International Economics Woraphon Yamaka

1. International EconomicsWoraphonYamaka Chapter 3: Sources of Comparative Advantage Modified form International Economics 9th Edition byRobert J. Carbaugh

2. Review Chapter 2 • In Chapter 2, we learned how the principle of comparative advantage applies to the trade patterns of countries. • Sometimes comparative advantage is determined by natural resources or climate, sometimes by the abundance of cheap labor, sometimes by accumulated skills and capital, and sometimes by government assistance granted to a particular industry • Some sources of comparative advantage are long lasting, such as huge oil deposits in Saudi Arabia; others can evolve over time, such as worker skills, education, and technology. In this chapter, we consider the major sources of comparative advantage: differences in technology, resource endowments, and consumer demand; and also, the existence of government policies, economies of scale in production, and external economies

3. Heckscher-Ohlin Theory • Ricardo formulated the principle of comparative advantage, Problem of Ricardo theory. 1) He did not explain what ultimately determines comparative advantage. 2) He simply took that relative labor productivity, and thus relative labor costs and relative product prices, differed in the two countries before trade. 3) His theory cannot explain the source of comparative advantage 4) Cannot explain the effect of international trade on the earnings of various factors of production in trading nations. • Heckscher-Ohlin Theory is introduced They mentioned that actor (resource) endowments determine a nation’s comparative advantage, their theory became known as the factor-endowment theory. It is also known as the Heckscher-Ohlin theory.1

4. Why relative price differentials? Factor endowment theory: assumptions • Nations all have the same tastes and preferences (same indifference curves) (we will focus only the input factor, not a demand of people) • Production possibilities curves depend on technology and resource endowments • technology and demand are approximately the same between countries, and thus it emphasizes the role of relative differences in resource endowments • Nation will export the product that uses a large amount of its relatively abundant resource, and it will import the product which in production uses the relatively scarce resource Carbaugh, Chap. 4

5. What does it mean to be relatively abundant/ scarce in a resource? U.S. capital/labor ratio equals 0.5 (100 machines/200 workers) China capital/labor ratio is 0.02 (20 machines/1,000 workers) United States the relatively capital-abundant country > capital/labor ratio capital/labor ratio China the relatively Labor-abundant country

6. How does the relative abundance of a resource determine comparative advantage according to thefactor-endowment theory? When a resource is relatively abundant, its relative cost is less than in countries where it is relatively scarce. For Example: Before the US and China trade • Comparative advantages are that capital is relatively cheap in the United States • Labor is relatively cheap in China. • So, the US has a lower relative price in aircraft, which use more capital and less labor. • China’srelative price is lower in textiles, which use more labor and less capital. Carbaugh, Chap. 4

7. Quiz: Let analyze the comparative advantage of US and Thai Economies, What can we conclude? Carbaugh, Chap. 4

8. Factor endowment model Visualizing the Factor-Endowment Theory Autarky equilibrium Suppose that in autarky, both countries have the same demand for textiles and aircraft that results in both countries producing and consuming at point A United States has a comparative advantage in aircraft while China has a comparative advantage in textiles because MRT(US)= 0.33 < MRT(CHINA)= 0.40

9. Factor endowment model Visualizing the Factor-Endowment Theory Post-trade equilibrium With trade, each country continues to specialize in the production of the product of its comparative advantage until its product price equalizes with that of the other country. (reach Point B) - The points that production possibilities curve is tangent to the common relative price slope of 1.0. ( Term of Trade 1:1) . - This relative price line becomes the equilibrium terms of trade (Price import =Price export)

10. Factor endowment model Factor endowment theory: implications • Factor price equalization (same resource prices) • The shift within each nation to use of cheaper factors, and away from expensive ones, leads to more equal factor prices (if factors are mobile) This lead a factor-price equalization. EX: Form previous graph, the Chinese demand for inexpensive American aircraft results in an increased American demand for its abundant resource, capital; the price of capital(R) thus rises in the United States. As China produces fewer aircraft, its demand for capital decreases, and the price of capital falls. The effect of trade is thus to equalize the price of capital in the two nations. R(US)= R(CHN) Similarly, the American demand for cheap Chinese textiles leads to an increased demand for more labor in China, its abundant resource; the price of labor(w) thus rises in China. With the United States producing fewer textiles, its demand for labor decreases, and the price of labor falls. W(US)= W(CHN) Carbaugh, Chap. 4

11. Factor endowment theory: implications • Distribution of income (Stolper-Samuelson theorem) Trade changes domestic distribution of income as demand for different factors changes • Free international trade benefits the abundant factor and harms the scarce factor. (see, Factor price equalization) • Some groups in society will oppose international trade. • Scarce factors will lobby government for trade protection. • Even though some in society lose, the country overall benefits from international trade relative to autarky. • A system of taxation and transfers could be developed to compensate the losers while leaving the gainers better off relative to autarky. Carbaugh, Chap. 4

12. Stoper – samuelson theory L China and K US gain from trade K China and L USloss from trade

13. Distribution of income Does trade worsen inequality? Before leaving the factor-endowment theory • Trade theory suggests that countries with abundant skilled labor will import goods which are made with unskilled labor • Equilibrium wage ratios for skilled/unskilled labor are affected by trade and technology change, immigration, and education & training • Evidence suggests that trade contributes relatively little to wage inequality, compared to technological change and other factors; better education and training are potential solutions Indeed, Skilled and unskilled make lead an inequality wage

14. Bringing theory closer to reality Economies of scale & specialization • Economies of scale provide incentives for specialization, since per unit costs go down as production increases • Trade provides a larger potential market for products, making higher production levels possible Carbaugh, Chap. 4

15. Economies of scale Economies of scale as basis for trade Although comparative-advantage theory has great appeal, it has little ability to explain why similar productivity countries trade with each others. This question can be explained by economies of scale By adding to the size of the domestic market, international trade permits longer production runs by domestic firms, which can lead to greater efficiency and reductions in unit costs EX. Companies such as Toyota and Honda reduce costs by specializing in machinery and labor and obtaining quantity discounts in the purchase of inputs.

16. Bringing theory closer to reality Other extensions of the theory • Overlapping demands • Intra-industry trade • Product cycles • Dynamic comparative advantage - industrial policy Carbaugh, Chap. 4

17. Bringing theory closer to reality Trade & the environment • Environmental regulation can lead to a policy tradeoff • Increased costs can reduce comparative advantage of regulated industry • Public receives health and environmental benefits • Concern that polluting industries would move to poor countries with less regulation • But studies indicate that environmental rules have a small role in investment location decisions • Polluter-pays principle: incentive to find ways to reduce pollution at least cost Carbaugh, Chap. 4