Global Economics
Eco 6367
Dr. Vera Adamchik
Chapter 3
Sources of
• In this chapter, we will discuss the factors
that ultimately determine why a country has
a comparative advantage or comparative
disadvantage in a product.
In Chapter 2 we learned:
• Trade begins as someone conducts
arbitrage to earn profits from the price
difference between previously separated
• With no trade, product prices differ because:
– supply conditions differ (different PPFs,
technologies and resource endowments);
– demand conditions differ (tastes and
Labor theory of value
• Adam Smith viewed the determination of
competitiveness from the supply side of the
market (labor theory of value  labor is the
only factor  the cost or price of a good
depends exclusively on the amount of labor
required to produce it) [p. 31 in the
Labor theory of value
• Like Smith, David Ricardo emphasized the
supply-side of the market. In his model, he
relied on the following assumptions [p. 32
in the textbook]:
• (2) In each nation, labor is the only input;
• (5) Costs … are proportional to the amount
of labor used.
In-class exercise
• However, Smith’s and Ricardo’s theories
fail to explain international trade when
technology is identical in both countries,
that is, production functions and PPFs are
the same in both countries.
• Exercise # 1 (handout).
The Factor-Endowment Theory
(a.k.a. the Heckscher-Ohlin theory
of trade) -- the basis for the
orthodox modern theory of
comparative advantage
• The leading theory of what determines
nations’ trade patterns emerged in Sweden.
• Eli Heckscher (an economic historian)
developed the core idea in a brief article in
• A clear overall explanation was developed
and publicized in the 1930s by Heckscher’s
student Bertil Ohlin (a professor and
politician, a Nobel laureate).
• Ohlin’s arguments were later reinforced by
Paul Samuelson (a Nobel laureate), who
derived mathematical conditions under
which the H-O prediction was strictly
The H-O theory emphasizes the role of
relative differences in resource
endowments as the ultimate determinant
of comparative advantage. The H-O
theory explains comparative advantage in
terms of underlying
1. differences across countries in the
availability of factor resources (factor
endowment) – abundant vs scarce factors;
2. differences across products in the use of
these factors in producing the products
– labor-intensive, capital-intensive, landintensive, etc.
Factor abundance
• The phrase different factor endowments
refers to different relative factor
endowments, not different absolute
• In other words, different factor endowments
= different factor proportions.
Relative factor abundance
May be defined in two ways:
• The physical definition (in terms of the
physical units of two factors). For example,
(K/L)I > (K/L)II  Country I is capitalabundant;
• The price definition (in terms of the
relative prices. The greater the relative
abundance of a factor, the lower its relative
price). For example, (r/w)I < (r/w)II 
Country I is capital-abundant.
Commodity factor intensity
• A commodity is said to be factor-Xintensive whenever the ratio of factor X to
a second factor Y is larger when compared
with a similar ratio of factor usage of a
second commodity.
For example, consider labor:
• A country is relatively labor-abundant if it
has a higher ratio of labor to other factors
than does the rest of the world.
• A product is relatively labor-intensive if
labor costs are a greater share of its value
than they are of the value of other products.
How does the relative abundance of
a resource determine
comparative advantage?
• When a resource is relatively abundant, its
relative cost is less than in countries where
it is relatively scarce.
• Difference in relative resource costs causes
the pre-trade differences in relative product
prices between two countries.
• The H-O theory says, in Ohlin’s own words:
Commodities requiring for their production
much of [abundant factors of production] and
little of [scarce factors] are exported in
exchange for goods that call for factors in the
opposite proportions. Thus indirectly, factors in
abundant supply are exported and factors in
scanty supply are imported.
(Ohlin, Bertil. International and Interregional
Trade, MA: Harvard University Press, 1933)
Or, in other words, the H-O theory predicts
that a country exports the product(s) that
use its relatively abundant factor(s)
intensively and imports the product(s)
using its relatively scarce factor(s)
Criticism: The Leontief paradox
Wassily Leontief theorized that since the U.S.
was relatively capital-abundant (and laborscarce) compared to other nations, the US
would be an exporter of capital intensive
goods and an importer of labor-intensive
goods. However, he found that US exports
were less capital intensive than US imports.
