ECO 3460: International Economics
Heckscher-Ohlin and other modern trade theories, part 1
© Dr. Michael McCully
Spring 2023
To fully explain world trade patterns, we need to discuss some additional trade theories
besides the Smith-Ricardo model.
The Smith-Ricardo theory was the major trade theory we remember from the 19th century.
It can be a good explanation of some world trade, and it identifies the important idea of
labor productivity as one possible key to success. So it continues to be a useful theory.
But in the early 20th century, a new theory was developed, called the Heckscher-Ohlin
theory (H-O). It improved on the Smith-Ricardo model and became very popular.
In the later decades of the 20th century, still more theories were developed, based on
additional new evidence about how world trade was evolving, and further scientific
theorizing.
Heckscher-Ohlin theory (H-O):
Also called the Heckscher-Ohlin-Samuelson theory (HoS), or the “factor proportions” theory
or the “factor endowment” theory.
(1) Origin: Eli Heckscher and Bertil Ohlin were Swedish economists; Sweden is a country
dependent on international trade and thus has had a lot of good international economists.
Heckscher published the initial version of the theory in 1919 and his student Ohlin refining it
in the 1930s.
(2) Why a new theory?
The Smith-Ricardo theory was based on very simple assumptions -- 2 countries, 2
products, 1 resource (labor). The model can also handle multiple countries and multiple
products -- just find each country’s strongest compar adv product.
In real life, we also have multiple resources, which complicates matters -- labor
productivity is not the only thing that determines prices and trade patterns. Labor was the
primary resource in Smith and Ricardo’s day, but after the 2nd Industrial Revolution (late
1800s), capital equipment was also essential in production. To say that trade was just
based on the amount of labor and its productivity did not make much sense – surely the
amount of machinery also mattered.
Resources are also called factors of production. Types of resources:
Labor (L)
Capital (K)
Land
(Labor is people's physical effort and mental abilities, including entrepreneurship.
Capital is usually defined as machines and buildings – the focus here is on physical capital
rather than financial capital. Land is not just the soil but also other natural resources and
raw materials – trees, minerals, water, etc.)
Heckscher and Ohlin said, let’s come up with a multiple-resource theory. H-O is still a
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supply-side theory, it still focuses on production and why a country can supply something
cheaply (it explains trade how some countries have cheaper resources and thus cheaper
production, helping them win).
It starts with two key ideas about resources. (In building their theory, they had to
think about resources, and how resources might matter.)
(a) Abundance: A particular resource is usually more available in 1 country than
another country.
(b) Intensity: A resource may be more needed for one of the products. Some
producers need a particular factor of production more than other industries, they use it more
“intensively” -- in technical language, if a product is made using a lot of capital (K), it is said
to be a "K-intensive" product. Other products may be labor-intensive, or land-intensive. For
example, textile (cloth) production is K-intensive, while sewing clothes together is Lintensive.
Economics graduate school is math-intensive. This class is more logic-intensive
(mental-exercise-intensive!).
[This theory can also be used to explain inter-regional trade, within a country – a
region may be more abundant in 1 resource than another.]
(3) Basic prediction of H-O theory:
A country will export products which use its abundant resources intensively. ("H-O
theorem"). If you have a lot of a resource, you make and export products that use that
resource, and export them. The country has the comparative advantage in the product that
uses its abundant factors intensively.
On the other hand, the country will import products that use its scarce factors
intensively. (These scarce resources may be more abundant in another country, and so the
other country uses them to make products.)
Why does this theory make sense? Does it pass the logic test? (And eventually we
also have to look at the evidence.)
An abundant resource is probably inexpensive – so products using the resource intensively,
can be produced more cheaply by your country, than by another country where this
resource is scarce. The country with the abundant resource has a price advantage so it has
an export advantage. Real-world example of China: China is labor-abundant, and it exports
many labor-intensive products such as clothing.
Does the import prediction make sense? A resource that is scarce in your country is
likely to be expensive. Instead of making products yourself that need your scarce resource,
you import them from some other country where that resource is plentiful and cheap.
Note: The focus here is on the trading of products, not resources. We are not saying
abundant resources will be exported – rather, we will export products made with abundant
resources. China does not export a significant amount of labor (people emigrating), but it
does export a lot of products made labor-intensively.
