Chapter 4 Lecture - Comparative
Advantage and Factor
Endowments
4-1
Learning Objectives
• Explain the Heckscher-Ohlin Trade Model.
• Diagram the changes in production and show
gains from trade after a country begins to
trade.
• Predict the impacts on different factors of
production of trade-opening.
• Predict the impacts on trade and production of
a change in factor endowments.
• Illustrate the product cycle for a product as it
becomes standardized in its production.
• List the trade-offs between foreign investment
and foreign trade.
4-2
Modern Trade Theory
• Adam Smith and David Ricardo assumed that
each country would have its own technology,
climate, and resources, and that these
differences would give rise to productivity
differences (and thus differences in
comparative advantage)
• In the 20th century, several economists
developed more detailed explanations of trade
in which comparative advantage of a country
depends on it’s endowments of inputs (factors
of production) to produce goods
4-3
Heckscher-Ohlin (HO) Trade Model
• The HO model states that a country’s
factors of production (a country’s
endowments of inputs) are used to
make each good give rise to productivity
differences between countries
– Factor abundance versus factor scarcity:
When a country enjoys a relative abundance
of a factor, the factor’s relative cost is less
than in countries where the factor is
relatively scarce
– A country’s comparative advantage lies in
the production of goods that use relatively
abundant factors
4-4
4-5
4-6
An Example of Factor Abundance
• Canadian capital-labor ratio: Kcan / L can is 2/10
or 1/5
• U.S. capital-labor ratio: Kus / L us is 50/150 or 1/3
• Since the U.S.’s capital-labor ratio is higher, it
is the relatively capital abundant country:
KUS K can
1 1

or 
LUS
Lcan
3 5
4-7
Heckscher-Ohlin (HO) Trade Model
• The U.S. is richly endowed with a wide
variety of factors: natural resources,
skilled labor, and physical capital
– Expectation: The U.S. will export
agricultural products (particularly those
requiring skilled labor and physical capital)
and machinery and industrial goods
(requiring physical capital and scientific and
engineering skills)
– Result: Major U.S. exports include grain
products made with small labor and large
capital inputs; and commercial aircraft
made with physical capital and skilled labor
4-8
Gains from Trade in the HO Model
• Ricardian model assumed that each country
faced a constant set of tradeoffs (e.g., 2 loaves
of bread for 3 tons of steel in the U.S.) because
of only one homogeneous input: labor
• The HO model assumes: (1) multiple inputs—
labor capital, farmland — and (2) variations in
the quality of inputs
• Thus, the PPC cannot be assumed to have
constant costs. Under the HO model, each
country has a rising opportunity cost for each
type of production
4-9
The United States’ Production
Possibilities Curve with Increasing
Costs
410
Opportunity Costs and the Slope
of the PPC
411
Gains from Trade in the HO Model
412
Gains from Trade in the
Hecksher-Ohlin Model
Capital
Intensive
Good
(e.g. paper)
(PC/PP)FA > (PC/PP)FT > (PC/PP)HA
Notation:
F = “foreign”
H = “home”
C=cloth
P=paper
A=autarky
FT=free trade
(PC/PP)FA
(PC/PP)HA
(PC/PP)FT
trade
trade
Labour intenstive
Good (e.g clothes)
413
Trade and Income Distribution
• The HO model provides a more sophisticated
way to analyze gains and losses from trade
because it drops unrealistic assumptions
– Labor can be divided into categories of
different skill levels
– Other types of inputs can be included
– Industries can require different mixes of
various inputs
• There is a systematic relationship between the
factor endowments of a country and the
winners and losers from trade
• Let’s analyze this claim further…
414
The Stolper-Samuelson Theorem
• Derived from the HO model
• Assumptions:
– Labor earns wages proportionate to its skill
level
– Owners of capital earn profits
– Landowners earn rents
– The amount of income earned per unit of
input depends on both the demand for inputs
and the supply of inputs (demand for an
input = derived demand)
– If an output is in high demand, its price is
high and the inputs used to produce it
receive higher returns
415
The Stolper-Samuelson Theorem
• An increase in the price of a good raises
the income earned by factors that are
used intensively in its production
• Conversely, a fall in the price of a good
lowers the income of the factors used
intensively in its production
416
The Stolper-Samuelson Theorem
417
The Stolper-Samuelson Theorem
Note: Not all factors used in the export
industries will be better off, and not all factors
used in import competing industries get hurt:
Abundant factors will benefit, while scarce
ones will be hurt
-In addition, factors face the magnification
effect: the change in output prices has a
magnified effect on factor incomes.
