Global Economics Eco 6367 Dr. Vera Adamchik

1. Global EconomicsEco 6367Dr. Vera Adamchik Sources of Comparative Advantage

2. In this chapter, we will discuss the factors that ultimately determine why a country has a comparative advantage or comparative disadvantage in a product.

3. In Chapter 2 we learned: • Trade begins as someone conducts arbitrage to earn profits from the price difference between previously separated markets. • With no trade, product prices differ because: • supply conditions differ (different PPFs, technologies and resource endowments); • demand conditions differ (tastes and preferences).

4. Labor theory of value • Adam Smith viewed the determination of competitiveness from the supply side of the market (labor theory of value  labor is the only factor  the cost or price of a good depends exclusively on the amount of labor required to produce it) [p. 31 in the textbook]

5. Labor theory of value • Like Smith, David Ricardo emphasized the supply-side of the market. In his model, he relied on the following assumptions [p. 32 in the textbook]: • (2) In each nation, labor is the only input; • (5) Costs … are proportional to the amount of labor used.

6. In-class exercise • However, Smith’s and Ricardo’s theories fail to explain international trade when technology is identical in both countries, that is, production functions and PPFs are the same in both countries. • Exercise # 1 (handout).

7. The Factor-Endowment Theory (a.k.a. the Heckscher-Ohlin theory of trade) -- the basis for the orthodox modern theory of comparative advantage

8. The leading theory of what determines nations’ trade patterns emerged in Sweden. • Eli Heckscher (an economic historian) developed the core idea in a brief article in 1919. • A clear overall explanation was developed and publicized in the 1930s by Heckscher’s student Bertil Ohlin (a professor and politician, a Nobel laureate). • Ohlin’s arguments were later reinforced by Paul Samuelson (a Nobel laureate), who derived mathematical conditions under which the H-O prediction was strictly correct.

9. The H-O theory emphasizes the role of relative differences inresource endowments as the ultimate determinant of comparative advantage. The H-O theory explains comparative advantage in terms of underlying • differences across countries in the availability of factor resources (factor endowment) – abundant vs scarce factors; • differences across products in the use of these factors in producing the products – labor-intensive, capital-intensive, land-intensive, etc.

10. Factor abundance • The phrase different factor endowments refers to different relative factor endowments, not different absolute endowments. • In other words, different factor endowments = different factor proportions.

11. Relative factor abundance May be defined in two ways: • The physical definition (in terms of the physical units of two factors). For example, (K/L)I > (K/L)II  Country I is capital-abundant; • The price definition (in terms of the relative prices. The greater the relative abundance of a factor, the lower its relative price). For example, (r/w)I < (r/w)II Country I is capital-abundant.

12. Commodity factor intensity • A commodity is said to be factor-X-intensive whenever the ratio of factor X to a second factor Y is larger when compared with a similar ratio of factor usage of a second commodity.

13. For example, consider labor: • A country is relativelylabor-abundant if it has a higher ratio of labor to other factors than does the rest of the world. • A product is relativelylabor-intensive if labor costs are a greater share of its value than they are of the value of other products.

14. How does the relative abundance of a resource determine comparative advantage? • When a resource is relatively abundant, its relative cost is less than in countries where it is relatively scarce. • Difference in relative resource costs causes the pre-trade differences in relative product prices between two countries.

15. The H-O theory says, in Ohlin’s own words: Commodities requiring for their production much of [abundant factors of production] and little of [scarce factors] are exported in exchange for goods that call for factors in the opposite proportions. Thus indirectly, factors in abundant supply are exported and factors in scanty supply are imported. (Ohlin, Bertil. International and Interregional Trade, MA: Harvard University Press, 1933)

16. Or, in other words, the H-O theory predicts that a country exportsthe product(s) that use its relatively abundant factor(s) intensively and imports the product(s) using its relatively scarce factor(s) intensively.