[Resources themselves can be exported, for example the U.S. exports some
minerals, excess labor may migrate to other countries, and you may send capital equipment
to your foreign factories. But that is not the main prediction of H-O theory.]
[In this theory, it’s not really efficiency that matters, it’s resource abundance. In real
life, both matter. If we’re more efficient than another country where wages are about the
same, we might have the comparative advantage. But if we are 5 times as efficient as
China, but Chinese labor abundance makes Chinese wages 10 times cheaper, China will
still have the advantage.]
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(4) US-Canada example:
Step 1: Which factors (resources) are abundant in the U.S. and Canada?
Abundance could be defined in several ways -- we could define it in absolute terms,
which country has more labor total?
But H-O theory says, it’s more important to define abundance relative to other
factors. Does a country have more capital than labor? (What is the size of the country's
capital/labor ratio?) Or labor/land, capital/land. How does this compare to other countries?
Ratios can also be called proportions, which is why the theory is sometimes called
the factor-proportions theory. H-O theory says country resource ratios determine trade.
Labor might actually be a little more abundant in Canada, relative to Canadian
capital, though the difference from the U.S. would not be great. Canada probably is more
abundant in forest land (compared to labor or capital). The U.S. is more abundant in capital
equipment.
Step 2: Which factors (resources) are used intensively in each country’s industries –
steel and lumber production? Which industry has the highest K/L ratio? Steel is especially
K-intensive, while lumber is more land-intensive.
Step 3: Put it all together.
U.S.: abundant K
Steel: K-intensive
Can.: abundant land
Lumber: land-intensive
If a country exports products which use its abundant factors intensively, we predict
Canada will export lumber and the U.S. will export steel. These are the comparative
advantages for the 2 countries. (They will import the products using scarce factors
intensively -- U.S. imports lumber, Canada imports steel.)
Even without considering the relative productivities, this theory predicts that we will
still probably see the U.S. exporting steel, and Canada exporting lumber.
With Smith and Ricardo's theory, we had to actually calculate the opportunity costs
before predicting trade patterns. With H-O theory, even if we only have a rough idea about
resource abundance and intensity, we can make some predictions. The H-O theory is very
practical to work with, if you need to make fast decisions, in business or journalism or the
diplomatic corps (or as a spy ).
(5) Scientifically testing H-O theory: Is H-O true? Does the theory make correct predictions
about what a country exports? (Is it accurate in predicting real-world trade patterns?) We
will see it is partly true.
(a) Evidence in favor: What is the real-world evidence? Do countries export products using
their relatively abundant resources, and import products requiring scarce resources?
Often true for LDCs (less-developed countries) [or long-deprived countries!]: export
labor-intensive clothing, land-intensive minerals, land-intensive tropical fruit [latter is also
climate-intensive].
Somewhat true for DCs (developed countries): the U.S. has relatively abundant
capital, especially compared to LDCs, and exports a lot of aircraft and machine tools. But
much of world trade is not easily explained by H-O.
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(b) The Leontief paradox: An early challenge to H-O theory.
An economist named Wassily Leontief, a Russian who came to the U.S. in 1931 and
eventually taught at Harvard, discovered some evidence in the 1950s that seemed to go
against H-O theory. But its defenders came up with a more sophisticated version of the
theory, which helped explain the contradictory evidence. This is how science works: come
up with a theory, test it, and then improve its weaknesses or replace it with other theories.
What was Leontief’s study all about? He made some standard assumptions:
U.S. was K-abundant.
So U.S. should export K-intensive products and import L-intensive (K-scarce)
products.
But he found on average the U.S. exports were less K-intensive than U.S. imports.
Despite abundant K, the U.S. exported products that did not use a high amount of K, and
imported products that were produced with a lot of K. Lots of L-intensive exports.
At the time nobody understood how that could be true, it was a logical puzzle or
"paradox", so it became known as the "Leontief paradox".
[People built their lives on H-O – now some evidence seemed to be attacking it.
Keep in mind the drama! The paradox!!]
(c) Saving the H-O theory by showing it still can explain the evidence:
Economists came up with several possible explanations for this paradox, defenses of
H-O, and then tested the explanations. We will focus on the most persuasive defense.
Basically, it is too simple to talk about "labor" as one factor -- in the real world, there
is an important difference between skilled labor and unskilled labor.
Because the U.S. arguably has more abundant skilled labor than any other resource,
it is not surprising if we primarily export skilled-L-intensive products ("knowledge-intensive").
