capital) and/or a technological advancement that allows a greater
amount of output per unit of input. Both would cause the PPF to shift outwards. Expansion of a
giv
en resource will favor the good that uses that input intensively.


Teaching Tip
:

There is a difference between an increase in labor or capital endowments and a technological
change in the strict factor proportions model. The H
-
O model assumes that the p
roduction
technology is the same in both countries, so any technological change would occur in the two
countries, whereas an endowment change could occur in one country without occurring in the
other.


b.

The Rybczynski Theorem


The
Rybczynski theorem

states
that if a resource in a nation increases,
at a given opportunity
cost
, it will produce more of the good that uses the resource intensively and produce less of the
other good. In the Country A and Country B example, if Country A, the capital abundant
count
ry, has an increase in its capital endowment, it will produce more machinery and less
textiles.


Given that the U.S. is a capital abundant nation and that this country continues to receive large
capital inflows, we would expect to see more production of ca
pital intensive goods and services
and less in labor intensive industries.


c.

Visualizing Global Economic Issues: The Rybczynski Theorem


For Critical Analysis: Does the increase in capital make Northland’s residents more or less
likely to trade? What if l
abor were to increase instead of capital?


The increase in capital induces Northland to produce more computers, the relatively capital
intensive good, and fewer baskets of food. Computers are the export good (Northland is capital
abundant) so this leads t
o more exports of computers and more imports of food. Trade is
increased. If labor were to increase rather than capital, the opposite would occur. Northland
would produce more food and fewer computers, leading to fewer computer exports and fewer
baskets

of food imports. Trade would be reduced. (See d. below)


d.

Growth and Trade


From the Rybczynski theorem, an increase in the abundant resource in a country will obviously
lead to the production of more of the export good (the good that uses the abundant re
source
intensively) and less of the other good. This will in turn lead to more exports and more imports
as more production is shifted to the dominant good. The effect is
pro
-
trade
. However, an
increase in the scarce resource in a country will lead to lo
cal production of more of the import
good and less of the export good. As a result, there are fewer imports and exports. In this case
the outcome is
anti
-
trade
.



Sources of Comparative Advantage

29



When Country A receives an increase in its capital endowment it produces more machinery,
w
hich is the export good, and fewer textiles. It exports the additional machinery (an increase in
exports) and imports more textiles (an increase in imports). The effect is thus pro
-
trade. If
Country B receives an increase in its capital endowment, it to
o will produce more machinery and
fewer textiles. In this case, however, this means fewer machinery imports and fewer textile
exports, reducing overall trade.


6.

Answers to End of Chapter Questions


1.

Utopia’s ratio of labor to capital is 100/75 = 1.33,
and Idealand’s is 75/50 = 1.5. Hence, Idealand is
relatively labor abundant and Utopia is relatively capital abundant.

2.

The capital to labor requirement of sandwiches is 0.5/1 = 0.5, and the capital to labor requirement of
bicycles is 0.9/0.9 = 1. He
nce, bicycles are relatively capital intensive in their production process
while sandwiches are relatively labor intensive in their production process.

3.

Because Utopia is relatively capital abundant and bicycles are relatively capital intensive in thei
r
production process, Utopia has a comparative advantage in bicycles and will export them to Idealand.
Likewise, because Idealand is relatively labor abundant and sandwiches are relatively labor intensive
in their production process, Utopia has a comparat
ive advantage in bicycles and will export them to
Idealand.

4.

Because Utopia has a comparative advantage in bicycles and Idealand has a comparative advantage in
sandwiches, then, under autarky, Utopia will have the higher price in sandwiches and Idealan
d will
have the higher price in bicycles. Because Utopia is relatively capital abundant and Idealand is
relatively labor abundant, Utopia has a higher wage rate relative to the rental rate of capital. When
the two nations begin to trade, the wage rate re
lative to the rental rate will begin to decline in Utopia
and rise in Idealand.

5.

According to the Stolper
-
Samuelson theorem, real returns to the holders of the relatively abundant
factor in Utopia, capital, will rise with free trade while returns to t
he holders of the relatively scarce
factor, labor, will decline. The opposite occurs in Idealand.

6.

The gains from specialization are completely exhausted when the opportunity costs are equal between
the two nations. A common slope of the line tangent

to the production possibilities frontiers
illustrates this outcome.

7.

HP is likely to have a comparative advantage in the high
-
skill areas of production such as design,
marketing, and delivery. A developing nation is likely to have a comparative advan
tage in assembly
and the manufacture of components.

8.

According to the Rybczynski theorem, the increase in capital stock will lead to an increase in the
production of capital
-
intensive goods and a decrease in the production of labor
-
intensive goods. Th
e
trade pattern of the emerging nations is likely to change to reflect this.

9.

According to the Rybczynski theorem, the economic growth that took place may or may not increase
trade for these nations, depending on which sector experienced the growth. I
t may be that, if the
nation is capital scarce, growth in the capital
-
intensive sector leads the nation to import fewer capital
-
intensive goods, thereby reducing trade.

10.

If the United States is relatively capital abundant, the increase in the labor sto
ck would lead to an
expansion in the labor
-
intensive sector. Because the United States is a large country, however, it is
unlikely that opportunity costs remain the same. This example shows that we must consider this
aspect when applying the Rybczynski t
heorem to large countries.