17. Criticism: The Leontief paradox Wassily Leontief theorized that since the U.S. was relatively capital-abundant (and labor-scarce) compared to other nations, the US would be an exporter of capital intensive goods and an importer of labor-intensive goods. However, he found that US exports were less capital intensive than US imports. Since this result was at variance with the predictions of the H-O theory, it became known as the Leontief Paradox.

18. The post-Leontief studies showed that the US was also abundant in farm-land and highly skilled labor. And the US was indeed a net exporter of products that use these factors intensively, as H-O predicts. • The trade patterns of some other developed countries (Japan, Canada) and of many developing countries (China) are broadly consistent with H-O. • In general, trade patterns fit the H-O theory reasonably well but certainly not perfectly.

19. Who gains and who loses from trade within a country?

20. According to H-O, opening to trade alters domestic production. There is expansion in the export-oriented sector, and there is contraction in the import-competing sector. • The changes in production have one set of effects on incomes in the short run, but another in the long run.

21. In the short-run(whenlabor and capital are immobile / cannot move easily from one industry to another), the specific-factor theory predicts the effects of trade on factor prices and incomes. • In the long run(when labor and capital can move freely among industries), the factor-price equalization theorem and the Stolper-Samuelson theorem predict the effects of trade on factor prices and incomes.

22. Trade and the Distribution on Income in the Short Run • The types of factors that cannot move easily from one industry to another are called specific factors. • In the short run laborers, plots of land, and other inputs are tied to their current lines of production.

23. In-class exercise • See “The Specific-Factor Theorem” handout. • Conclusions: for the short-run, gains and losses divide by output sector: All groups tied to rising sectors gain, and all groups tied to declining sectors lose.

24. Trade and the Distribution on Income in the Long Run

25. Factor-Price Equalization • By redirecting demand away from the scarce resource and toward the abundant resource in each nation, trade leads to facto-price equalization. • In each nation, the cheap resource becomes relatively more expensive, and the expensive resource becomes relatively cheaper, until price equalization occurs.

26. In-class exercise • See “The Factor-Price Equalization Theorem & The Stolper-Samuelson Theorem” handout. • Conclusions: given certain conditions and assumptions, free trade equalizes not only product prices but also the prices of individual factors between the two countries.

27. The Stolper-Samuelson Theorem

28. If countries gain from opening trade, why do free-trade policies have so many opponents year in and year out? • The answer is that trade does typically hurt some groups within any country. • Hence, a full analysis of trade requires that we identify the winners and losers from freer trade.

29. Wolfgang Stolper and Paul Samuelson developed the Stolper-Samuelson theorem in an article published in 1941.

30. The Stolper-Samuelson theorem: • With full employment both before and after trade takes place, the increase in the price of the abundant factor and the fall in the price of the scarce factor because of trade imply that the owners of the abundant factor will find their real incomes rising and the owners of the scarce factor will find their real incomes falling.

31. In-class exercise • See “The Factor-Price Equalization Theorem & The Stolper-Samuelson Theorem” handout. • Conclusion: • Net gains for both countries but different effects on different groups: • Winners: landowners in Farmland and workers in Peopleland. • Losers: workers in Farmland and landowners in Peopleland.

32. It is not surprising that owners of the relatively abundant resources tend to be “free traders” while owners of relatively scarce resources tend to favor trade restrictions.

33. Criticism • We may not see the clear-cut income distribution effects with trade because relative factor prices in the real world do not often appear to be as responsive to trade as the H-O and S-S imply. • In addition, income distribution reflects not only the distribution of income between factors of production but also the ownership of the factors of production. Since individuals or households often own several factors of production, the final impact of trade on personal income distribution is far from clear.

34. The product life-cycle theory

35. The explanations of international trade presented so far are similar in that they presuppose a given and unchanging state of technology. • The product cycle hypothesis attempts to offer a dynamic theory of technology and trade.

36. Technology-based comparative advantage can arise over time as technological change occurs at different rates in different sectors and countries. • Hence, a country can develop a comparative advantage based on its technological improvements or innovations (that mainly come from R&D).