Examples include movies, software, financial services, machine tools, and aircraft. Some of
these exports don't require much physical K to produce, just computers combined with
skilled labor [for example, you can even make movies with a cell phone, but you need the
knowledge to write and direct and cut the movie well, if you want anyone to watch it].
It’s also logical for us to import K-intensive goods such as cars, to the extent that
they also use unskilled labor in their assembly (which is scarcer in the U.S.).
The improved version of H-O theory looks at these sub-varieties of the factors of
production (we have at least 4 resources – unskilled labor, skilled labor, capital, land).
Skilled labor is also called "human capital." [You could list the 4 resources as
unskilled labor, human capital, physical capital, and land. It's called human capital because
one has to invest time and money to gain a skill, just like investing to get machines. Could
entrepreneurial abilities be considered a type of human capital?]
If you are analyzing a country, it may be helpful to divide skilled labor into more
specific categories – for example, engineering-skilled labor & entrepreneurial-skilled labor.
(6) New challenges to H-O theory: Over time, economists found more serious evidence
against H-O theory. H-O theory remains a good explanation of a significant amount of world
trade. But its predictions just aren’t true in many other cases. So we need additional trade
theories to explain these cases, in addition to the labor productivity explanation of trade.
What are the more-detailed predictions of H-O theory, and what is the evidence for or
against them? There are 4 trade puzzles or mysteries.
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(a) Endowment puzzle: H-O theory predicts most trade will take place between “differentendowment” countries. This is just a re-phrasing of our original prediction, we will see.
Reality (the evidence): Much of world trade is between similar-endowment countries.
“Endowment” means resource mix or inheritance. How much capital does the country
have compared to labor, or compared to land? Some countries have a K-abundant
endowment (L scarce), so they should be able to make K-intensive products cheaply and
export them. Other countries are labor abundant, and the L-scarce countries would import
from them.
So H-O theory predicts you are most likely to trade with a country different from you,
opposite from you in terms of resource mix. Opposites complement each other. If 2
countries have the same K endowment, they may not trade much with each other.
Evidence: The “different-endowment-trade” hypothesis is testable. If it were true, most trade
would be DC-LDC trade. Developed countries are physical and human-capital-abundant,
while developing countries are unskilled-labor-abundant.
But according to a WTO report accessed 1/16/2013
(http://www.wto.org/english/thewto_e/coher_e/mdg_e/development_e.htm), developing
countries in 2009 only accounted for about 37% of world exports, and about half their
exports went to other developing countries. Most trade is among the developed countries
themselves (U.S.-Japan-Europe), in dollar amount and in terms of where DCs get their
imports – despite the fears of some journalists regarding a “flood” of LDC imports. The
"flood" may exist in certain industries, but it doesn't exist in general, at least not yet.
Because many developed countries have similar resource mixes, what the evidence
says is that most trade is between similar-endowment countries. We'll be explaining this a
bit later. (Preview: Culture theory is one explanation.)
(b) Specialization puzzle: H-O theory predicts trade will cause countries to become very
specialized; maybe the industry migrates entirely to the country with the best skills and no
one else can make the product competitively or export it. The H-O theory says imports may
wipe out your old industry completely. In that case, just focus on what the country does best
– your export industries expand in a free-trade world, and hopefully they will absorb all the
laid-off workers. Critics say this transition is rocky and at least some workers will not be able
to make the shift. They are probably right and it can be troubling if industries if industries
are entirely lost, quickly.
Reality: Sometimes multiple countries hold on to an industry and successfully export
the product to each other. Reality may not be as pessimistic as the story in the previous
paragraph. Sometimes industries are wiped out in 1 country while expanding in others, but
other times, each country has the industry but it has refocused and specialized within this
industry, which creates opportunities for trade.
H-O’s prediction of growing specialization is similar to the Smith-Ricardo’s prediction
of the same thing, and makes sense. As each country produces the products they are best
at (strongest comparative advantage), H-O theory leads us to expect the world will get more
specialized. Country A does what it is best at, and imports the other product from country B.
A’s better industry expands, the weaker industry shrinks.
Evidence: This is partly true – for example, developed countries do cut back on the
production of some labor-intensive products (such as apparel) and expand their higher-tech
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production (computer chips), as their economies become more open.
