Semester III
306 – International Business Economics
UNIT1
International Trade: Trade Theories ,
Ricardo and Comparative advantage,
Heckscher Ohlin model of factor
abundance , Krugman’s model of IntraIndustry Trade
Introduction: INTERNATIONAL TRADE
We live in a global marketplace.
The food on your table might include fresh fruit
from Chile, cheese from France, and bottled
water from Scotland.
Your wireless phone might have been made in
Taiwan or Korea.
The clothes you wear might be designed in Italy
and manufactured in China.
The American statesman Benjamin Franklin
(1706–1790) once wrote: “No nation was
ever ruined by trade.”
Many economists would express their
attitudes toward international trade in an
even more positive manner.
The evidence that international trade confers
overall benefits on economies is pretty
strong.
There are very few models of trade that
include all five reasons for trade
simultaneously. The purpose of each model
is to establish a basis for trade and then to
use that model to identify the expected
effects of trade on prices, profits, incomes,
and individual welfare.
In the real world, trade takes place because of a
combination of all these different reasons. Each
single model provides only a glimpse of some of the
effects that might arise.
Consequently, we should expect that a combination of
the different outcomes that are presented in
different models is the true characterization of the
real world.
Unfortunately, because of this, understanding the
complexities of the real world is still more of an art
than a science.
Reason for Trade #1: Differences in Technology
Advantageous trade can occur between countries
if the countries differ in their technological abilities
to produce goods and services.
Technology refers to the techniques used to turn
resources (labor, capital, land) into outputs (goods
and services).
The basis for trade in the Ricardian model of
comparative advantage in "The Ricardian Theory
of Comparative Advantage" is differences in
technology.
Reason for Trade #2: Differences in Resource Endowments
Advantageous trade can occur between countries if the
countries differ in their endowments of resources.
Resource endowments refer to the skills and abilities of a
country’s workforce, the natural resources available
within its borders (minerals, farmland, etc.), and the
sophistication of its capital stock (machinery,
infrastructure, communications systems).
The basis for trade in both the pure exchange model
in
"The Pure Exchange Model of Trade" and the
Heckscher-Ohlin model in "The Heckscher-Ohlin (Factor
Proportions)
Model"
is
differences
in
resource
endowments.
Reason for Trade #3: Differences in Demand
Advantageous trade can occur between countries if
demands or preferences differ between countries.
Individuals in different countries may have different
preferences or demands for various products.
For example, the Chinese are likely to demand more rice
than Americans and the Japanese more fish than
Americans would, even if they all faced the same prices.
There is no formal trade model with demand differences,
although
the
monopolistic
competition
model
in "Economies of Scale and International Trade" does
include a demand for variety that can be based on
differences in tastes between consumers.
Reason for Trade #4: Existence of Economies of Scale in
Production
The existence of economies of scale in production is
sufficient to generate advantageous trade
between two countries.
Economies of scale refer to a production process in
which production costs fall as the scale of
production rises. This feature of production is also
known as “increasing returns to scale.”
Reason for Trade #5: Existence of Government
Policies
Government tax and subsidy programs alter the prices
charged for goods and services. These changes can be
sufficient to generate advantages in production of
certain products.
In these circumstances, advantageous trade may arise
solely due to differences in government policies across
countries. "Domestic Policies and International
Trade", "Production Subsidies as a Reason for
Trade" and "Consumption Taxes as a Reason for
Trade" provide several examples in which domestic tax
or subsidy policies can induce international trade.
RICARDO AND
COMPARATIVE
ADVANTAGE
Ricardo used the theory of comparative advantage to
argue against Great Britain’s protectionist Corn Laws,
which restricted the import of wheat from 1815 to 1846.
In arguing for free trade, the political economist stated that
countries were better off specializing in what they enjoy a
comparative advantage in and importing the good in
which they lack a comparative advantage.
He introduced this theory for the first time in his book “On
the Principles of Political Economy and Taxation”, 1817,
using a simple numerical example concerning the trade
between Portugal and the England
What is an Opportunity Cost?
To
understand the theory behind a comparative
advantage, it is crucial to understand the idea of an
opportunity cost. An opportunity cost is the foregone
benefits from choosing one alternative over others.
