Trade model extensions and applications synopsis of chapter content

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The theory of comparative advantage as presented by Ricardo identifies relative differences in labor productivity between nations as the source of comparative advantage but does not attempt to provide a theoretical explanation for such productivity differences. The primary objectives of this chapter are to explore and analyze various approaches to understanding more fully the sources of comparative advantage and to assess the ability of comparative advantage theory to explain actual trade patterns among nations.
Eli Heckscher and Bertil Ohlin formulated a theory in the 1920s and 1930s that identified different relative factor endowments as the source of comparative advantage among nations. For instance, if one country has a relative abundance of land and another country a relative abundance of capital, the first country will have a comparative advantage in producing and exporting a land-intensive product such as wheat, while the second country would have a comparative advantage in a capital-intensive product such as autos. Transformation schedules would be bowed out, because in each country some land and capital would be relatively better suited to wheat production and some to auto production. However, in the first country the transformation schedule would be extended farther out along the wheat axis because of land abundance, and in the second country it would be extended farther out along the auto axis because of capital abundance. If demand conditions (community indifference curves) are identical or at least similar in the two nations, price lines without trade will show wheat to be relatively inexpensive in the first country because of its land abundance, and autos to be relatively inexpensive in the second country because of its capital abundance. With trade, an equilibrium terms-of-trade line between the two initial extremes will induce the first country to shift toward more wheat production as wheat rose in price, while the second country will shift toward more auto production as autos rose in price in that country. Each nation will export the product that uses intensively the factor of production that is relatively abundant in that country, and import the product that uses intensively the factor of production which is scarce in that country. In effect, each nation gains access to scarce factors of production (land, capital, or labor) through trade, importing such resources indirectly through products intensive in their use.
A further implication of the factor endowments theory is that international trade tends to equalize not only the relative prices of products between nations (for instance, wheat and autos) but also the prices of factors of production. If we consider labor and capital to be the factors of production, pre-trade wage rates will be relatively low in the labor-abundant country and high in the labor-scarce country. With trade, the labor-abundant country will increase production of the labor-intensive product, and the labor-scarce country will shift away from such production. This production shift will strengthen the demand for labor and raise wage rates in the first country, and relieve such demand and reduce wage rates in the second country, thus bringing wage rates closer together. In similar fashion, capital costs or interest rates will converge as trade increases demand for capital in the capital-abundant country and as imports of capital-intensive products alleviate the scarcity of capital in the other country. Thus, international trade tends to bring about factor-price equalization between countries.
The conditions under which factor-price equalization occurs are quite restrictive, so we rarely find complete equalization of wage rates, interest rates, and rental rates among nations in the real world. However, the tendency toward such equalization does explain why increased trade among nations often brings with it a concern about the impact of such trade on the distribution of income within each nation. Within each nation, the returns to the scarce factor of production tend to fall, while the returns to the abundant factor tend to rise. Workers in capital-abundant countries resist the potential impact of trade on their wage rates, and owners of capital in labor-abundant countries fear that trade will bring lower interest rates in their country. The inclination to favor trade restrictions in each case is understandable, although the realization that each nation enjoys overall gains from trade according to comparative advantage might encourage us rather to consider the use of internal government spending, taxation, and transfer programs to address the distributional impacts of trade.
How well does the Heckscher-Ohlin factor endowment theory explain actual trade patterns among nations? The most celebrated effort to test this theory was that of Wassily Leontief in 1954, who applied a mathematical input-output model of the U.S. economy to 1947 trade data. He found that the capital/labor ratio for U.S. export industries actually was lower than for U.S. import-competing industries, exactly the opposite of what the factor endowment theory would predict for a capital-abundant nation such as the United States. He later achieved similar results using 1951 trade data. Economists have developed a variety of theoretical and empirical explanations for what has come to be known as the Leontief Paradox. Most of these explanations essentially involve creating a more generalized factor endowment model, recognizing the importance of finer distinctions within the general categories of land, labor, and capital as factors of production. U.S. exports, for instance, were found to be intensive in their use of skilled labor, engineering talent, and research and development input; these are resources that the United States had in abundance relative to its trading partners.
One particular theory that reflects the importance of multiple factors of production is the product life cycle theory. According to this theory, new products developed through technological innovation are introduced first in a home market such as the United States, where both a large market and the resources important at this initial stage are found. During the second stage, the domestic industry develops a capacity for export, again reflecting comparative advantage within the context of a generalized factor endowment model. During the third stage, foreign production begins, usually in other industrial countries to which the home firms exported during the second stage. A fourth stage witnesses the loss of competitive advantage in the home market as the technological gap narrows, and during a final fifth stage the product becomes standardized and is imported into the original home market. Developing countries often gain a production advantage at this point, again in a manner consistent with the generalized factor endowment model since they have an abundance of the semi-skilled labor that becomes a more important input at this stage in the product life cycle.
One thing made more clear by these extensions of the Heckscher-Ohlin theory is that a nation's relative factor endowments easily may change over time. Industrial nations in Europe along with Japan have narrowed the technological gap that favored the United States after World War II. Several developing countries now are quite capable of operating near the middle or even toward the beginning of the product life cycle. Comparative advantage now must be viewed in dynamic terms, with a nation's ability to operate at the beginning of the product life cycle dependent on its continuing efforts to develop skilled labor, research scientists, and innovators with solid managerial and engineering talents. The term industrial policy has been introduced to recognize the potential role of government in helping to shape and develop a nation's dynamic comparative advantage.
Several other aspects of trade theory and trade patterns among nations deserve at least brief mention. Trade theory based on factor endowments generally assumes resources to be immobile among countries but perfectly mobile inside each country. However, if some resources such as capital are specific to individual industries, the distributional impacts of trade are altered. For instance, owners of specialized plants or equipment that are used in export industries will gain as trade opens up, while owners of specialized equipment that is limited to use in import-competing industries will lose from trade. These effects tend to be short-term rather than long-term in nature.
The presence of economies of scale in production also may influence trade patterns, generally encouraging nations to specialize to a greater extent in their comparative advantage industries than otherwise would be optimal; if economies of scale are extreme, they may specialize completely in production of export goods. The presence or expectation of economies of scale also can influence governments to support key industries in hopes of gaining advantage from experience and high-volume output.