But in real life, for some products there is "intra-industry trade" (IIT), which means
multiple countries produce and trade the same type of product, such as cars. No country
has an exclusive advantage, and the industry for this particular product does not migrate
totally to specific countries (no complete specialization). Some industries survive and thrive
in multiple countries, 1 country does not dominate.
H-O theory can explain some IIT, but not most of it. [Ask students why car production
doesn’t totally end up in 1 country. Most likely theories are demand theories, not supplyside theories like H-O is.]
(c) Cost puzzle: H-O theory predicts the more you produce a product, the more your costs
rise. Reality: In some industries, average costs fall as they produce more.
The H-O cost prediction is simply bringing in an idea from elsewhere in economics.
[Is there any explanation in resource-abundance terms?] Classical economists like Smith
and Ricardo assumed per-unit costs were constant, every extra unit cost the same. But
neoclassical economists, observing factory production, noticed that as you produce more
and more, your “marginal cost” goes up (extra units tend to cost more and more; marginal
means extra).
Why? Perhaps extra workers don’t have enough capital equipment to work with (you
are paying extra wages but that cost is not spread over many units). “Diminishing returns.”
And there are practical issues when you try to produce a lot – having to pay overtime, extra
freight charges to get materials to the business fast, etc. There may also be management
problems (rising overhead costs).
Rising marginal costs pull up the overall average cost of the product, and this forces
you to increase the price you are charging customers.
Example: Say, 1st ton of lumber in Canada costs 1.5.
1st US ton costs 4.
2nd Canadian ton costs 3.
3rd Canadian ton costs 5.
The US lumber industry loses some sales to Canada. But if Canadian costs rise fast
enough and consumer demand is high (at least 3 tons of lumber), the U.S. lumber industry
can still exist in a smaller form. U.S. doesn’t totally specialize in steel, Canada doesn’t
totally specialize in lumber.
It may be impossible for you to get a complete advantage over other countries, rising
costs can prevent complete specialization.
Evidence: Rising costs certainly do exist in many times and places in the real world. It’s a
basic idea in microeconomic theory. But in the long run, certain complex manufacturing and
service industries experience falling per-unit costs. An example is high-definition televisions.
These falling costs in the long run can help you develop, and then keep and strengthen,
your comparative advantage. Other countries cannot easily take away your advantage.
Preview of the explanation: economies of scale and learning curve effects.
(We're probably talking about different industries than in the IIT case. Some
industries are spread out in the world, others gravitate to a few particular countries. But it's
not the simple picture of H-O, and the speed of industry migration or the lack of it, may not
match what H-O predicts – so this point overlaps with the puzzle we will talk about next.)
(d) Advantage-shifting puzzle: H-O theory predicts comparative adv changes over time (the
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adv can shift to other countries), but not very fast, so trade patterns won’t change fast
(maybe not for 20+ years): In other words, H-O makes a prediction about dynamic compar
adv. Reality: Sometimes comparative advantage shifts much faster or much slower than HO would lead us to expect.
The H-O prediction about dynamic comparative advantage is an extension of H-O’s
static trade prediction. H-O said what gets traded at any moment is based on a country’s
resources. But if compar adv is only based on resources, it can only change when resource
endowments change. The exporting country’s labor supply or labor skill must increase a lot
compared to other resources; or its capital must increase; or key natural resources run out;
so that its advantages change or are lost.
Or, there must be a significant endowment change in the partner country, so that
there’s role reversal and the partner country becomes the exporter, such as China and India
putting so much money into education that they end up with a greater percentage of skilled
workers than the U.S., in particular industries.
Because proportions actually tend to change slowly, it takes a long time to educate
people, H-O would predict compar adv changes slowly, and trade patterns are fairly stable.
A 2013 article said by 2020, China planned to have 195m graduates from community
colleges and 4-year universities, a little over 14% of its population. The US will have about
120m graduates, a smaller absolute number but about 37% of its total population. Even if
100% of 18-year-old Chinese students went to college, the percentage of college-educated
in China would rise slowly, because the new graduates’ education level would be averaged
together with everyone else in China. (Stats source: Keith Bradsher, “Next Made-in-China
Boom: College Graduates,” New York Times, 1/17/13,
http://www.nytimes.com/2013/01/17/business/chinas-ambitious-goal-for-boom-in-collegegraduates.html?_r=0 )
H-O would predict that higher-skilled industries would not move from the U.S. to
China until China has a greater percentage of skilled labor than the US.