-A 75% decline in the price of bread can lead
to a more than 75% decline in the income of
labor used in the production of bread
418
The Stolper-Samuelson Theorem
• Ultimately, the effects on income of an
opening of trade depends on the
flexibility of the affected factors
– If labor is stuck in bread production and
unable to move to making steel, it will be
hurt much worse than when it is flexible and
free to move
– U.S. avocado producers might not oppose
Mexican avocado imports as fiercely as they
do, if they could easily move to producing
other goods
419
Specific Factors Model
• The HO model assumes that factors are
mobile in the long run, meaning that
they can migrate easily from one sector
to another
• The Specific Factors model assumes that:
(1) land and capital are immobile and
cannot migrate (specific factors); and
(2) labor is fully mobile and can migrate
from one sector to another (variable
factor)
420
Specific Factors Model
• A country’s endowment of a specific factor plays
a more critical role than a factor in the HO
model in determining comparative advantage
– When trade opens, incomes rise for the
owners of the abundant specific factor
– The income distribution effect on labor is
indeterminate, as workers can easily move to
the expanding sector
421
Specific Factors Model
The main difference between HO and
Specific Factors: the specific factor plays
a critical role
• Example: Canada is relatively well
endowed with land and that the United
States is relatively well endowed with
capital. Then Canada exports bread,
and the United States exports steel.
422
Ten Largest Oil Reserves
423
Empirical Tests of the Theory of
Comparative Advantage
• Tests of theories based on factor endowments
(such as HO) yield mixed results
- Empirical tests are difficult: how to measure
factor endowments or prices in an autarky,
for example
• Besides factor endowments, trade is affected
by
– Technological differences
– Economies of scale
– Corporate structures
– Economic policies
424
Extension of the HO Model:
The Product Cycle
• The product cycle was developed by
Raymond Vernon
• Production of a good is cyclical
– In the early stage of production,
manufacturers need to be near a high-income
market where consumer feedback is greatest.
– Experimentation with fundamentally new
designs begins to wane as product
development shifts toward incremental
improvements in a basic design.
425
Product Cycle
• In the middle phase, production begins
to shift to countries with low labor
costs.
• Consumption of the good in a highincome country exceeds its production:
production moves where labor costs
are lower
• Countries reach the late phase of the
product cycle when consumption in
high income nations begins to exceed
production.
426
The Product Cycle in High-Income
Countries
427
The Product Cycle in LowIncome Countries
428
Extension of the HO Model: Foreign
Trade versus Foreign Investment
In the product cycle:
-firms invest abroad instead of exporting
-some of the output may be imported
back into the home country
-a very different pattern from the simple
Heckscher-Ohlin model where countries
export one good and import another
429
Implications
Heckscher-Ohlin model exports one good
and imports implies firms prefer to invest
abroad rather than to export (they
substitute foreign investment for foreign
trade)
Second, the part of the output that they
ship from their foreign operation back
into the home country is international
trade, but it is handled entirely within a
single firm (intra-firm trade)
430
Intra-firm Trade
Intra-firm trade - international trade between a
parent company and a foreign owned affiliate.