37. In some ways this technology-based explanation is an alternative that competes with the H-O theory. • However, there is also a link to the H-O theory: the suitable location of R&D matches the factor proportions of production using the new technology to the factor endowments (that is, availability of highly skilled labor and venture capital) of the national locations.

38. The product life-cycle theory, proposed by Raymond Vernon in the mid-1960s, suggested that as products mature both the optimal production location and the location of sales will change affecting the flow and direction of trade: • Initially, R&D, production and consumption are likely to be in an advanced developed country. • Later, as demand grows in other developed countries, the innovating country begins to export.

39. Over time, demand for the new product will grow in other advanced countries making it worthwhile for foreign producers to begin producing for their home markets. • The innovating country might also set up production facilities in those advanced countries where demand is growing, limiting the exports from the innovating country.

40. Over time, the product and its production technology become more standardized and familiar (mature). Factor intensity in production tends to shift away from skilled labor and toward less-skilled labor. • The technology diffuses and production locations shift into other countries, eventually into developing countries that are abundant in cheap less-skilled labor.

41. Trade patterns change in the manner consistent with shifting production locations. The location of production of a product shifts from the leading developed countries to developing countries as the product moves from its introduction to maturity and standardization. • The innovating country is initially the exporter of the new product, but it eventually becomes an importer.

42. The product life cycle theory accurately explains what happened with a number of high technology products developed in the US in the 1960s and 1970s. For example, • Pocket calculators were pioneered by Texas Instruments and Hewlett-Packard in the US in the early 1970s. • Soon Sharp and other Japanese firms began to dominate a product whose characteristics had begun to stabilize. • More recently, assembly production shifted into the developing countries.

43. The product life-cycle theory

44. Nonetheless, the usefulness of the product cycle hypothesis is limited due to the difficulties in determining the phases of the cycle: 1. In many industries – especially high-tech – product and production technologies are continually evolving because of ongoing R&D. 2. International diffusion often occurs within multinational (global) corporations. In this case, the cycle can essentially disappear. New technology can be transferred within the corporation for its first production to other countries, including developing countries.

45. Alternative models of trade:New trade theory

46. Standard theories of international trade (developed by Adam Smith, David Ricardo, and Heckscher-Ohlin) focus on production-side differences as the basis for comparative advantage. According to these theories, the sources of production-side differences are differences in technologies, differences in factor productivities, differences in factor endowments, and differences across products in the use of productive factors in producing the products.

47. Hence, according to these theories, the more different the countries are – regarding productivity, technology, or capital-to-labor ratio – the greater the economic gain from specialization and trade. Thus, we may expect that the predominant portion of international trade will occur between countries that are different in these regards. In other words, we may expect that developed countries (capital-abundant, high productivity, advanced technologies) will trade with developing countries (labor-abundant, low-productivity, outdated technology).

48. In-class exercise • Conduct a simple test of the standard theories of international trade. Go to the U.S. Census Bureau webpage http://www.census.gov/foreign-trade/statistics/highlights/index.html ;click on the “Top trading partners” link;click on December of the previous year (because the December data show the annual values for each year).What countries were the top 10 purchasers of U.S. exports? What countries were the top 10 suppliers of U.S. imports? Compare these lists. Does the overall pattern of the U.S. trade partners appear to match well with the predictions of the standard trade theories? Why or why not? Are there any features of the data that appear to violate strongly these predictions?

49. In-class exercise Conclusions: • Industrialized countries (which are similar in many aspects in their technologies, technological capabilities, and factor endowment) trade extensively with each other. • Trade between industrialized countries is nearly half of all world trade. • These facts appear to be inconsistent with comparative-advantage theory.

50. Intra-industry trade • An increasing fraction of world trade consists of intra-industry trade, in which a country both exports and imports the same or very similar products (products in the same product category / industry). • Even very subtle production-side (i.e., technology-based) comparative advantages seem to be unable to explain the phenomenon of intra-industry trade.