Evidence: Again, some truth. But there are numerous cases where production sites and
trade shift slower or faster than the resource endowments change.
Some industries don’t move production to other countries even when it might seem
there is cheaper labor in other countries (pharmaceuticals?). We make our pharmaceuticals
ourselves. It’s true that the invention process takes highly-skilled labor, one reason the
industry is here. But the making of the pills is pretty simple, so why is it still done here? [Ask
students.] One reason is quality – something that consumers want, besides cheap prices,
an additional demand factor. Another reason is to protect U.S. intellectual property from
being stolen at overseas production facilities – a supply factor not considered by H-O
theory.
Other products such as apparel may suddenly shift their production to Mexico even
though there’s been no big change in U.S.-Mexican labor amounts, etc. Or the fast shift of
U.S. furniture production to production in China.
An industry might move more quickly to China than country-wide resource
percentages change, for various reasons. It might be because China has more skilled labor
in that industry, or has more advanced technology in the industry that can replace skilled
labor. But it might also be because the Internet allows constant communication, and the
airline industry means global flights are possible – a company has the option of moving
production to a cheaper country and just emailing or flying in skilled labor as necessary.
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So trade economists have debated with each other about the explanations of these trade
puzzles. Some try to further adapt H-O theory and keep it as the primary theory. Others
have come up with additional theories.
Our viewpoint is, no single theory is enough. Businesses trying to understand the world
economy need to be familiar with a variety of theories. Trade patterns are further
complicated in real life by trade barriers and exchange rates (future sections of course).
Modern trade theories and how they help explain the puzzling trade patterns:
These theories are improvements to the simple version of the H-O theory, or alternative
theories (they consider other reasons for competitive success, besides resource abundance
and mix). Know the key idea of each theory, and examples (positive evidence), and
contrary evidence if any.
Culture theory
Culture theory provides a partial explanation of two puzzles – why trade takes place
between countries whose endowments appear similar (on the surface), and why countries
may have stable comparative adv’s even as world endowments change.
Key idea: Countries have business strengths rooted in their culture – their values,
beliefs, worldview, and the behavior that results. Different countries have different cultures,
so they have different comparative advantages. Trade partners may have a similar
percentage of skilled labor, but skilled in different ways – culture-specific labor. The
recommendation is to export products that build on your cultural strengths.
(Another way of saying it: Cultural strength  specific skills  adv in specific
products. The general culture can make people especially good at certain business skills.
So then the country is exceptionally good at making products that intensively need those
skills. They have an advantage in exporting those products. It’s taking the idea of skilled
labor one step further – culture-specific skilled labor.)
Examples and evidence: [Talk to your neighbor 1 st, before class discussion.]
German culture emphasizes attention to detail, which helps give German companies
an advantage in producing engineering-intensive products, such as luxury cars, high-quality
optics and specialty machine tools.
Japanese culture emphasizes social skills and working in teams, as well as
aesthetics (beauty).
Social skills (focus on social harmony and keeping people happy) makes Japanese
companies good in customer research and wanting to improve products to be more
customer-friendly or having more features. Teamwork makes Japanese production good at
"lean manufacturing" of mass-produced cars and electronics. ("Lean manufacturing" =
using few resources, being fast and non-wasteful. Japanese teamwork learned as children,
enables Japanese adults to do mass production faster and better than other cultures.) The
emphasis on aesthetics helps the Japanese to produce high-quality products, both on the
inside and the outside of the product – cars that never break.
U.S. culture emphasizes individualism and creativity (supporting skills such as
inventiveness and customer service). The creative trait gives U.S. companies an advantage
in producing creative products such as software and entertainment. The focus on every
customer as a unique individual gives the US an advantage in any business which requires
good customer service to every individual customer – financial advising, fast food, etc.
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In short, even if it appears each country has about the same abundance of labor, the
labor is slightly different in each case. Culture socializes people in a way that happens to
help them in producing certain products more efficiently and easily. It teaches them life
skills when young, that help them later on to be successful in specific industries.
[They did not initially "design" their culture to be good at certain businesses, it just
happened. But then it is likely that a country will try to reproduce the successful culture in
schools, so it can stay successful in business – for example, encourage American students
to be creative thinkers. Business success becomes a self-reinforcing process.]