•Intra-firm trade is difficult to measure
• Reasons for intra-firm trade
– Firms take advantage of cross-country
differences in the price of inputs
– A firm may reduce distribution costs in a
foreign market by operating through an
affiliate
• Intra-firm trade is growing in importance
– In mid-90’s, about 1/3 of US merchandise
exports and 2/5 of merchandise imports
were intra-firm
431
Intra-firm Trade
Trade between affiliates of companies located in different
countries. Much intra-firm trade consists of trade in
parts, components, and other inputs from which final
products are made. An example of intra-firm trade is an
American automobile manufacturer shipping] an engine
from one of its factories in the United States to an
assembly plant it owns in Mexico for placement in an
automobile that is being built there. Because the final
market for many of the goods traded within firms is the
United States, and because many of the foreign factories
of U.S. multinational companies have replaced factories in
the United States, U.S. intra-firm exports often are
associated with the destruction, not the creation, of
American jobs
Glossary Definition By http://www.americaneconomicalert.org/view_glossary.asp?Prod_ID=308
432
OLI Theory
OLI theory (ownership-locationinternalization)
– Firms investing abroad own an asset that
gives them an competitive advantage
(Ownership)
– Firms seek a production location that offers
them advantages (Location)
– Firms try to internally capture the
advantages of foreign asset ownership
(Internalization)
http://astro.temple.edu/~pippin/oli.htm
433
Off-shoring and Outsourcing
• Off-shoring is defined as the movement of some or all of
a firm’s activities to a location outside the home country
• Outsourcing is the reassignment of activities to another
firm, either inside or outside the home country
– Trade in services is consistent with traditional trade
models based on comparative advantage
– Fundamental debate is the impact of outsourcing on
jobs
• All combinations of off-shoring and outsourcing are
possibilities and exist in the world economy
• Some firms off-shore, but do not outsource, choosing to
use a foreign affiliate; a foreign-based operation owned
by the firm in the home country
434
Causes of OS
• Two main causes of the recent increase in OS:
– New technologies
• Information
• Communication
– Entry of new populations into world economy
• China
• India
• Former Soviet states
– These make OS possible for jobs that can be done at a
distance
– Activities are offshored if they can be done more cheaply
elsewhere
– Thus OS occurs due to
• Comparative Advantage
– Due to technology differences
– Due to factor-endowment differences
• Economies of Scale
435
Effects of OS
• Disagreements
– Skeptics say OS,
• is largely negative
• He defines offshoring as “substituting foreign for
domestic labor”
– Many mainstream trade economists
• see offshoring as ordinary trade
• are largely positive
– Blinder (a very well-respected macro
economist)
• sees it as beneficial overall
• but worries about effects on US labor
436
Effects of OS
• Effects that are Like trade:
– All of the effects of trade that we have studied, are
valid for this. OS is trade.
– Thus
• Countries as a whole gain, due to comparative
advantage, economies of scale, etc.
• Some people within the countries lose – especially
those whose jobs are lost
• Theory says that “scarce factors” are hurt by
trade, and thus also by outsourcing.
• Effects that are Unlike trade
– Increased insecurity: workers feel more threatened
• New groups (white collar, in high-income
countries) are seeing the threat
– Employers can “move jobs”; workers can’t
• Thus employers gain in bargaining over wages
437
Effects of OS
• Effects that are Unlike trade
– (Possible) loss of technological advantage
• Poor countries acquire the knowledge that rich
countries previously had exclusively.
• Thus
– Poor countries become more productive
– Their incomes rise
– Therefore OS helps economic development
• OS from US may create jobs in US
– OS can make a firm or industry viable that would not have
been viable without OS
– Example: US software company, IMC.
(IMC = Information Management Consultants.
Makes software to exploit human genome
research.)
• Became viable only with coding done in India.
• Now it employs six engineers in the US for every one in
India
438
Effects of OS
• Effects that are Unlike trade
– (Possible) loss of technological advantage
• Terms of trade of rich countries worsen, costing
them some of their gains from trade
– Thus rich countries may lose from the loss of
exclusive technologies due to OS
– But what they are losing are the gains from trade.
Refusing to trade would only make things worse.
439
Effects of OS
• OS raises productivity (see Amiti and
Wei)
– They estimated the causes of US
productivity growth over 1992-2000
– 11% of it was due to “service offshoring”
– Only 3-6% was due to imported material
inputs
– Why? Because firms choose to offshore the
less efficient parts of what they do.
440
Effects of OS
• OS threatens some occupations more
than others (see Blinder’s examples)
Offshorable
Not offshorable
electronic service
personal service jobs
tax accounting
onsite auditing
computer programming
computer repair
architects
builders
radiology
pediatrics and geriatrics
lawyers who write contracts
litigators who argue cases in court
441
Facts about OS
• Blinder estimates that 30-40 million US jobs
are potentially offshorable.
– Compare to civilian employment in Jun
2008: 145.9 million
– So Blinder is estimating that up to a quarter
of US employment is potentially threatened
by offshoring
– Thus it “rattles” him
• But the actual amount is still relatively small
– Brainard and Litan say OS accounts for only
2% of those who involuntarily lose their
jobs. (It would be a much smaller share of
all job turnover)
442
Adjusted labor income share in developed G20 countries,
1991–2013
Adjusted labour income share
(%)
68
64
60
56
United Kingdom
Japan
France
Germany
United States
Canada
Italy
Australia
52
443
Changes in Shares of
Domestic Income
444
Tom Friedman’s View of OS
• Tom Friedman (author of The World Is Flat)
• CEOs no longer think of outsourcing (or
offshoring) at all, because
– They don’t think of “in” or “out”
– Things are “Made in the World”
– They produce “anywhere through global
supply chains “
• Friedman thinks the US has advantages that
will let us prosper in this new world:
– protection for intellectual property
– secure capital markets
– government funding for science
– strength in logistics (FedEx, UPS)
445
A final note on Outsourcing
• http://www.youtube.com/watch?v=rYaZ57B
n4pQ
446
Migration and Trade
• Three primary factors:
– Supply-push factors: forces inside a nation that cause
people inside an nation to think about leaving
– Demand-pull factors: forces that pull a migrant to a
particular country or place within a country
– Social networks: ability of migrants to congregate
near family or community members to more easily
assimilate into new locale
• Main Reason for Migration: Better Wages
• Other Reasons
– Better living conditions
– Freedom/Persecution
– Climate
Thank you to Dr. Alan Deardorff (UMICH) for permission to use this example
447
448
Effects of Migration
Labor markets in two countries
before migration
Mexico
wM
U.S.