A theory developed by Staffan Linder maintains that trade in manufactured goods occurs between countries with similar domestic demand conditions. Hypothesizing that similar tastes or preferences derive primarily from similar income levels, Linder predicted that trade in manufactured goods would occur between countries with overlapping demands as reflected in overlapping ranges of per capita income. Although detailed empirical support for this theory has not been found, it is evident that much trade in manufactures does occur among industrial nations, rather than between industrial and developing nations as the factor endowment theories would predict. Another important recent phenomenon that can be viewed within this general framework is the growing tendency toward intraindustry trade. Much of this trade within broad industry categories can be understood in terms of product differentiation, especially in oligopolistic industries where economies of scale are important; thus, many industrial nations export certain types of automobiles and import other types, for instance. The competition among industrial nations resulting from such intraindustry trade within the manufacturing sector also creates intense pressures for governments to adopt industrial policy strategies to protect and enhance domestic market and export market shares.

Another significant development in recent years is the expansion of trade in services, although we often tend to think of trade as involving primarily raw materials and manufactured products. Some services, such as transportation and tourism, traditionally have been a part of international trade. However, the growing importance of business services involving areas such as technology transfer, construction, engineering, consulting, accounting, banking, and finance has raised new questions about how the concept of comparative advantage might apply in these areas and about the often more subtle barriers that governments utilize to restrict the international flow of such services.
Finally, two other factors that influence international trade patterns but are not incorporated in simplified trade theories are transportation costs and environmental regulations. Transportation costs effectively prevent the complete international equalization of prices for traded goods, with the price in the importing nation exceeding that in the exporting nation by the amount of the transport costs. Some products either cannot be traded internationally or are prohibitively expensive to ship, but in other cases transportation costs simply reduce the volume of trade below what it would be without such costs. For some products, such as those involving natural resources, processing activities will be located either near the resources or near the final markets, depending on whether the processing is weight-losing or weight-gaining in nature.
In a similar manner, environmental regulations generally increase production costs. If such regulations deal with pollution effects from consumption, they increase product costs but do not directly affect production location. However, if the regulations deal with pollution which arises from production, such as that associated with steel production, they may affect production location and trade patterns by giving relative cost advantages to those nations with the least restrictive regulations. Some observers view such production shifts as legitimate or appropriate, while others call for international harmonization of environmental laws, offsetting subsidies, or countervailing trade barriers in order to prevent such shifts.

