Chapter 3. Sources of
Comparative Advantage
Advantage
Factor Endowments as a Source of
Comparative Advantage (1)
(1)
Ricardian theory takes for granted that relative labor
productivity, labor costs and product prices
differed in 2 countries before trade.
But Ricardo’s assumption of labor as the only factor of
production ruled out an explanation of how trade
affects the distribution of income among factors of
production within a nation,
& why some favor trade, and some oppose it.
Factor Endowments as a Source of
Comparative Advantage (2 )
Heckscher & Ohlin formulated a theory to answer
these questions – The factor-endowment theory:
The immediate basis for trade is the difference
between pre-trade relative product prices of trading
nations.
Prices depend on the production possibilities
curves and tastes and preferences (demand
conditions) in the trading countries
Assumption: technology and demand are
approximately the same between countries
Production possibilities curves depend on
technology and resource endowments
Factor Endowments as a Source of
Comparative Advantage (3)
Factor-endowment theory
◦ Capital/Labor Ratio
Determines comparative advantage
◦ A country exports a good that uses a large
amount of its relatively abundant resource
◦ A country imports a good which (in
production) uses its relatively scarce
resource
Factor Endowments as a Source of
Comparative Advantage (4)
Effect of resource endowments on
comparative advantage
Factor Endowments as a Source of
Comparative Advantage: example
Chinese Manufacturers Beset by Rising
Wages and a Rising Yuan (or Renmimbi)
Developing labor shortage and rising wages
because of:
◦ China’s one-child policy: fewer young adults
◦ Land policies discourage migration from country,
since must tend family plots or lose them
◦ Cannot enroll children in city schools or gain other
government services until they have been officially
declared urban dwellers; takes years
Table 3.23.2-Total Capital Stock per
Worker of Selected Countries…
Factor Price Equalization (1 of 3)
•
Factor-Price Equalization
• Redirects demand away from the scarce
resource towards the abundant resource in
each nation
• Trade leads to factor-price equalization
• The cheap resource becomes relatively more
expensive
• The expensive resource becomes relatively
less expensive
• Eventually, price equalization occurs
Figure 3.23.2- The Factor
Factor-Price Equalization Theory
Factor Price Equalization (2 of 3)
The effect of trade is to equalize the
price of capital in the two nations
American demand for Chinese textiles
leads to increased demand for labor in
China; wages increase; more imports
Reverse happens in U.S. til equalization
But in real world, no full factor-price
equalization
Table 3.43.4- Indexes of Hourly
Compensation for Mfg. Workers..
Factor Price Equalization (3 of 3)
In real world – no full factor-price
equalization (cont.)
◦ Uneven ownership of human capital
Education, training, skill, and the like
◦ Not all countries use the same technology
New and better technology replaces older
technologies – faster in developed countries
◦ Transportation costs and trade barriers
Reduce the volume of trade
Is International Trade
a Substitute for Migration?
Immigrants contribute to the economy:
◦ Increase the size of the labor force
◦ Fill low-skilled jobs which few native-born citizens are
willing and available to do
◦ Bring jobs that contribute to technological innovation
But critics say:
◦
◦
◦
◦
They take jobs away from the guest country’s citizens
Suppress domestic wages
Consume sizable amounts of public services
Need legal restrictions to lessen flow
Is International Trade
a Substitute for Migration?
Can trade reduce immigration?
Factor-endowment model:
• International movements in resources are not
essential
• International trade in products can achieve the
same result
• Complement labor migration, short and nearlong terms
• Expanding trade – some unemployed workers
• Forced to seek employment abroad
Is the FactorFactor-Endowment Theory a
Good Predictor of Trade Patterns?
Wassily Leontief: 1st attempt to research
the factor-endowment theory empirically
◦ Given: U.S. has relatively abundant capital,
relatively labor scarce
◦ According to theory, U.S. will:
Export capital-intensive goods
Import-competing goods will be labor intensive
Leontief tested capital / labor ratios for 200 export
industries & import-competing industries in U.S. in
1947
Is the FactorFactor-Endowment Theory a
Good Predictor of Trade Patterns?
Leontief’s findings:
◦ Capital / labor ratio for U.S. exports lower
than that of it’s import-competing industries
◦ Concluded that exports were less capitalintensive than import-competing goods
◦ Findings contradicted the predictions of the
factor-endowment theory:
Leontief paradox
Further studies mixed.
Economies of Scale
and Comparative Advantage (1)
Economies of Scale (increasing returns
to scale) exist when –
◦ Expansions of the scale of production cause
total production costs to increase less
proportionately than output.