Since this result was at variance with the
predictions of the H-O theory, it became
known as the Leontief Paradox.
• The post-Leontief studies showed that the
US was also abundant in farm-land and
highly skilled labor. And the US was indeed
a net exporter of products that use these
factors intensively, as H-O predicts.
• The trade patterns of some other developed
countries (Japan, Canada) and of many
developing countries (China) are broadly
consistent with H-O.
• In general, trade patterns fit the H-O theory
reasonably well but certainly not perfectly.
Who gains and who loses
from trade
within a country?
• According to H-O, opening to trade alters
domestic production. There is expansion in
the export-oriented sector, and there is
contraction in the import-competing sector.
• The changes in production have one set of
effects on incomes in the short run, but
another in the long run.
• In the short-run (when labor and capital are
immobile / cannot move easily from one
industry to another), the specific-factor
theory predicts the effects of trade on factor
prices and incomes.
• In the long run (when labor and capital can
move freely among industries), the factorprice equalization theorem and the
Stolper-Samuelson theorem predict the
effects of trade on factor prices and
Trade and the Distribution on
Income in the Short Run
• The types of factors that cannot move easily
from one industry to another are called
specific factors.
• In the short run laborers, plots of land, and
other inputs are tied to their current lines of
In-class exercise
• See “The Specific-Factor Theorem”
• Conclusions:
for the short-run, gains and losses divide by
output sector: All groups tied to rising
sectors gain, and all groups tied to declining
sectors lose.
Trade and the Distribution on
Income in the Long Run
Factor-Price Equalization
• By redirecting demand away from the
scarce resource and toward the abundant
resource in each nation, trade leads to factoprice equalization.
• In each nation, the cheap resource becomes
relatively more expensive, and the
expensive resource becomes relatively
cheaper, until price equalization occurs.
In-class exercise
• See “The Factor-Price Equalization
Theorem & The Stolper-Samuelson
Theorem” handout.
• Conclusions:
given certain conditions and assumptions,
free trade equalizes not only product prices
but also the prices of individual factors
between the two countries.
The Stolper-Samuelson Theorem
• If countries gain from opening trade, why
do free-trade policies have so many
opponents year in and year out?
• The answer is that trade does typically
hurt some groups within any country.
• Hence, a full analysis of trade requires that
we identify the winners and losers from
freer trade.
• Wolfgang Stolper and Paul Samuelson
developed the Stolper-Samuelson theorem
in an article published in 1941.
The Stolper-Samuelson theorem:
• With full employment both before and after
trade takes place, the increase in the price of
the abundant factor and the fall in the price
of the scarce factor because of trade imply
that the owners of the abundant factor will
find their real incomes rising and the
owners of the scarce factor will find their
real incomes falling.
In-class exercise
• See “The Factor-Price Equalization
Theorem & The Stolper-Samuelson
Theorem” handout.
• Conclusion:
– Net gains for both countries but different effects
on different groups:
– Winners: landowners in Farmland and workers
in Peopleland.
– Losers: workers in Farmland and landowners in
• It is not surprising that owners of the
relatively abundant resources tend to be
“free traders” while owners of relatively
scarce resources tend to favor trade
• We may not see the clear-cut income
distribution effects with trade because relative
factor prices in the real world do not often
appear to be as responsive to trade as the H-O
and S-S imply.
• In addition, income distribution reflects not
only the distribution of income between factors
of production but also the ownership of the
factors of production. Since individuals or
households often own several factors of
production, the final impact of trade on
personal income distribution is far from clear. 33
The product life-cycle theory
• The explanations of international trade
presented so far are similar in that they
presuppose a given and unchanging state of
• The product cycle hypothesis attempts to
offer a dynamic theory of technology and
• Technology-based comparative advantage
can arise over time as technological change
occurs at different rates in different sectors
and countries.
• Hence, a country can develop a comparative
advantage based on its technological
improvements or innovations (that mainly
come from R&D).