KEY CONCEPTS AND TERMS (Define each concept, and briefly explain its significance.)
Factor endowments
Heckscher-Ohlin factor endowments theory

Impact of trade on income distribution among factors of production

Factor-price equalization

Leontief paradox

Generalized factors of production model

Product life cycle theory

Dynamic comparative advantage

Industrial policy

Linder theory of overlapping demand

Interindustry versus intraindustry trade

Specific-factors trade model

Economies of scale

Transportation costs and trade

Environmental regulations and trade

TRUE OR FALSE? (On an exam, be prepared to explain why the statement is true or false.)
T F 1. In the factor endowment theory, a nation with more capital per worker than another nation will have a comparative advantage in capital-intensive products.
T F 2. The factor endowment theory predicts that trade will cause relative wages to fall in a labor-abundant nation.
T F 3. The Leontief paradox is that industrial nations tend to trade more with each other than with developing nations.
T F 4. The product life cycle model states that a new product will be produced throughout its lifetime in whatever nation first succeeds in introducing that product.
T F 5. Generalized factor endowment models emphasize the roles of different varieties of labor and capital in determining a nation's comparative advantage.
T F 6. The overlapping demand theory explains why trade often occurs between industrial nations with similar levels of per capita income.
T F 7. Owners of specialized equipment used only in a nation's export industry will tend to lose as that nation moves from self-sufficiency to more participation in trade.
T F 8. Dynamic comparative advantage recognizes that a nation's export patterns will shift as products move through the life cycle and relative factor endowments change.
T F 9. The existence of transportation costs often causes a reversal of comparative advantage between nations.

T F10. Strict U.S. laws on auto exhaust emissions create a production advantage for Japanese auto firms over domestic firms in the United States.

1. In the Heckscher-Ohlin factor endowment theory of comparative advantage,

a. the transformation schedule is a straight line, as in the Ricardian theory

b. labor is the only relevant factor of production

c. a nation's comparative advantage depends on how well endowed it is with specific factors of production such as labor and capital, relative to its trading partners

d. the nation with the largest labor force will have a comparative advantage in labor-intensive products

2. In the Heckscher-Ohlin theory, two nations have the potential for mutual gains from trade with each other if

a. they have similar levels of per capita income

b. their transformation schedules reflect different relative abilities to produce labor- and capital-intensive goods, based on their relative resource endowments

c. the tastes or preferences of people in one country differ significantly from those of people in the other country

d. transportation costs are zero

3. If a labor-abundant nation trades freely with a capital-abundant nation, there will be a tendency for

a. wages to rise relative to capital costs in both nations

b. wages to fall relative to capital costs in both nations

c. wages to rise in the first nation relative to wages in the second nation

d. wages to fall in the first nation relative to wages in the second nation
4. The empirical finding known as the Leontief paradox was that

a. U.S. exports were more labor-intensive than U.S. imports, even though the United States is regarded as a capital-abundant nation

b. the United States traded more with other industrial nations than with developing nations

c. trade reduced rather than increased the welfare of citizens in the United States

d. U.S. exports grew much less rapidly than U.S. GNP over time
5. Potential explanations for the Leontief paradox include all of the following except:

a. the United States imposed high tariffs on labor-intensive imports

b. the United States actually has a larger relative labor force than its major trading partners

c. U.S. exports are intensive in their use of skilled labor

d. the United States tends to export high-technology products that require significant scientific and engineering inputs
6. According to the product life cycle model,

a. the nation that begins producing and exporting a new product will continue to do so until the product becomes obsolete

b. products initially imported into the United States will later be produced in the United States, once the market becomes established

c. the United States has a comparative advantage in products with short life cycles

  1. a new product initially produced in the United States may later be exported from developing nations to the United States, once it becomes a mature, standardized product

7. Linder's overlapping demand theory of trade

a. helps to explain the extensive trade between industrial and developing nations

b. maintains that manufactured goods are first produced for the home market, then exported to nations with similar levels of per capita GNP

c. strongly supports the factor endowment theory of comparative advantage

d. explains why nations specialize completely, and do not produce at home any of the products they import

8. The growing importance of intraindustry trade

a. reflects the declining importance of economies of scale

b. explains why governments are reluctant to adopt aggressive industrial policies

c. primarily involves homogeneous products

d. often involves differentiated products in industries where economies of scale are present