Cultural advantages also tend to keep industries rooted in particular countries, or at
least very slow to move, even if labor is cheaper somewhere else. MNCs can open
subsidiaries abroad, but may not be able to transfer the culture. So, sometimes the only
way to satisfy consumers is keep producing in the cultural homeland, and export the results.
Can you trust a Swedish car if it wasn’t made in Sweden? Can you expect good customer
service if you aren't in America?
It’s an idea which complements H-O theory rather than really going against it. Some
countries are abundant in one type of cultural labor, others in other types. Similarendowment countries still have to trade if they want to get the advantages of each other’s
cultures. Instead of “skilled labor,” we have “German skilled labor” – so we would predict
that a country that is abundant in German skilled labor would be the dominant producer of
the type of products which are German-skilled-labor-intensive. If the culture can’t be
transplanted to another country, it is risky to move the production. (Japanese companies
used to be worried about moving their production culture to the U.S., though eventually the
Americans adapted to the new manufacturing style.)
Intra-industry trade (IIT) theories:
Another one of our puzzles is the amount of trade taking place within certain industries.
Countries import a product even if the domestic industry is capable of producing a
competitive product, as shown by its exporting. Multiple countries make and export a
product, rather than specializing. Sometimes the “same” product is made and exported by
multiple countries – they sell to each other.
Why doesn’t the best country (say in cars) produce all the world output, and export
it? Why are there multiple car producers, exporting to each other?
(Pay attention to the spelling here -- "intra" means within, "inter" means between. Intraindustry trade is trade within the same industry, such as cars. Similarly, companies use the
“Internet” but may also have an “intranet” connecting their employees only.)
60% or more of trade between DCs has been estimated to be IIT, and this percentage has
grown over time. There’s also some IIT between DCs and the “newly-industrialized
countries” or "NICs" (East Asia, Latin America), and the “BRICs” (=who?).
It makes trade harder to predict if no country has an exclusive advantage.
Sometimes it is a little bit predictable. But often we can explain the trade only after the fact,
not necessarily predict it.
We have several IIT theories, some supply-side, some demand-side, or a combination.
There’s multiple explanations because there are actually several different types of IIT, and
people debate about which theory is the best explanation. First we have to ask what kind of
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IIT we are talking about.
Identical IIT: Some IIT involves the trading of homogeneous or standardized products, such
as wheat and electricity (US-Canada) or vegetables (US-Mexico).
The explanations for identical IIT are transportation costs, and seasonality of supply.
Countries will trade identical products across borders if transport costs are lower than
trading between distant internal regions. Canada is mostly a border-population country, so
its cities sometimes trade with U.S. cities and vice versa rather than with each other. For
example, Winnipeg, Manitoba is much closer to Chicago than to Toronto; 800 miles vs.
1300 miles. (Similarly, the U.S. electricity grid is not well-connected from East to West – so
we cannot easily send electricity from North Carolina to California, for example, but we do
trade electricity north and south with Canada.)
Transportation between countries tends to be very cheap nowadays, and it is usually
a very small percentage of the total costs of making and selling a product – but sometimes
it is significant enough (relative to selling price) that it does affect whether companies try to
sell domestically vs. try to find international customers.
The seasonality factor refers to temporary surpluses and shortages in a country,
which can cause trade with a neighbor. The U.S. may sell vegetables to Mexico in the
summer but import vegetables in the winter. U.S. vegetable demand is constant, but
domestic supply isn't – so surpluses are exported and shortages are filled by imports. (For
the year as a whole, IIT has happened – trade both directions.)
Differentiated IIT: Most IIT involves the trading of “differentiated” products, companies
making different versions (such as furniture or cars). Here there are at least three major
explanations, H-O theory, consumer taste theory, and Linder's thesis (marketing).
(1) H-O theory:
An updated version of H-O theory can explain differentiated IIT, if the industry has internal
differences in the resource mix (factor intensity) that is needed. Some countries will
specialize in 1 area, other countries in another area, and there will be trade of differentintensity items. Two main types of examples:
(a) Some industries have different-intensity final products (versions): In a broadly defined
industry such as furniture, wood furniture is more land- and labor-intensive to produce, steel
furniture is capital-intensive. So it’s not surprising if some countries specialize in one variety
and others in another variety. "Furniture" is both imported and exported. Statistical illusion.