• In some ways this technology-based
explanation is an alternative that competes
with the H-O theory.
• However, there is also a link to the H-O
theory: the suitable location of R&D
matches the factor proportions of
production using the new technology to the
factor endowments (that is, availability of
highly skilled labor and venture capital) of
the national locations.
The product life-cycle theory, proposed by
Raymond Vernon in the mid-1960s,
suggested that as products mature both the
optimal production location and the location
of sales will change affecting the flow and
direction of trade:
• Initially, R&D, production and consumption
are likely to be in an advanced developed
• Later, as demand grows in other developed
countries, the innovating country begins to
• Over time, demand for the new product will
grow in other advanced countries making it
worthwhile for foreign producers to begin
producing for their home markets.
• The innovating country might also set up
production facilities in those advanced
countries where demand is growing,
limiting the exports from the innovating
• Over time, the product and its production
technology become more standardized and
familiar (mature). Factor intensity in
production tends to shift away from skilled
labor and toward less-skilled labor.
• The technology diffuses and production
locations shift into other countries,
eventually into developing countries that are
abundant in cheap less-skilled labor.
• Trade patterns change in the manner
consistent with shifting production
locations. The location of production of a
product shifts from the leading developed
countries to developing countries as the
product moves from its introduction to
maturity and standardization.
• The innovating country is initially the
exporter of the new product, but it
eventually becomes an importer.
The product life cycle theory accurately
explains what happened with a number of
high technology products developed in the
US in the 1960s and 1970s. For example,
• Pocket calculators were pioneered by Texas
Instruments and Hewlett-Packard in the US
in the early 1970s.
• Soon Sharp and other Japanese firms began
to dominate a product whose characteristics
had begun to stabilize.
• More recently, assembly production shifted
into the developing countries.
The product life-cycle theory
Nonetheless, the usefulness of the product cycle
hypothesis is limited due to the difficulties in
determining the phases of the cycle:
1. In many industries – especially high-tech –
product and production technologies are
continually evolving because of ongoing R&D.
2. International diffusion often occurs within
multinational (global) corporations. In this case,
the cycle can essentially disappear. New
technology can be transferred within the
corporation for its first production to other
countries, including developing countries.
Alternative models of trade:
New trade theory
• Standard theories of international trade
(developed by Adam Smith, David Ricardo,
and Heckscher-Ohlin) focus on productionside differences as the basis for
comparative advantage. According to
these theories, the sources of productionside differences are differences in
technologies, differences in factor
productivities, differences in factor
endowments, and differences across
products in the use of productive factors in
producing the products.
• Hence, according to these theories, the more
different the countries are – regarding
productivity, technology, or capital-to-labor ratio –
the greater the economic gain from specialization
and trade. Thus, we may expect that the
predominant portion of international trade will
occur between countries that are different in these
regards. In other words, we may expect that
developed countries (capital-abundant, high
productivity, advanced technologies) will trade
with developing countries (labor-abundant, lowproductivity, outdated technology).
In-class exercise
• Conduct a simple test of the standard theories of
international trade. Go to the U.S. Census Bureau webpage ;
click on the “Top trading partners” link;
click on December of the previous year (because the
December data show the annual values for each year).
What countries were the top 10 purchasers of U.S.
exports? What countries were the top 10 suppliers of U.S.
imports? Compare these lists. Does the overall pattern of
the U.S. trade partners appear to match well with the
predictions of the standard trade theories? Why or why
not? Are there any features of the data that appear to
violate strongly these predictions?
In-class exercise
• Industrialized countries (which are similar
in many aspects in their technologies,
technological capabilities, and factor
endowment) trade extensively with each
• Trade between industrialized countries is
nearly half of all world trade.
• These facts appear to be inconsistent with
comparative-advantage theory.
Intra-industry trade
• An increasing fraction of world trade
consists of intra-industry trade, in which a
country both exports and imports the same
or very similar products (products in the
same product category / industry).
• Even very subtle production-side (i.e.,
technology-based) comparative advantages
seem to be unable to explain the
phenomenon of intra-industry trade.