◦ Long-run average costs of production
decrease
Economies of scale classified as –
◦ Internal
◦ External
Economies of Scale
and Comparative Advantage (2)
Internal Economies of Scale
◦ At the firm-level as output increases
(triggered by increase in demand from
exports), the average cost decreases
◦ Provide additional cost incentives for
specialization in production
◦ Home market effect:
Industries locate near largest market, to exclusion
of small market areas, which may become
unindustrialized
Figure 3.5 - Economies of Scale as a
Basis for Trade
Economies of Scale
and Comparative Advantage (3)
External Economies of Scale
The average cost of the typical firm decreases as
the output of the whole industry in this area
increases
Concentration of an industry’s firms in a particular
geographic attracts larger pools of a specialized
type of worker; New knowledge about production
technology spreads among firms in the area
Expanding industry as a source of growth, tax
revenues; R&D at universities benefit businesses
Clusters of component suppliers close to center of
manufacturing
Overlapping Demands
as a Basis for Trade (1(1))
Theory of overlapping demands:
◦ Factor-endowment theory - explains trade in
primary products and agricultural goods
Not the trade in manufactured goods
◦ Force influencing manufactured-good trade
Domestic demand conditions
◦ Firms within a country – manufacture goods
for which there is a large domestic market
A nation’s exports - extension of the production
for the domestic market
Overlapping Demands
as a Basis for Trade (2 )
Theory of overlapping demands (cont.)
◦ Consumer demand - conditioned strongly by
income levels
A country’s average or per capita income will yield
a particular pattern of demand
Nations with high per capita incomes will demand
high-quality manufactured goods (luxuries)
Nations with low per capita incomes will demand
lower-quality goods (necessities)
Inter-Industry trade vs. Intra
InterIntra--Industry
Trade
Inter-industry trade
◦ The exchange between nations of products
of different industries
◦ Based on inter-industry specialization
Each nation specializes in a particular industry in
which it enjoys a comparative advantage
Industrial countries have practiced intraindustry specialization:
◦ Focusing on the production of particular
products within a given industry
Intra--Industry Trade
Intra
Advanced industrial nations emphasize
intra-industry trade
◦ Two way trade in a similar commodity
Existence of intra-industry trade is
incompatible with models of comparative
advantage discussed
◦ Intra-industry trade involves flows of goods
with similar factor requirements
◦ Most such trade conducted among industrial
countries
Table 3.53.5Intra--Industry Trade Examples…
Intra
Technology as a Source of
Comparative Advantage…
Technological innovations
◦ Different nations, at different rates of speed
◦ Result in:
New methods of producing existing commodities
Production of new commodities
Commodity improvements
◦ Often transitory
Such dynamic changes have given rise to a
another explanation of international
trade --
Technology as a Source of
Comparative Advantage…
The product life cycle theory
◦ Manufactured goods undergo a predictable
trade cycle:
1. Manufactured good introduced to home market
2. Domestic industry shows export strength
3. Foreign production begins
4. Domestic industry loses competitive advantage
5. Import competition begins
Radios, Pocket Calculators, and the
International Product Cycle
The experience of radios and pocket
calculators illustrate the product life
cycle model. Pocket calculators:
Invented in 1961 in U.S.; marketed for $1,000
By 1970, competing pocket calculators from several
U.S. & Japanese firms; price dropped to $400
More firms entered market; some assembled
product in foreign countries with lower labor
Still more firms entered, improved technology; by
mid 1970’s pocket calculators sold for $10-$20,
sometimes less
Dynamic Comparative Advantage:
Industrial Policy
Dynamic comparative advantage
◦ Comparative advantage in a particular
industry
◦ Can be created
Mobilization of skilled labor, technology and capital
Industrial policy:
◦ Government is actively involved in creating
comparative advantage
◦ Strategy to revitalize, improve and develop an
industry
Figure 3.6 - Trade Effects of
Governmental Regulations
Transportation Costs & Comparative
Advantage (1)
Transportation costs
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◦
Costs of moving goods
Freight charges
Packing and handling expenses
Insurance premiums
An obstacle to trade
Impede the realization of gains from trade
liberalization
Transportation Costs & Comparative
Advantage (2)
Differences across countries in
transport costs
◦ A source of comparative advantage
◦ Affect the volume and composition of trade
Trade effects of transportation costs
◦ The high-cost importing country
Produce more, consume less, and import less
◦ The low- cost exporting country
Produce less, consume more, and export less
Figure 3.73.7- Free Trade Under
Increasing Cost Conditions
Transportation Costs & Comparative
Advantage (3)
Transportation costs
• Reduce the volume of trade
• Reduce the degree of specialization in
production
• Reduce the gains from trade
• One possible reason for international wage
differential