1. Comparative Advantage and Factor Endowments
Chapter 4
Comparative Advantage and Factor Endowments

2. Learning Objectives Explain the Heckscher-Ohlin Trade Model.
PPC (Production Possibility Curve)
Predict the impacts on different factors of production of trade-opening.
Predict the impacts on trade and production of a change in factor endowments.

3. Learning Objectives (cont.)
Illustrate the product cycle for a product as it becomes standardized in its production.
Wage Inequality

4. Modern Trade Theory
Adam Smith and David Ricardo assumed that each country would have its own technology, climate, and resources, and that these differences would give rise to productivity differences (and thus differences in comparative advantage)
In the 20th century, several economists developed more detailed explanations of trade in which comparative advantage of a country depends on it’s endowments of inputs (factors of production) to produce goods

5. Heckscher-Ohlin (HO) Trade Model
The HO model states that a country’s factors of production (a country’s endowments of inputs) are used to make each good give rise to productivity differences between countries
Factor abundance versus factor scarcity: When a country enjoys a relative abundance of a factor, the factor’s relative cost is less than in countries where the factor is relatively scarce
A country’s comparative advantage lies in the production of goods that use relatively abundant factors

6. Key assumptions As in the Ricardian model 2 goods, 2 countries.
Ricardian model assumed that each country faced a constant set of tradeoffs (e.g., 2 loaves of bread for 3 tons of steel in the U.S.) because of only one homogeneous input: labor
The HO model assumes: (1) multiple inputs—labour, capital, land, etc.—and (2) heterogeneity in the quality of inputs, i.e. skilled and unskilled labour.
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7. TABLE 4.1 An Example of Factor Abundance
Canada is not a good example here: better to think of a developing country like Bolivia, Peru or Venezuela
Canadian capital-labor ratio: Kcan / L can is 2/10 or 1/5
U.S. capital-labor ratio: Kus / L us is 50/150 or 1/3
Since the U.S.’s capital-labor ratio is higher, it is the relatively capital abundant country: (KU.S. / L U.S. > KCan. / LCan. or 1/3 > 1/5 )
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8. Implications
US is capital abundant relatively to Canada, so capital should be relatively cheap in the US and the US would have a relatively lower cost in producing capital-intensive goods> the US will have a lower opportunity cost in the production that uses relatively more capital and less labour.
US should export capital abundant goods, Canada labour abundant.
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9. Heckscher-Ohlin (HO) Trade Model (cont.)
The U.S. is richly endowed with a wide variety of factors: natural resources, skilled labor, and physical capital
Expectation: The U.S. will export agricultural products (particularly those requiring skilled labor and physical capital) and machinery and industrial goods (requiring physical capital and scientific and engineering skills)
Result: Major U.S. exports include grain products made with small labor and large capital inputs; and commercial aircraft made with physical capital and skilled labor.
But not all model predictions are good… Leontief found that U.S. exports were less capital-intensive than U.S. imports, even though the U.S. is the most capital-abundant country in the world: Leontief paradox.
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10. Table 5-2: Factor Content of U.S. Exports and Imports for 1962
This paradox is probably due to historical factors: in the sixties, US mainly traded with quite similar countries, such as EU countries or Japan. The major developing economies were out of international trade because of political factors (communism, dictatorships, etc.)

11. Empirical Evidence of the Heckscher-Ohlin Model
However, in general, patterns of exports between developed (high income) and developing (low/middle income) countries are in line with the HO theory.
US imports from Bangladesh are highest in low-skill-intensity industries, while US imports from Germany are highest in high- skill-intensity industries.

12. Fig. 5-12: Skill Intensity and the Pattern of U. S
Fig. 5-12: Skill Intensity and the Pattern of U.S. Imports from Two Countries
Source: John Romalis, “Factor Proportions and the Structure of Commodity Trade,” American Economic Review 94 (March 2004), pp. 67–97.