In-class exercise
• Go to, click
on “Country/Product Data”, then on
“NAICS web application”, then choose
“World” in the lower window, then choose
“December” of the previous year to get
cumulative annual data. Analyze intraindustry trade of the US with the ROW.
Spread of technology
• Furthermore, technology quickly spreads
internationally because it is difficult for a
country to keep its technology secret.
• Hence, many countries usually have access
to the same technologies for production and
are capable of achieving similar levels of
resource productivity.
Global industries dominated
by a few large firms
• Boeing and Airbus – commercial aircraft.
• Sony, Nintendo, and Microsoft – videogame
Trade facts in search of better theory
1. Substantial trade among industrialized
countries, much of which is intra-industry
2. The dominance of a few large firms in
some world industries.
We turn next to the theories that focus not
only on the supply side differences
(technology, endowment, etc.) but also on
the demand side differences as the source
of trade.
The Linder Theory
• The theory was proposed by the Swedish
economist Staffan Burenstam Linder in
• The Linder theory is a dramatic departure
from the H-O model because it is almost
exclusively demand oriented.
• The Linder theory postulates that tastes of
consumers are conditioned strongly by their
income levels; the per capita income level
of a country will yield a particular pattern of
• Trade will occur in goods that have
overlapping demand, meaning that
consumers in both countries are demanding
the particular item.
In-class exercise
• Figure 2 (handout).
• Exercise # 2 (handout).
• The important implication is that
international trade in manufactured goods
will be more intense between countries with
similar per capita income levels than
between countries with dissimilar per capita
income levels.
• The Linder theory identifies the goods that
would be traded between any pair of
countries. However, the theory does not
identify the direction in which any given
good will flow. Linder made it clear that a
good might be sent in both directions – both
imported and exported by the same country!
(That is, intra-industry trade.)
The Krugman Model
The Krugman theory of trade focuses on:
– product differentiation & monopolistic competition;
– substantial internal scale economies and global
– external scale economies (industries that concentrate in
a few places).
• The major alternative theories of
international trade relax assumptions # 4, 5,
and 6 (p. 32) and use the existence of
economies of scale as a major departure
from the standard theory.
• Increasing returns to scale (IRS), or
economies of scale, exist if increasing
expenditures on all inputs (with input prices
constant) increases the output quantity by a
larger percentage.
• Therefore, the average cost of producing
each unit of output declines, as output
The PPF with
decreasing opportunity costs / increasing returns
The PPF is bowed
inward rather than
outward; that is,
opportunity costs
decrease the higher
the level of
production in an
F rozen
P izza
A utom obiles
Internal economies of scale
• Scale economies are internal if the
expansion of the size of the firm itself is the
basis for the decline in its average cost.
• Ways to reduce the average cost:
– greater specialization of workers;
– more specialized machines;
– spreading of up-front fixed costs (R&D
or production setup costs) over more
units of output.
External economies of scale
• Scale economies external to the individual
firm relate to the size of the entire industry
within a specific geographic area.
• The average cost of the typical firm declines
as the output of the industry in the area is
larger. (Better input markets – specialized
services and labor; swift diffusion of new
knowledge about product and technology
through direct contacts among the firms or
as skilled workers transfer from firm to
Demand & Product differentiation
• Growth in intra-industry trade over time and
higher intra-industry trade for higherincome countries can be understood partly
from the demand side.
• Income growth shifts demand toward
luxuries, and product variety is a luxury.
Affluent people vary their choices of wines,
beers, automobiles, music, clothing, travel
expenses, and so on.
• Full customization of production in a single
country would be too costly.
• Hence, some varieties will be imported,
while the varieties produced in the country
can be exported to affluent consumers in
other countries.
• When all firms face similar downwardsloping average cost curves, so there may
be no comparative advantage.
• Rather, a country’s trade is based on
product differentiation.
• The basis for exporting is the domestic
production of unique models (or varieties)
demanded by some consumers in foreign
• The basis for importing is the demand by
some domestic consumers for unique
models produced by foreign firms.