For example, a laborer can use one hour of work to
produce either 1 cloth or 3 wines. We can think of
opportunity cost as follows: What is the forgone benefit
from choosing to produce one cloth or one wine?
Therefore:
By producing one cloth, the opportunity cost is 3 wines.
By producing one wine, the opportunity cost is ⅓ cloth.
Ricardian Model Assumptions



The modern version of the Ricardian Model assumes
that there are two countries, producing two goods,
using one factor of production, usually labor.
The model is a general equilibrium model in which all
markets (i.e., goods and factors) are perfectly
competitive.
The goods produced are assumed to be
homogeneous across countries and firms within an
industry.
Ricardian Model Assumptions


Goods can be costlessly shipped between
countries (i.e., there are no transportation
costs).
Labor is homogeneous within a country but
may have different productivities across
countries. This implies that the production
technology is assumed to differ across
countries.
Ricardian Model Assumptions



Labor is costlessly mobile across industries
within a country but is immobile across
countries.
Full employment of labor is also assumed.
Consumers (the laborers) are assumed to
maximize utility subject to an income
constraint.
Practical Example: Comparative Advantage
Consider two countries (France and the United
States) that use labor as an input to produce two
goods: wine and cloth.
In France, one hour of a worker’s labor can produce
either 5 cloths or 10 wines.
In the US, one hour of a worker’s labor can produce
either 20 cloths or 20 wines.
It is important to note that the United States enjoys an
absolute advantage in the production of cloth and
wine. With one labor hour, a worker can produce
either 20 cloths or 20 wines in the United States
compared to France’s 5 cloths or 10 wines.
The United States enjoys an absolute advantage in the
production of cloth and wine.
To determine the comparative advantages of France
and the United States, we must first determine the
opportunity cost for each output:
France:
Opportunity cost of 1 cloth = 2 wine
Opportunity cost of 1 wine = ½ cloth
The United States:
Opportunity cost of 1 cloth = 1 wine
Opportunity cost of 1 wine = 1 cloth
Comparative Advantage and its Benefits in Free Trade
How does identifying each country’s comparative advantage aid in
understanding its benefits in free trade?
First, let’s assume that the maximum amount of labor hours
is 100 hours.
In France:
If all labor hours went into wine, 1,000 barrels of wine could be
produced.
If all labor hours went into cloth, 500 pieces of cloth could be
produced.
In the United States:
If all labor hours went into wine, 2,000 barrels of wine could be
produced.
If all labor hours went into cloth, 2,000 pieces of cloth could be
produced.
Following Ricardo’s theory of comparative advantage in
free trade, if each country specializes in what they enjoy
a comparative advantage in and imports the other
good, they will be better off.
Recall that:
France enjoys a comparative advantage in wine.
The United States enjoys a comparative advantage in
cloth.
In France, the country specializes in wine and produces 1,000
barrels. Recall that the opportunity cost of 1 barrel of wine in
the United States is 1 piece of cloth. Therefore, the United
States would be open to accepting a trade of 1 wine for up to
1 piece of cloth.
The potential gains from trade
for Europe by specializing in
wine is represented by the
arrow:
In France, the country
specializes in wine and
produces 1,000 barrels.
Recall that the opportunity
cost of 1 barrel of wine in
the United States is 1 piece
of cloth. Therefore, the
United States would be
open to accepting a trade
of 1 wine for up to 1 piece
of cloth.
The potential gains from trade
for the United States by
specializing in cloth is
represented by the arrow:
In the United States, the
country specializes in cloth
and
produces
2,000
pieces.
Recall
that
the
opportunity cost of 1
piece of cloth in France is
2
barrels
of
wine.
Therefore, France would
be open to accepting a
trade of 1 cloth for up to 2
barrels of wine.
Therefore, using the theory of comparative
advantage, a country that specializes in their
comparative advantage in free trade is able
to realize higher output gains by exporting
the good in which they enjoy a comparative
advantage and importing the good in which
they suffer a comparative disadvantage.
