Copyright © 2007 South-Western, a division of Thomson Learning. All rights reserved. Chapter 3 Sources of Comparative Advantage

Copyright © 2007 South-Western, a division of Thomson Learning. All rights reserved. Introduction Comparative advantage –What are the sources of a nation’s comparative advantage?

Copyright © 2007 South-Western, a division of Thomson Learning. All rights reserved. Factor Endowments Factor-Endowment (Heckscher-Ohlin) Theory –Explains comparative advantage by differences in relative national supply conditions –Key determinant: Resource endowments –Assumptions: Perfect competition Same demand conditions Uniform quality factor inputs Same technology used

Copyright © 2007 South-Western, a division of Thomson Learning. All rights reserved. Factor-Endowment Theory Relative price levels differ among nations because: –Nations have different relative endowments of factor inputs –Different commodities require factor inputs with differing intensities for production Example: Hypothetical resource endowments in the U.S. and China that are used in the production of aircraft and textiles (Table 3.1)Table 3.1 Capital/labor ratios for selected countries (Table 3.2)Table 3.2 Continued

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Copyright © 2007 South-Western, a division of Thomson Learning. All rights reserved. Back

Copyright © 2007 South-Western, a division of Thomson Learning. All rights reserved. Factor-Price Equalization Redirecting demand away from the scarce factor toward the abundant factor –Cheap factor becomes more expensive; expensive factor becomes cheaper –Not fully possible in a real world situation: Much income inequality across countries results from uneven ownership of human capital Technology usage not identical Transportation costs and trade barriers –Indexes of hourly compensation (Table 3.3)Table 3.3

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Copyright © 2007 South-Western, a division of Thomson Learning. All rights reserved. Trade and Distribution of Income Theoretically, increased trade could worsen inequalities in wages though this may benefit national income –Example: Trade increases the supply of unskilled labor to the U.S. economy Lowers unskilled labor wages for the American worker Calls for protection against import competition

Copyright © 2007 South-Western, a division of Thomson Learning. All rights reserved. Does Trade Make the Poor Even Poorer? Skilled and unskilled: Widening wage gap –Factors responsible: trade, technology, education, immigration, and union weakness –Determining relative contributions of trade and other influences on wage discrepancy Analytical framework (Figure 3.1) used views this as an outcome of the interaction between labor supply and demandFigure 3.1

Copyright © 2007 South-Western, a division of Thomson Learning. All rights reserved. Actual Trade Patterns and the Factor-Endowment Theory Wassily Leontief (1954) –Data (1947) suggested that capital/labor ratio for U.S. export industries was lower than that of its import-competing industries (Table 3.4)Table 3.4 –Conclusion: Exports were less capital- intensive than import-competing goods –Leontief paradox contradicted the predictions of the factor-endowment theory Study repeated with 1951 data with similar results

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Copyright © 2007 South-Western, a division of Thomson Learning. All rights reserved. Actual Trade Patterns Studies suggest a more generalized factor-endowment model –Takes into account many subvarieties of capital, land, and human factors –Recognizes that factor endowments change over time as a result of investment and technological advances Shares of world resources for various countries and regions in 1993 (Table 3.5)Table 3.5 Continued

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Copyright © 2007 South-Western, a division of Thomson Learning. All rights reserved. Actual Trade Patterns Recent researchers –Focus on the importance of worker skills in the creation of comparative advantage Investments in skill, education, and training, which enhance a worker’s productivity, create human capital U.S. Human capital relative to other nations (Table 3.6)Table 3.6 Continued

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Copyright © 2007 South-Western, a division of Thomson Learning. All rights reserved. Increasing Returns to Scale and Specialization “New trade theory” (1980s) –Founded on the notion of increasing returns to scale (economies of scale) –Nations with similar factor endowments take advantage of massive economies of scale Develop an industry that has economies of scale Produce great quantities at low average unit costs Trade those low-cost goods to other nations –Effect of economies of scale on trade (Figure 3.3)Figure 3.3