• Intra-industry trade in different products can
be large, even between countries that are
similar in their general production
Economies of scale
• Yet, demand effects cannot be the whole
• Economies of scale play a supporting role,
by encouraging production specialization
for different varieties.
• With trade, firms in each country produce
only a limited number of varieties of the
basic product, but in greater quantities
(domestic market + exports), which leads to
a lower unit production costs.
• If internal scale economies are modest or
moderate, then there is room in the industry
for a large number of firms. If, in addition,
products are differentiated, then we have a
mild form of imperfect competition called
monopolistic competition.
• If internal scale economies are substantial
over a large range of output, then it is likely
that a few firms will grow to be large in
order to reap the scale economies. If a few
large firms dominate the global industry,
then we have an oligopoly.
• The countries in which these firms are
located will then tend to be net exporters of
the product, while other countries are
• External scale economies appear to explain
the clustering of some industries:
• Silicon Valley – high-tech semiconductor,
computer, and related producers.
• New York City – banking and finance.
• Hollywood (Bollywood in Bombay) –
• Italy – stylish clothing, shoes, and
• Switzerland – watches.
Gains from trade
• A major additional source of national gains
from trade is the increase in the number of
varieties of products that become available
to consumers through imports.
• Without trade, nations might not be able to
produce those products where economies of
scale are important. With trade, markets are
large enough to support the production
necessary to achieve economies of scale.
Implications of new trade theory
• Nations may benefit from trade even when
they do not differ in resource endowments
or technology.
• The theory does not contradict comparative
advantage theory, but instead identifies a
source of comparative advantage.
• Governments should consider strategic
trade policies that nurture and protect firms
and industries where first mover advantages
and economies of scale are important.
Criticism of new trade theory
1. The monopolistic-competition model
suggests that product differentiation can be
a basis for successful exporting, although it
does not predict which specific varieties of
a differentiated product will be produced by
which country.
Criticism of new trade theory
2. The models based on substantial scale
economies (internal or external) indicate
that production tends to be concentrated at a
small number of locations, but they do not
precisely identify which specific countries
will be the production locations. History,
luck, and perhaps early government policy
can have a major impact on the actual
production locations.
The gravity model of trade
• The analysis of the major trade partners has
led to the development of the gravity model
of trade, so called because it has similarity
to the Newton’s law of gravity, which states
that the force of gravity between two
objects is larger as the sizes of the two
objects are larger, and as the distance
between them is smaller.
The gravity model of trade posits that trade
flows between two countries will be larger
• the economic sizes of the two countries are
• the geographic distance between them is
• other impediments to trade are smaller.
Economic size
• Economic size is usually measured by a
country’s GDP, which represents both its
production capability and the income that is
generated by its production.
• In statistical analysis, the elasticity of trade
values with respect to GDP is usually found
be about 1.
• In statistical analysis, a typical finding is
that a doubling of distance between partner
countries tend to reduce the trade between
them by one-third to one-half. This is
actually a surprisingly large effect, one that
cannot be explained by the monetary costs
of transport alone, because these costs are
not that high.
Other impediments
• Government policies like tariffs can place
impediments to trade.
• However, perhaps the most remarkable
finding from statistical analysis using the
gravity model is that national borders
matter much more than can be explained
by government policy barriers.
• Even for trade between the US and Canada
(where government barriers are generally
very low), this border effect is very large.
• A series of studies (McCallum, 1995;
Anderson and van Wincoop, 2003)
examined trade between the US and Canada
and show that GDP and distance are
• The key finding is that there is also an
astounding 44% less international trade than
there would be if the provinces and states
were part of the same country.
• Hence, there is something about the national
Other kinds of impediments (or removal of
impediments) to trade:
Countries that share a common language
trade more with each other.
Countries that have historical links (for
example, colonial) trade more with each
Countries that are members of a preferential
trade area trade more with each other.
Countries that have a common currency
trade more with each other.
• A country with a higher degree of
government corruption, or with weaker
legal enforcement of business contracts,
trade less with other countries.