CRITICISMS OF COMPARATIVE ADVANTAGE
○
○
Cost of trade. To export goods to India imposes
transport costs.
External costs of trade. Exporting goods leads to
increased pollution from ‘air-freight’ and can
contribute to environmental costs not included in
models which only include private costs and
benefits.
CRITICISMS OF COMPARATIVE ADVANTAGE
○
Diminishing returns/diseconomies of scale. Specialisation means
a country will increase the output of one particular good.
However, for some industries increasing output may lead to
diminishing returns. For example, if Portugal has a comparative
advantage in wine, it may run out of suitable land for growing
grapes.
A contemporary example is Mongolia. Mongolia was believed to
have a comparative advantage in cattle farming. However,
according to Erik Reinert opening of markets to international
competition in 1991 led to an increased size of animal herds, but this
led to over-grazing and loss of grazing land. [Reinert, E
(2004) “Globalization and economic development: an Alternative
Perspective”, Edward Elgar pub. p 158.]
CRITICISMS OF COMPARATIVE ADVANTAGE
○
○
Static comparative advantage. A developing economy, in subSaharan-Africa, may have a comparative advantage in
producing primary products (metals, agriculture), but these
products have a low-income elasticity of demand, and it can
hold back an economy from diversifying into more profitable
industries, such as manufacturing.
Dutch disease. Dutch disease is a phenomenon where countries
specialise in producing primary products (oil/natural gas) but
doing this can harm the long-term performance of the
economy. In the 1970s, the Netherlands specialised in
producing natural gas, but this led to the neglect of
manufacturing and when the gas industry declined, the
economy was left behind its near neighbours.
CRITICISMS OF COMPARATIVE ADVANTAGE
○
Gravity theory. Proposed by Jan Tinbergen, in 1962, this states
that international trade is influenced by two factors – the
relative size of economies and economic distance. The
model suggests that countries of similar size will be attracted
to trade with each other.
Economic distance depends on geographical distance
and trade barriers. The implication is that countries
economically close and of similar size will engage in similar
levels of bilateral trade. It also suggests trade is more likely
between countries which are geographically close.
CRITICISMS OF COMPARATIVE ADVANTAGE
○
○
Trade – not a Pareto improvement. Trade can lead to an
increase in net economic welfare. However, it doesn’t
mean that everyone will become better off. Some
workers in uncompetitive industries may lose out and
struggle to gain employment in new industries.
Complexity of global trade. Models of comparative
advantage usually focus on two countries and two
goods, but in the real world, there are multiple goods and
countries. Increasingly there is growing demand for a
variety of goods and choice – rather than competing on
simple price.
The Heckscher-Ohlin Model
Introduction
Eli Heckscher (1919) and Bertil Ohlin (1933) found the
basis for crucial and substantial theoretical
developments
of
international
trade
by
emphasizing the relationships between the
composition of countries’ factor endowments and
commodity trade patterns.
The Heckscher-Ohlin (H-O) theory is the simplest
explanation for why countries involve in trade of
goods and services with other countries.
Introduction
Heckscher-Ohlin model, which is the general
equilibrium mathematical model of international
trade theory, is built on the Ricardian theory of
comparative advantage by making prediction on
trade patterns and production of goods based on
the factor endowments of nations
Assumptions of the Heckscher- Ohlin Model
○
○
○
The following assumptions pertain to the 2*2
model of Heckscher-Ohlin.
It is assumed that there are only two nations (1
and 2) with two goods for trade (X and Y) and
two factors of production (capital and labour).
For producing the goods, both nations use the
same technology and they use uniform factors of
production.
Assumptions of the Heckscher- Ohlin Model
○
○
○
In both countries, good X is labour intensive and Y
is capital intensive.
The tastes and preferences of both nations are
the same (both countries can be represented in
the same indifference curve).
In both nations, the assumption of constant returns
to scale is applicable for the production of goods
X and Y.
Assumptions of the Heckscher- Ohlin Model
○
○
○
In both nations, specialization in production is not
complete.
Goods and factor markets in both nations are
perfectly competitive.
There exists perfect mobility of factors of
production
within
each
country
though
international mobility is not possible.
