Sources of Comparative Advantage Chapter 3 Copyright © 2009 South-Western, a division of Cengage Learning. All rights reserved.

Factor Endowment Theory economists Heckscher and Ohlin explanation of: determinants of comparative advantage impact of trade on earnings of factors nation will export goods which it produces with resources that are relatively abundant nation will import goods which it produces with resources that are relatively scarce

Factor Endowment - Example U.S.: capital/labor ratio = 0.5 (100/200) China: capital/labor ratio = 0.02 (20/1,000) Since the U.S. has relatively more abundant capital, the U.S. will produce capital-intensive goods with China producing goods that are more labor-intensive.

Graphical Example U.S. MRT = 0.33 China’s MRT = 4.0 implication is that U.S. has a lower relative price in aircraft so U.S. has comparative advantage in aircraft & China has comparative advantage in textiles

Graphical Example (cont.) equilibrium at points B and B  where slopes of PPCs are equal represents equal relative price for each country U.S. trades 6 aircraft to China for 6 textiles resulting in point C for consumption

Implications of Factor Endowment U.S. - relatively abundant capital China - relatively abundant labor expectation – U.S. produces capital intensive goods and China produces labor intensive list of top exports confirm theory’s suggestions

Factor Price Equalization specialization causes U.S. to use more capital and China to use more labor increases price of capital in U.S. and the price of labor in China until factor costs are equal

Stolper-Samuelson Theory increased income for producers of goods associated with relatively abundant resources decreased income for producers of goods associated with relatively scarce resources magnification effect – change in price of the resource is greater than the change in the price of the good produced with that resource implication: overall, free trade provides gains to a nation but specifically some parties gain while others lose

Specific Factor Theory previous models assumed all resources were completely mobile within a country in actuality specific factors may exist that cannot move easily from one industry to another specific factor theory analyzes short run income distribution effects in contrast to previous theories focused on long term results assuming resource mobility among industries conclusion: trade causes losses for resources specific to import-competing industries and gains for resources specific to export industries

Leontief Paradox Leontief tested validity of factor endowment theory using 1947 data on capital to labor ratios results: ratio lower for U.S. export industries than for import-competing industries contrary to factor endowment theory repeated using 1951 data – similar results

Trade & Income Inequality wage ratio = wage of skilled workers divided by wage of unskilled workers labor ratio = quantity of skilled workers divided by the quantity of unskilled workers supply and demand will determine wage ratio and thus the level of income inequality S0 D0 2.0 Labor Ratio Wage Ratio

Technological Change free trade, decreased transportation costs, and skill biased technology increase the demand for skilled workers in relation to unskilled workers result is an increase in the wage ratio promotes a greater degree of income inequality S0 D0 2.0 Labor Ratio Wage Ratio 2.5 D1

Immigration increase in unskilled workers decreases the supply of skilled workers in relation to unskilled workers result is an increase in the wage ratio again promotes a greater degree of income inequality S0 D0 2.0 Labor Ratio Wage Ratio S2 2.5 1.5

Education and Training increased education and training lead to an increase in the supply of skilled workers in relation to unskilled workers result is a decrease in the wage ratio reduces income inequality in this case S0 D0 2.0 Labor Ratio Wage Ratio S1 1.5 2.5

Increasing Returns to Scale increasing returns to scale also known as economies of scale imply lower costs per unit at higher levels of output increasing returns theory – despite limited comparative advantage trade can be beneficial if trade leads to lower cost per unit associated with economies of scale home market effect – countries will specialize in goods with large domestic demand since proximity will reduce transportation costs

Theory of Overlapping Demands economist Staffan Linder firms produce goods with large domestic demand and these goods are potential exports export potential to countries with consumer tastes similar to domestic market consumers conditioned by their income levels high income – demand higher quality goods; luxuries low income – demand lower quality goods; necessities limited trade in goods between wealthy and poor nations because of limited overlap of demand

Intraindustry Trade industrialized nations have practiced intraindustry specialization – focus on particular products within a given industry 2006 data contradicts Ricardo and Heckscher-Ohlin

Intraindustry Trade (cont.) Reasons for trade - homogeneous goods lower transportation costs near borders seasonal variations may impact both supply and demand Reasons for trade - differentiated goods demand of the ‘minority’ consumers not met by domestic producers overlapping demand segments economies of scale associated with greater output of a specific type of good

Product Life Cycle Theory goods undergo a predictable trade cycle shifting from export to import over the following stages: introduction of good in home market domestic industry exports foreign production begins domestic industry loses comparative advantage imports become more likely implications: gains from trade are based on technological innovation and spread of that innovation to other countries continual innovation needed to remain competitive

Dynamic Comparative Advantage Ricardo’s analysis was static assuming that comparative advantage did not change. In actuality, comparative advantage can and does change over time. Industrial policy refers to government attempts to change or create comparative advantage. Such policy is used to stimulate industries with high productivity, economic significance, and a possibility of long term growth.

Government Regulation Free trade leads to equal prices in the U.S. and South Korea. South Korea exports 4 tons to the U.S. exports imports

Government Regulation (cont.) increase in U.S. environmental regulation increases costs and decreases supply leads to higher prices and more exports from South Korea to the U.S. exports imports imports

Transportation Costs free trade will cause the U.S. to produce more autos and Canada to produce fewer until the prices are equal U.S. will export autos to Canada and the price will be $6,000 in both markets

Transportation Costs (cont.) transportation costs will increase the price to $7,000 in Canada Canada will import fewer autos from the U.S. as a result of higher price U.S. price falls to $5,000 as a result of fewer exports and lesser demand Exports Imports