(b) Some industries make relatively-standardized products but have different-intensity
stages of production: Dress shirts are all very similar. But producing the textiles (fibers and
cloth) may be capital-intensive and take place in the US – companies need to use
machines to coat the cloth so it is wrinkle-resistant, stain-resistant. But sewing the shirt
together uses unskilled labor, so that might take place in an LDC such as El Salvador. The
textiles are produced here, exported to El Salvador, then the shirt is re-imported. We have
both exports and imports in the "textiles and apparel industry." (Producing in Latin America
also keeps the transportation time shorter than producing in China – important for fashionsensitive items.)
People often assume that most trade is finished products, ready to use. But a lot of
trade is actually intermediate goods – goods in process. This trade may take place inside
MNCs – one subsidiary makes a part, sends it to another subsidiary, as part of the MNC’s
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global supply chain.
(2) Consumer taste theory/income elasticity theory:
But what about cars? Most are similarly capital-intensive – so H-O has a hard time
explaining why multiple countries make cars, not just 1 country.
Consumer taste theory helps explains some other examples of IIT. It’s a demandside theory. (H-O has a supply-side emphasis. Supply-side theory says consumers only
care about price and so a company can only get an adv by making things cheaply.
Demand-side theory says consumers have other concerns, too, and you get an adv if you
can satisfy these concerns – if you can make a product “attractive” not just cheap.)
Consumer tastes differ, for instance they may have very visible differences in their needs.
Some need small cars, others need large cars, creating segmented markets. We are talking
here about a non-price factor – consumers who don't just want the cheapest car.
Consumers may actually be willing to pay more than the average price for a product,
if they can get a specific version or style.
Countries might respond to this taste difference by specializing and trading – some
countries might specialize in making small cars while others specialize in large ones.
U.S. auto producers recognized American desires for large cars and trucks faster
than the Japanese did, because of U.S. producers had the right cultural background and
geographic experience to do so (long driving distances). Japan's limited land area meant
the evolution of small-car production was a very natural event. In each country, some
consumers were neglected, and were satisfied by the other country. IIT happens.
Consumers also have more subtle tastes and preferences, such as a taste for variety
(different styles). People like to have products which are different from their neighbors’
version. So they may have a taste for foreign products simply because they are foreign, a
different image or style, and are less likely to buy them if not made in that foreign country. If
some people in both countries have foreign tastes, IIT will occur. [“Boxy” Honda Element?]
In sum, this theory says (a) tastes differ within a country, (b) the country may
specialize in satisfying the majority’s tastes, so (c) products to satisfy minority tastes have to
be imported.
Income elasticity: Elasticity refers to how big the consumer response is to an economic
change. Income elasticity specifically asks, how much more do consumers buy, if their
income goes up? Big response = elastic, small response = inelastic.
Consumer tastes, together with the idea of income elasticity, help explain why IIT
has been a growing % of total trade. During the past few decades, most consumers in
developed countries and East Asian countries and the BRICs have experienced growing
incomes. They have had to decide what to spend the income on.
If basic needs have been met, most of this extra income gets spent on “luxuries.”
Luxuries have an "income-elastic" demand (demand for such products grows at a faster %
than people’s income does, because income is being shifted towards these products).
This helps explain IIT because many internationally-traded IIT products are
“luxuries.” People want models that are more sophisticated, higher quality, or bigger.
And variety itself is a kind of luxury, especially when we are talking about expensive
manufactured products. Poor people are just happy to have a car, any car. Wealthier
people want specific types of cars, and are willing to buy them from other countries.
So, higher-income people and countries import more high-end items than lowerincome ones. Cars, cell phones, other electronics, Italian leather, Milan fashion, appliances.
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(Lower-income people do have a taste for variety – but the lack of money means
they are likely to express this taste using relatively-inexpensive items – clothing, music, etc.
Perhaps ironically, higher-income people then have to adopt the new clothing or music
styles or be seen as “uncool.”)
(3) Linder’s thesis:
This helps explain some IIT between nearby or similar countries.
Linder's thesis is the hypothesis of the Swedish economist Staffan Burenstam
Linder. He predicted (a) producers will first try to make products with high domestic
demand, in deciding what to make and what varieties. (b) Then they will try to get a bigger
market by exporting. And in deciding where to export, they will export products first to
countries with similar tastes. Why? Because this helps minimize product marketing and
redesign costs, during your early global expansion as a company. And neighbors will export
to you, 1st.