13. Gains from Trade in the HO Model
As in the Ricardian model: increase in market size <> Specialization <> gains for trade
As in the Ricardian model, there are gains for trade as, with respect to autharky, the price of the exported good rises and the one of the imported good falls in both countries.
The price of the exported good rises because foreign consumers buy the cheaper good produced from home, so increase its demand.
The price of the imported good falls as the foreign country is relatively more productive (with respect to the home country) in the good imported.
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14. Other implications
Another crucial assumption of the HO model is that each country has a rising opportunity cost for each type of production, i.e. the more you produce of one good the more it costs to produce it.
So there is less tendency toward specialization than in the Ricardian model, where full specialization was the best outcome.
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15. FIGURE 4.1 The United States’ Production Possibilities Curve with Increasing Costs

16. Other implications: trade and the income distribution
Differently from the Ricardian model, the HO model allows to study the effect of trade on the income distribution within a country. In general, the Ricardian model ruled out the potentially harmful effects of trade for some member of the society.
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17. Trade and Income Distribution
The HO model provides a more sophisticated way to analyze gains and losses from trade because it drops unrealistic assumptions
Labor can be divided into categories of different skill levels
Other types of inputs can be included
Industries can require different mixes of various inputs
There is a systematic relationship between the factor endowments of a country and the winners and losers from trade
Let’s analyze this claim further…
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18. The Stolper-Samuelson Theorem
Derived from the HO model
Assumptions:
Labor earns wages proportionate to its skill level
Owners of capital earn profits
Landowners earn rents
The amount of income earned per unit of input depends on both the demand for inputs and the supply of inputs (demand for an input such as labour = derived demand)
If an output is in high demand, its price is high and the inputs used to produce it receive higher returns
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19. The Stolper-Samuelson Theorem (cont.)
An increase in the price of a good raises the income earned by factors that are used intensively in its production. Since the price of export increases with international trade, owners of the factor used intensively in the exported good sector gain (skilled labour in the US).
Conversely, a fall in the price of a good lowers the income of the factors used intensively in its production. Since the price of the good imported declines with inter. trade, owners of the factor used intensively in the import-competing industry loose (unskilled labour in the US).
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20. Remark
As in the Ricardian model, the earnings of the inputs used intensively in the production of the good exported increase because these earnings are proportional to the demand of the exported good and so to its price, both increasing with trade.
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21. The Stolper-Samuelson Theorem (cont.)
The main idea is that trade of goods is equivalent to trade of production factors.
Since international trade reallocates the production of goods across countries, it changes also the demand of factors of production across countries.
There will be factors of production whose demand declines after trade (i.e. workers in the apparel and textile industry in the US) and factors of production whose demand increases (i.e. ICT engineers, managers in the financial sector or software developers in the US)
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22. The Stolper-Samuelson Theorem (cont.)
Note: Not all factors used in the export industries will be better off, and not all factors used in import competing industries get hurt: in general abundant factors will benefit, while scarce ones will be hurt.
Why?
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23. Answer
What really matters is the change in the total demand of each factor of production, no the change in each industry: in particular, the unskilled labour displaced in the textile sector (that uses intensively unskilled labour) cannot be fully relocated to the IT or financial sector (that uses intensively skilled labour). Therefore, the demand of unskilled workers in the US declines and so their wage.
A fraction of the displaced unskilled labour is re-employed in the IT sector that expanded and can hire more unskilled workers, but not all as it is a skill-intensive sector.
What we can do with the rest? Well: displaced unskilled workers should accept lower wages to make their employment profitable for firms or, in the long run, they should acquire better skills to find a job in the export sector.
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24. The Stolper-Samuelson Theorem (cont.)
Ultimately, the effects of international trade on factor’s income depends on the flexibility of the affected factors
If labor is stuck in bread production and unable to move to making steel, it will be hurt much worse than when it is flexible and free to move
U.S. avocado producers might not oppose Mexican avocado imports as fiercely as they do, if they could easily move to producing other goods or use the land to build houses.
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25. A variant of the HO model: the Specific Factors Model
The HO model assumes that factors are mobile, meaning that they can migrate easily from one sector to another
The Specific Factors model assumes that: (1) land, capital and certain types of skilled labour are immobile and cannot migrate (specific factors); and (2) other types of labour with general skills can fully mobile and can migrate from one sector to another (variable factor)
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26. Examples
An agent of a Rock star cannot be easily relocated to become an agent of a football player.
A PC can be productively used in several applications.
A nuclear plant cannot easily be redesign to produce energy from carbon, while a carbon plant can be restructured to produce energy from gas.
A human resource manager can be reemployed easily in another sector
An engineer specialized in nuclear energy cannot be easily relocated in projecting wind turbines (that requires competences in aerodynamics).
An IT expert might find it difficult to suddenly shift to Linux from windows
A typewriter might find it difficult to shift from a keyboard (i.e. QWERTY) to another.
Reemploying a specific factor of production from a sector to another is often a matter of time and depends upon the implementation of the appropriate supportive policies (e.g. retraining, education).
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27. Specific Factors Model (cont.)
A country’s endowment of a specific factor plays a critical role in determining comparative advantage and the distribution of income
When trade opens, incomes rise for the owners of the abundant specific factor
The income distribution effect on the mobile factor (call it ‘labour’ for simplicity) is indeterminate, as workers can easily move to the expanding sector
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28. TABLE 4.2 A Specific Factors Model, example
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29. Implications of the model
Quite similar to the implications of the HO model for the income distribution and the patterns of trade (export the good using the abundant factor, import the good using the scarce one).
The only difference is that the model allows to better understand the effect of trade on sector-specific factors of production and why the owners of relatively immobile factors fiercely oppose any trade liberalization (political determinants of trade policies, see lecture2 on policies).
In particular, why some sectors oppose so much to trade liberalization.
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30. Empirical Tests of the Theory of Comparative Advantage
Tests of theories based on factor endowments (such as HO) yield mixed results
- Empirical tests are difficult: how to measure factor endowments or prices in an autarky, for example
Besides factor endowments, trade is affected by
Technological differences
Economies of scale
Corporate structures
Economic policies
Empirical evident supports Ricadian but not H-O model

