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

2. 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

3. 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.

4. 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

5. 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

6. 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

7. 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

8. 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

9. 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

10. 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

11. 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

12. 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

13. 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

14. 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

15. 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

16. 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

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

18. 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

19. 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

20. 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.

21. 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

22. 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

23. 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

24. 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