wU
SM0
SU0
wU0
DU
wM0
DM
L
Thank you to Dr. Alan Deardorff (UMICH) for permission to use this example
L
449
Effects of Migration
Effect of migration on labor supplies
Mexico
wM
SM1
U.S.
wU
SM0
SU0
SU1
wU0
DU
wM0
DM
−L
L
+L
Thank you to Dr. Alan Deardorff (UMICH) for permission to use this example
L
450
Effects of Migration
Effect of migration on wages
Mexico
wM
SM1
U.S.
wU
SM0
SU0
SU1
wU0
wU1
DU
wM1
wM0
DM
−L
L
+L
Thank you to Dr. Alan Deardorff (UMICH) for permission to use this example
L
451
Effects of Migration
• Other effects, not in this simple model
– Migrants
• Pay taxes
• Use government services
• Which is larger? There is debate on this
– Many migrants carry wealth with them out
of their country of origin
• Financial
• Human capital
– Raising concern about a “brain drain”
– But see Economics Focus
» Possibility of emigration provides incentive to
acquire more education
» Leads to more education even at home
452
Effects of Migration
• Losers from migration
– In country of emigration: owners of
factors other than labor see their
productivity and incomes are reduced by
having less labor to work with
– In the country of immigration: workers
compete with the incoming workers and
their wage falls
Note that there may be different kinds of
labor. Only those most similar to the
immigrants lose.
– These tend to be unskilled workers in the
most common cases
453
Effects of Migration
• Migration changes population density; may cause congestion
– “overcrowded schools, congested highways, deteriorating
ecology and lagging infrastructure”
• Diversity: presence of immigrants adds
– Cultural enrichment
– Cultural (ethnic) frictions
• Xenophobia (fear or dislike of “others”)
• Many migrants send money back to their country of origin
– Such “remittances” provide important income for poor
countries
• Demographic effects
– Immigrants tend to be young and have large families
– This provides a larger young generation, whose earnings
can support the elderly
• Aging population is less of a problem for the US than for
Europe and Japan, because of immigration
454
Policies to Affect Migration
• Immigration Quotas, based on
–
–
–
–
Race
Country of origin
Income, wealth, skill
Family connections
• “Guest worker” Programs
– Permit workers to enter temporarily to fill a
labor-market need
– Hard to enforce “temporary”
455
The Impact of Trade on
Wages and Jobs
• In the short-run, trade may (1) reduce jobs in
an industry that is not competitive vis-à-vis
foreign industries and (2) increase jobs in
competitive industries
• In the medium- and long-run, trade has very
little effect on the number of jobs
– The abundance or scarcity of jobs is a
function of (1) labor market policies, (2)
incentives to work, and (3) government
macroeconomic policies
456
Why Wages Differ across Countries
(Mostly these are the same reasons we’ve seen before, for
why countries trade)
• Relative Factor Endowments
– Of labor relative to other factors, such as land,
capital, natural resources
– Countries that have an abundance of these other
factors tend to have
• High demand for labor, and thus
• High wage
• They are likely to attract migration
• Differences in Technology
– Advanced technology makes labor more productive
– Causes higher wages, and attracts migration
457
Why Wages Differ across Countries
• Other causes for a country to have high wages
– Infrastructure
– Competitive and efficient markets
– Strong institutions (“Intangible wealth”)
• trust among people in a society
• an efficient judicial system
• clear property rights
• effective government
• Labor Unions?
Do these contribute to high wages and thus attract
migration?
– This cuts both ways:
• Labor unions do seek to increase wages and
improve working conditions for their members
• But one way to do that is to keep out migrant labor458
459
Your Thoughts
460