31. Extension of the HO Model: The Product Cycle
The product cycle was developed by Raymond Vernon
Production of a good is cyclical
In the early stage of production, manufacturers need to be near a high-income market where consumer feedback is greatest.
Experimentation with fundamentally new designs begins to wane as product development shifts toward incremental improvements in a basic design.

32. Product Cycle (cont.)
In the middle phase, production begins to shift to countries with low labor costs.
consumption of the good in a high-income country exceeds its production: production moves where labor costs are lower
Countries reach the late phase of the product cycle when consumption in high income nations begins to exceed production.

33. FIGURE 4.5 The Product Cycle in High-Income Countries

34. FIGURE 4.6 The Product Cycle in Low-Income Countries

35. TABLE 4.4 Top Ten Chinese Exports to the United States, 2011

36. The Impact of Trade on Wages and Jobs
In the short-run, trade may (1) reduce jobs in an industry that is not competitive vis-à-vis foreign industries and (2) increase jobs in competitive industries
In the medium- and long-run, trade has very little effect on the number of jobs
The abundance or scarcity of jobs is a function of (1) labor market policies, (2) incentives to work, and (3) government macroeconomic policies

37. Example: Trade and Unemployment
Trade shifts jobs from import-competing to export sector.
Process not instantaneous – some workers will be unemployed as they look for new jobs.
How much unemployment can be traced back to trade?
From 1996 to 2008, only about 2.5%

38. Example: Trade and Unemployment
Figure 4-12 shows that there is no obvious correlation between unemployment rate and imports relative to GDP for the U.S.
Unemployment is primarily a macroeconomic problem that rises during recessions.
The best way to reduce unemployment is by adopting macroeconomic policies to help the economy to recover, not by adopting trade protection.

39. Fig. 4-12: Unemployment and Import Penetration in the U.S.
Source: US Bureau of Economic Analysis for imports and US Bureau of Labor Studies for unemployment.

40. Income Inequality Trade might increase Income Inequality in Short run
Long run: Income inequality is due to technology change, which increases the demand for skilled labor