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Copyright © 2007 South-Western, a division of Thomson Learning. All rights reserved. Increasing Returns to Scale and Specialization Cost incentives for specialization –Benefit from longer production runs, decreasing average costs Home market effect –Specializing in products with large domestic demand Minimized shipping costs coupled with economies of scale Smaller countries might become deindustrialized becoming peripheral to the economic core Continued

Copyright © 2007 South-Western, a division of Thomson Learning. All rights reserved. Overlapping Demands as a Basis for Trade Theory of overlapping demands - Staffan Linder –Firms are motivated to manufacture goods with a large domestic market Export is an extension of this production –Consumer tastes are strongly conditioned by income levels –Nations with similar per capita incomes likely consume similar types of manufactured goods and will likely trade with each other

Copyright © 2007 South-Western, a division of Thomson Learning. All rights reserved. Overlapping Demands as a Basis for Trade –Potential for trade in manufactured goods between wealthy and poor nations is small Small extent of demand overlap Linder’s theory and facts –High proportion of trade in manufactured goods takes place among the relatively high- income nations –Bulk of lower income, developing countries tend to have more trade with high-income countries than with lower-income countries

Copyright © 2007 South-Western, a division of Thomson Learning. All rights reserved. Intraindustry Trade Intraindustry specialization –Opening up of trade: Range of products produced and sold by each nation changes Intraindustry Trade (Examples: Table 3.7)Table 3.7 –Appears to be incompatible with the models of comparative advantage –Involves flows of goods with similar factor requirements –Reasons for trade in homogeneous goods: Transportation costs Seasonal –Most trade occurs in differentiated products

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Copyright © 2007 South-Western, a division of Thomson Learning. All rights reserved. Intraindustry Trade Differentiated products in industrial nations –“Majority’’ and ‘‘minority’’ consumer tastes –Overlapping demand segments Intraindustry trade is explained by product differentiation and economies of scale –Fewer adjustment problems are likely to occur with specialization Transfer of resources from import-competing to export-expanding sectors Lessened problem of structural unemployement Continued

Copyright © 2007 South-Western, a division of Thomson Learning. All rights reserved. Product Cycle: Technologically Based Theory of Trade Product life cycle theory –Technological innovation: Key determinant of trade patterns –Stages in a trade cycle Manufactured good is introduced to home market Domestic industry shows export strength Foreign production begins Domestic industry loses competitive advantage Import competition begins –Example: Experience of U.S. and Japanese manufacturers of radios, pocket calculators

Copyright © 2007 South-Western, a division of Thomson Learning. All rights reserved. Dynamic Comparative Advantage: Industrial Policy Static nature of Ricardian theory Dynamic comparative advantage –Additional resources can be made available because they can be created or imported Mobilization of skilled labor, technology, and capital –In addition to business sector, government can establish policies to promote opportunities for change through time

Copyright © 2007 South-Western, a division of Thomson Learning. All rights reserved. Industrial Policy A strategy to revitalize, improve, and develop an industry –Requires resources be directed to industries in which: Productivity is highest Linkages to the rest of the economy are strong Has future competitiveness –Strategy developed collectively by government, business, and labor

Copyright © 2007 South-Western, a division of Thomson Learning. All rights reserved. Industry Policy Advocacy –The Japanese example Criticism –The causal factor in Japanese industrial success is unclear –May lead to trade-inhibiting protectionism –May favor politically powerful industries –Raises the question of whether the government does a better job than the private sector in creating comparative advantage Continued

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Copyright © 2007 South-Western, a division of Thomson Learning. All rights reserved. Government Regulatory Policies and Comparative Advantage Government regulations to pursue goals: –Workplace safety –Product safety –A clean environment Steelmakers complain about regulatory burdens (Table 3.9)Table 3.9 –Improves the well-being of the public –Results in higher costs for domestic firms Erodes an industry’s competitiveness Trade effects of pollution regulations (Figure 3.4)Figure 3.4