Assumptions of the Heckscher- Ohlin Model
○
○
○
There are no restrictions or limitations to the free flow
of international trade. That is, there exist no
transportation costs, tariffs, or like other obstructions
either to control or to restrict the exports or imports.
It is assumed that there exists full employment of all
resources in both nations. That is, there will not be
any under employed resource in either nation.
The exports and imports between the nations are
balanced. It means that the total value of the
exports will be equal to the total value of imports in
both nations.
The physical definition of factor abundance is
based on the relative physical amounts of the
factors present in the country, e.g., the
difference in the capital/labor ratios.
The
country whose K/L ratio is the largest is defined
to be the capital-abundant country. The price
definition is based on relative prices of the
factors rather than on measurements of their
presence in the country.
It is hypothesized that the relatively-abundant
factor in a country should be relatively cheaper
compared to a second country.
Thus,
according to this definition, if the ratio of the
price of capital to the price of labor is lower in
one country (A) compared to a second country
(B), country A is said to be the capitalabundant country.
Heckscher-Ohlin theory of foreign trade can be
stated in the form of two theorems namely:
1) Heckscher-Ohlin Trade Theorem: The HeckscherOhlin Trade Theorem establishes that a country
tends to specialize in the export of a commodity
whose production requires intensive use of its
abundant resources and imports a commodity
whose production requires intensive use of its
scarce resources.
Heckscher-Ohlin theory of foreign trade can be stated in the
form of two theorems namely:
2) The Factor-Price Equalization Theorem: The Factor-
Price Equalization Theorem states that international
trade tends to equalize the factor prices between the
trading nations
In the absence of foreign trade, it is quite likely that
factor prices are different in different countries.
International trade equalizes the absolute and relative
returns to homogenous factors of production and their
prices. In other words, the wages of homogeneous
labour and returns to homogeneous capital will be the
same in all those nations which engage in trading.
○
○
The factor price equalization theorem says that if the
prices of the output of goods are equalized
between countries engaged in free trade, then the
price of the input factors will also be equalized
between countries.
This implies that the wages and rents will converge
across the countries with free trade, or in other
words, trade in goods is a perfect substitute for trade
in factors, or in other words, trade in goods is a
perfect substitute for trade in factors, The HeckscherOhlin theorem, thus, postulates that foreign trade
eliminates the factor price differentials
○
○
The factor price equalization theorem is in fact
a corollary to the Heckscher-Ohlin trade theory.
It holds only so long as Heckcher-Ohlin Theorem
holds.
When the prices of the output of goods are
equalized between countries as they move to
free trade, then the prices of the factors (capital
and labour) will also be equalized between
countries.
○
○
It means that product mobility and factor
mobility become perfect substitutes.
Whichever factor receives the lowest price
before two countries integrate economically
and effectively become one market will
therefore tend to become more expensive
relative to other factors in the economy, while
those with the highest price will tend to
become cheaper
Limitations of Heckscher Ohlin's H-O Theory
Heckscher Ohlin's Theory has been criticised on
basis of following grounds :1.
Unrealistic Assumptions : Besides the usual
assumptions of two countries, two commodities,
no transport cost, etc. Ohlin's theory also
assumes no qualitative difference in factors of
production, identical production function,
constant return to scale, etc. All
these
assumptions makes the theory unrealistic one.
Limitations of Heckscher Ohlin's H-O Theory
2. Restrictive : Ohlin's theory is not free from
constrains. His theory includes only two
commodities, two countries and two factors. Thus
it is a restrictive one.
3. One-Sided Theory : According to Ohlin's theory,
supply plays a significant role than demand in
determining factor prices. But if demand forces
are more significant, a capital abundant country
will export labour intensive good as the price of
capital will be high due to high demand for
capital.
Limitations of Heckscher Ohlin's H-O Theory
4. Static in Nature : Like Ricardian Theory the H-O
Model is also static in nature. The theory is based
on a given state of economy and with a given
production function and does not accept any
change.
5. Wijnholds's Criticism : According to Wijnholds, it
is not the factor prices that determine the costs
and commodity prices but it is commodity
prices that determine the factor prices.