9. Differences in environmental regulations between nations are most likely to affect production location and trade patterns when

a. the regulations deal with consumption pollution such as food safety or auto exhaust emissions

b. the regulations deal with production pollution such as air pollution from steel manufacturing

c. regulations deal with either consumption or production pollution; the type is not important

d. international subsidies are used to equalize the standards

10. The existence of transportation costs in international trade

a. creates a gap between the prices of goods in the exporting nation and in the importing nation, and reduces the volume of trade

b. often reverses or changes the pattern of trade predicted by the factor endowment model

c. means that processing activities will be located near the source of raw materials if the processing is weight-gaining in nature

d. means that complete factor-price equalization between nations is more likely to occur

1. Assume that Mexico has a higher labor-to-capital ratio than the United States, leaving the United States well endowed with capital relative to Mexico. Assume also that clothing is labor-intensive in production relative to autos.
a. Use the factor endowment theory framework to label the two transformation schedules below, indicating which one represents Mexico and which one represents the United States.

b. Assuming similar tastes or preferences as reflected in the two indifference curves shown in part a, draw the pre-trade price line for each country. Which one is steeper? What does this mean? In which country are autos relatively more expensive? Does this make sense, given what you know about production capabilities in each nation?

c. Now draw a pair of international terms-of-trade lines (one on each diagram) to illustrate the potential for trade between Mexico and the United States. Why must these lines be parallel to each other? Why will the new price line for the United States be steeper than the pre-trade line? Why will the new line for Mexico be flatter than before trade? Explain in words what this means. Show and explain how production will shift in each country according to comparative advantage. Draw an additional indifference curve for each country to show the new consumption point. Identify the desired amounts of exports and imports for each country. What must be true if the terms-of- trade lines that you drew generate equilibrium in trade between Mexico and the United States? If you find that the United States would offer to export more autos than Mexico would like to import at the selected price ratio, would your terms-of-trade line need to become steeper or flatter to bring about equilibrium? Explain why, and what this means in terms of auto and clothing prices.

2. In the example presented in Question 1, explain what would be expected to happen to wage rates in Mexico and in the United States, according to the factor-price equalization theory. How does this help to explain labor concerns about free trade? In the real world, in what ways are the conditions for complete factor-price equalization unlikely to be met, and how might these limitations apply to the example of Mexico and the United States?

3. How do the various explanations for the Leontief paradox, and frameworks such as the product life cycle theory, help to create a more "dynamic" comparative advantage theory and illustrate how nations may either gain or lose specific comparative advantages as they enhance or neglect their productive resources over time?

4. How do the existence of economies of scale and the Linder theory of overlapping demands help to explain the phenomenon of intraindustry trade? Why does this relate more to trade among industrial nations than to trade between industrial and developing nations? Which of these trade patterns do the traditional approaches to comparative advantage more effectively explain?

5. It is easy to visualize trade in products. Try to explain, with specific examples, how trade can take place in services. Why is the volume of trade in business services growing, and how can we go about trying to explain a nation's comparative advantage in exporting certain types of business services?

6. How do environmental regulations established by national governments affect international trade patterns? Why is it important to distinguish between consumption pollution and production pollution in analyzing this impact? For instance, why would strict air pollution standards for steel production be expected to have an impact on trade and foreign investment patterns, whereas stiff U.S. environmental standards on auto exhaust emissions would not?

1. Find examples in recent newspapers or magazines of U.S. industries that appear to be in the first stages of the product life cycle and to show good export potential. Locate other examples dealing with domestic industries that are facing serious competition from imports. Do these appear in any way to represent industries in the later stages of the product life cycle?
2. Consult recent statistical sources on the composition of U.S. exports and imports to find examples of intraindustry trade. Do you also find examples of exports or imports that are more easily explainable in traditional comparative advantage terms?
3. Locate articles dealing with the opposition of U.S. labor organizations or other interest groups to free trade, and see if the concerns of these groups can be understood in terms of the redistribution predictions of the factor-price equalization theory.
4. Consult magazines dealing with environmental issues for examples of conflicts within the United States between protecting the environment and keeping industry and jobs at home. Look also for examples of developing countries reluctant to strengthen environmental policies in order to attract foreign investment from industrial nations.

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