The similar-taste countries might be your neighbors, and/or similar-endowment
countries.
Linder's thesis is a mixture of demand- and supply-side factors.
Companies usually start out with a local focus. They produce and improve products
which have a potentially high local demand. An example is car companies in Britain.
Britain's strict social-class barriers meant the wealthy class wanted unique products, and
high income inequality meant the wealthy could afford practically anything. So Rolls-Royce
focused on unique luxurious cars.
But eventually local demand is not enough, due to saturation or new competitors
(Jaguar, etc.). So companies start to look at markets in other countries. Business people
want to export to markets where the demand will be high. Where should they export first?
Often they export to very similar countries (hope for similar demand) – this is one reason
why U.S.-Canada trade is higher than U.S.-Mexico trade, despite Canada's smaller
consumer population. In 2013, US exports to Canada + imports from Canada = $632.3b,
while US exports and imports with Mexico = $506.7b ( https://ustr.gov/countriesregions/americas/canada, https://ustr.gov/countries-regions/americas/mexico )
Countries can be similar culturally, and more concretely, can be similar in terms of
per capita income and the income distribution pattern. Similar cultures and average income
levels tend to create similar demand patterns for manufactured goods. Going first to similar
countries helps minimize marketing research costs, marketing campaign costs, and product
redesign costs (the cost of adapting the product to other cultures, such as the need to
change the size of the car or move the steering wheel in a car). The US and Canada both
like big cars, and both drive on the right-hand side of the road.
In short, marketing costs matter – the opportunity to minimize those costs affects
your trade patterns.
The similar country can also provide you with high-volume sales, leading to greater
economies of scale and even more sales in the future. Virtuous circle. And you hopefully
will get the cash flow necessary to pay the redesign costs of entering less-similar markets.
(Such as moving the steering wheel, for cars aimed at the Japanese market, and reducing
the average size of the cars you sell there.)
Supply-side roots: What causes similar income levels? Countries with similar factor
endowments (similar amounts of labor relative to capital) are more likely to have similar
income levels and income distribution. So again it is sort of a supplement to H-O theory
rather than a total alternative.
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Linder’s thesis does make a good contribution to our understanding of trade (for ex.,
why we trade more with Canada than Mexico). There is a lot of truth to this theory. But like
any theory, it has weaknesses. It is not always a perfect guide to where you should export
first, or how real-world trade develops.
(a) Sometimes dissimilar countries can be your best first markets (give you higher
sales), despite the redesign and marketing costs, if they have large populations and if the
local competitors are weak.
This is especially true if they are in your cultural sphere of influence and thus eager
to buy your country’s version of a product. Many British colonies had root cultures very
different from Britain, but were taught to emulate British culture. So local people bought
British-style products because it made them feel "closer" to Britain. Similarly, some analysts
worry that America practices a "cultural imperialism," using American entertainment to
spread American culture – with the aim of “brainwashing” people into buying American
products even if local versions or other foreign products are better. Latin America?
(b) And, “similar” countries are unlikely to be culturally identical to your country –
even if you decide to go to this country first, study the unique cultural preferences and be
aware of them. Don’t just assume, “our current advertising is OK.” If you overlook
uniqueness, your sales could turn out to be disappointing, and then you would have to
spend a lot of money to re-design your ads or product and re-promote it. Examples: Have to
make Canadian labels bilingual (English and French). Argentinians tend to think of
themselves as having stylish "European" tastes, while Brazil is more down-to-earth with
more of an American-style mass market – your advertising campaign might have to be
completely different in these neighboring countries.
Linder's thesis also has a weakness on the production side. The theory implies that if
you are selling in your home market, your strongest import competitors will come from
similar countries. (Using our example, the theory works both directions – Canadian
companies probably expand first into US sales, creating competition for U.S. companies.)
(c) But in reality, companies from dissimilar countries may be your strongest
competitors, if they see opportunities in your home market. Basically, their abundant, cheap
resource advantages can give them high sales and high profits even if they have to spend a
little extra money on market research and advertising, due to their lack of cultural familiarity
with your market. Hong Kong is a major producer of artificial Christmas trees due to its
cheap labor, despite the lack of local demand; not much local celebration of Christmas.
Sometimes being able to produce things cheaply triumphs over every other source of
comparative advantage. [It trumps everything else.]