Sources of Comparative Advantage Chapter 3 Copyright © 2009 South-Western, a division of Cengage Learning. All rights reserved. Factor Endowment Theory economists Heckscher and Ohlin o explanation of: 1) determinants of comparative advantage 2) impact of trade on earnings of factors o nation will export goods which it produces with resources that are relatively abundant o nation will import goods which it produces with resources that are relatively scarce Factor Endowment - Example o U.S.: capital/labor ratio = 0.5 (100/200) o China: capital/labor ratio = 0.02 (20/1,000) o Since the U.S. has relatively more abundant capital, the U.S. will produce capital-intensive goods with China producing goods that are more labor-intensive. Graphical Example U.S. MRT = 0.33 China’s MRT = 4.0 implication is that U.S. has a lower relative price in aircraft so U.S. has comparative advantage in aircraft & China has comparative advantage in textiles Graphical Example (cont.) equilibrium at points B and B where slopes of PPCs are equal represents equal relative price for each country U.S. trades 6 aircraft to China for 6 textiles resulting in point C for consumption Implications of Factor Endowment o U.S. - relatively abundant capital China - relatively abundant labor o expectation – U.S. produces capital intensive goods and China produces labor intensive o list of top exports confirm theory’s suggestions Factor Price Equalization o specialization causes U.S. to use more capital and China to use more labor o increases price of capital in U.S. and the price of labor in China until factor costs are equal Stolper-Samuelson Theory o increased income for producers of goods associated with relatively abundant resources o decreased income for producers of goods associated with relatively scarce resources o magnification effect – change in price of the resource is greater than the change in the price of the good produced with that resource o implication: overall, free trade provides gains to a nation but specifically some parties gain while others lose Specific Factor Theory o previous models assumed all resources were completely mobile within a country o in actuality specific factors may exist that cannot move easily from one industry to another o specific factor theory analyzes short run income distribution effects in contrast to previous theories focused on long term results assuming resource mobility among industries o conclusion: trade causes losses for resources specific to import-competing industries and gains for resources specific to export industries Leontief Paradox o Leontief tested validity of factor endowment theory using 1947 data on capital to labor ratios o results: ratio lower for U.S. export industries than for import-competing industries o contrary to factor endowment theory o repeated using 1951 data – similar results Trade & Income Inequality S0 Wage Ratio o wage ratio = wage of skilled workers divided by wage of unskilled workers o labor ratio = quantity of skilled workers divided by the quantity of unskilled workers o supply and demand will determine wage ratio and thus the level of income inequality 2.0 D0 2.0 Labor Ratio Technological Change S0 2.5 Wage Ratio o free trade, decreased transportation costs, and skill biased technology increase the demand for skilled workers in relation to unskilled workers o result is an increase in the wage ratio o promotes a greater degree of income inequality 2.0 D1 D0 2.0 Labor Ratio Immigration S2 S0 2.5 Wage Ratio o increase in unskilled workers decreases the supply of skilled workers in relation to unskilled workers o result is an increase in the wage ratio o again promotes a greater degree of income inequality 2.0 D0 1.5 2.0 Labor Ratio Education and Training S0 Wage Ratio o increased education and training lead to an increase in the supply of skilled workers in relation to unskilled workers o result is a decrease in the wage ratio o reduces income inequality in this case S1 2.0 1.5 D0 2.0 Labor Ratio 2.5 Increasing Returns to Scale o increasing returns to scale also known as economies of scale imply lower costs per unit at higher levels of output o increasing returns theory – despite limited comparative advantage trade can be beneficial if trade leads to lower cost per unit associated with economies of scale o home market effect – countries will specialize in goods with large domestic demand since proximity will reduce transportation costs Theory of Overlapping Demands economist Staffan Linder o firms produce goods with large domestic demand and these goods are potential exports o export potential to countries with consumer tastes similar to domestic market o consumers conditioned by their income levels high income – demand higher quality goods; luxuries low income – demand lower quality goods; necessities o limited trade in goods between wealthy and poor nations because of limited overlap of demand Intraindustry Trade o industrialized nations have practiced intraindustry specialization – focus on particular products within a given industry o 2006 data contradicts Ricardo and HeckscherOhlin Intraindustry Trade (cont.) Reasons for trade - homogeneous goods o lower transportation costs near borders o seasonal variations may impact both supply and demand Reasons for trade - differentiated goods o demand of the ‘minority’ consumers not met by domestic producers o overlapping demand segments o economies of scale associated with greater output of a specific type of good Product Life Cycle Theory goods undergo a predictable trade cycle shifting from export to import over the following stages: 1) 2) 3) 4) 5) introduction of good in home market domestic industry exports foreign production begins domestic industry loses comparative advantage imports become more likely implications: • gains from trade are based on technological innovation and spread of that innovation to other countries • continual innovation needed to remain competitive Dynamic Comparative Advantage o Ricardo’s analysis was static assuming that comparative advantage did not change. o In actuality, comparative advantage can and does change over time. o Industrial policy refers to government attempts to change or create comparative advantage. o Such policy is used to stimulate industries with high productivity, economic significance, and a possibility of long term growth. Government Regulation o Free trade leads to equal prices in the U.S. and South Korea. o South Korea exports 4 tons to the U.S. Government Regulation (cont.) o increase in U.S. environmental regulation increases costs and decreases supply o leads to higher prices and more exports from South Korea to the U.S. Transportation Costs o free trade will cause the U.S. to produce more autos and Canada to produce fewer until the prices are equal o U.S. will export autos to Canada and the price will be $6,000 in both markets Transportation Costs (cont.) o transportation costs will increase the price to $7,000 in Canada o Canada will import fewer autos from the U.S. as a result of higher price o U.S. price falls to $5,000 as a result of fewer exports and lesser demand