Limitations of Heckscher Ohlin's H-O Theory
6. Consumers' Demand ignored : Ohlin forgot an
important fact that commodity prices are
also influenced by the consumers' demand.
7. Haberler's Criticism : According to Haberler,
Ohlin's theory is based on partial equilibrium. It
fails to give a complete, comprehensive and
general equilibrium analysis.
Limitations of Heckscher Ohlin's H-O Theory
8. Leontief Paradox : American economist Dr.
Wassily Leontief tested H-O theory under U.S.A
conditions. He found out that U.S.A exports
labour intensive goods and imports capital
intensive goods, but U.S.A being a capital
abundant country must export capital intensive
goods and import labour intensive goods than
to produce them at home. This situation is called
Leontief Paradox which negates H-O Theory.
Limitations of Heckscher Ohlin's H-O Theory
9. Other Factors Neglected : Factor endowment is
not the sole factor influencing
commodity price and international trade. The H-O
Theory neglects other factors like
technology, technique of production, natural
factors, different qualities of labour, etc.,
which can also influence the international trade.
KRUGMAN’S MODEL OF INTRA-INDUSTRY
TRADE
Krugman (1979, 1980)
Monopolistic competition is a particular
market structure where many key
(theoretical) contributions were made in
the 1970s.
Probably the most famous reference is
Dixit and Stiglitz (1977) who developed the
CES (constant elasticity of substitution)
case.
Paul Krugman saw the potential of these
developments for the international trade literature.
 He combined it with increasing returns to scale
(scale economies).
 This leads to intra-industry trade (as opposed to
inter-industry trade based on neoclassical models
of comparative advantage such as Ricardo and
HeckscherOhlin).
 His breakthrough contributions along those lines
(including applications to economic geography)
eventually won Krugman the Nobel prize in 2008
(as a rare solo recipient).
Key ingredients for the new trade model
(Krugman 1979, Nobel prize in 2008)
1) Goods are differentiated, i.e. not strictly identical.
2) We
allow
for
imperfect
competition:
“Monopolistic competition” firms can influence the
price they charge, but no strategic interaction.
3) Firms enjoy increasing returns to scale, by which
we mean that the average costs for a firm fall as
more output is produced.
What are the main features of .monopolistic competition.?
Monopolistic competition is a model of an imperfectly competitive
industry. It is a special case of oligopoly. It assumes that:
 Each firm can differentiate its product from the product of
competitors (no homogeneous goods). These differentiated
products (or .varieties.) are good but not perfect substitutes. They
may differ slightly in terms of branding, quality or location.
Example: different varieties of toothpaste on supermarket shelves.
Thus, there is .competition. but not perfect competition.
 Each firm ignores the impact of changing its own price on the
prices set by its competitors (no strategic interaction): even though
each firm faces competition, it behaves as if it were a monopolist
and sets the profit-maximising price for its product. But in the long
run, the entry of new firms (i.e., new varieties) drives profits down to
zero.
Monopoly profits rarely go uncontested because they
attract market entry of
Other firms.
A firm in a monopolistically competitive industry is expected:
 to sell more the larger the total sales of the industry and
the higher the prices charged by its rivals,
 to sell less the larger the number of firms in the industry
and the higher its own price.
○
Define international trade and describe how it differs from internal trade? 2. Critically
examine the arguments for and against international trade? 3. Do you think international
trade is always beneficial ?Substantiate your arguments? 4. What are the major
arguments against liberal trade? 5. Do you think the developing countries will be
disproportionately disadvantaged if they engage in liberal trade? 6. What consequences
do you foresee for the industrial sector if a nation has greater openness of trade? 7. Using
Ricardian model, explain how two countries can gain from trade? What does the
Ricardian model suggest regarding the effect of trade? 8. What are the underlying
reasons that explain the differences among nations? Explain the predictions from different
theories in international trade. 9. Describe the reasons why international trade is opposed
by many people? 10. “Specialization in production always increases the prosperity of a
country” Do you agree with the statement? Substantiate your answer. 11. Explain the
Heckscher-Ohlin theory of international trade. 12. Compare the classical and modem
theories of international trade.