B.  Sources of Comparative Advantage

1.  Factor endowments

• Ricardo assumed labor was the only factor of production

• Heckscher-Ohlin Theory - comparative advantage explained by differences in resource endowments

• Also known as Factor Endowment Theory

Ex. - Brazil (coffee), U.S. (wheat)

a.  Assumptions

• Perfect competition

• Same demand (tastes and preferences)

• Factor inputs uniform in quality

• Same technology

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b.  Consequences

• Relative prices differ because countries have different endowments of factor inputs

• Different commodities require different combinations of factor inputs

• Country will have comparative advantage in and export commodity where a large amount of the relatively abundant input is used

• Country will import commodity where relatively scarce input is used

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• Effect of resource endowments on comparative advantage

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• Relative abundance means relative (opportunity) cost is less

• Capital stock per worker:

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• Factor Endowment Theory

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c. Factor price equalization

• Trade alters the mix of factors used in production

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• Trade leads to equalization of relative factor prices

- Demand increases for abundant factor => price of factor increases

- Demand decreases for scarce factor => price of factor decreases

Ex. - Auto industry

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• Wages differ due to:

- Labor is not identical - differences in human capital

- Different technology used

- Transportation costs and trades barriers prevent equalization

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d.  Empirical evidence

• Leontief paradox - U.S. exporting industries have lower capital/labor ratio than import-competing industries

• Need to look at subvarieties of inputs, e.g., skilled vs. unskilled labor

• Human capital an important consideratio

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2.  Distribution of income

• Could get worse even while overall income is increasing

- If skilled workers are abundant, increased demand increases wages

- Demand for low-skilled workers decreases

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• Stolper - Samuelson Theorem

- Increase in price of goods increases income earned by resources that are used intensively in its production

- Decrease in price of goods reduces the income of the resources that it uses less intensively

- Magnification effect - change in the price of resource is greater than change in the price of good that uses the resource intensively

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• Is trade bad for unskilled workers?

- International trade and technological change increases demand for skilled workers relative to unskilled workers

- Immigration decreases supply of skilled workers relative to unskilled workers

- Education and training increases supply of skilled workers relative to unskilled workers

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a.  Immigration

• Pros

- Increase size of labor force

- Few low-skill jobs native Americans unwilling to do

- Bring jobs that contribute to technological innovation

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• Cons

- Take away jobs from Americans

- Suppress domestic wages

- Consume public services

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b.  Specific factors theory

• Workers acquire skills for specific occupations, not easily transferrable

• Resources specific to import-competing industries lose as a result of trade

• Resources specific to export industries gain as a result of trade

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3.  Skill as a source of comparative advantage

• Countries with highly educated workers - exports concentrated in skill-intensive goods

• Countries with less educated workers - export goods that require little skilled labor

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4.  Increasing returns to scale and specialization

• "New trade theory" - returns to scale added to theory of comparative advantage, not to replace it

• Nations with similar factor endowments may still trade to take advantage of economies of scale

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• Home market effect - countries specialize in products that have a large domestic demand

- Minimize transportation cost and achieve economies of scale

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• External economies

- Average cost for firm decreases as output for the industry expands in an area

- Due to pools of specialized workers, spread of knowledge

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• Small market areas may deindustrialize, become suppliers of commodities

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5.  Overlapping demands

• Linder - domestic demand key determinant for trade in manufactured goods

• Greatest export potential in markets with similar tastes and incomes

- High income - demand high quality manufactured goods (luxuries)

- Low income - demand low quality manufactured goods (necessities)

• Wealthy nations will trade with wealthy nations, poor with poor

• Unequal income distribution means some demands overlap between wealth and poor countries - some poor in wealthy countries, some wealthy in poor countries

• Evidence supports for wealthy countries, less so for developing countries

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6.  Miscellaneous issues

a.  Intraindustry trade

• Interindustry trade - trade of different products between different countries

- Due to interindustry specialization - countries focus on different industries where they have advantages

• Intraindustry specialization - focus on particular products within a given industry

Ex. - Automobiles, semiconductors

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• Intradindustry trade - two-way trade in a similar commodity

Ex. - Automobiles, computers

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• Due to:

(1) Homogeneous products

(a) Geography and transportation costs

Ex. - U.S. and Canada

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(b) Seasonality

Ex. - Northern vs. Southern Hemisphere

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(2)  Differentiated products

(a)  Minority tastes

Ex. - U.S. cars in Japan

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(b)  Overlapping demand segments

Ex. - Luxury cars to high-income buyers

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(c)  Economies of scale

• Economies of scale achieved by specializing in subcategories

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b.  Business services

• Nonstorable

Ex. - Tourism, construction, banking, finance, insurance, medical and legal services

• Comparative advantage applies

- Heterogeneous => need to look at subcategories

- Human and physical capital (communications, technology) endowments determine advantage

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7.  Product life cycle theory

• Technological innovation a key determinant of trade patterns

• Stages

(1) Manufactured good is introduced to home market

- Small market

- Technological uncertainty

(2) Domestic industry shows export strength

- Exports to markets with similar tastes and income levels

(3) Foreign production begins

- Locate closer to foreign market

- Reduce production costs

(4) Domestic industry loses competitive advantage

- Foreign imitation as technology becomes more commonplace

(5)  Import competition begins

- Production process becomes standardized

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8.  Government policy

a.  Dynamic comparative advantage

• Industrial policy - government attempts to create comparative advantage

Ex. - Japan

• Target emerging ("sunrise") industries, e.g., high tech

• Policies:

- Anti-trust immunity

- Tax incentives

- R&D subsidies

- Loan guarantees

- Low interest loans

- Trade protection

• Need cooperation by government, business, and labor

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(1)  Pros

• Allows country to expand into higher productivity industries

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(2)  Cons

• Could pick losers

• Some industries successful without government help

• Increased trade restrictions could result

• Pork-barrel politics

• Free market could achieve a better result

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b.  Government regulatory policies

• Workplace safety (Occupational Safety and Health Administration), product safety (Consumer Product Safety Commission), clean environment (Environmental Protection Agency)

• Increases cost of production

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• Tradeoff:  domestic companies hurt, more trade vs. higher quality of life

• Other domestic industries may benefit, e.g., forest products

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9.  Transportation costs

• Transportation costs - costs of moving goods, freight charges, packing and handling expenses, insurance premiums

• Obstacle to trade - could impede realization of gains from trade

a.  Trade effects

• Without transportation costs

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• With transportation costs

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b.  Impact of transportation costs

• Reduce trade

• Reduce degree of specialization

• Reduce gains from trade

• Allow factor price differentials (wages) to persist

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c.  Transportation costs decreasing

• Transportation costs as percent of imports:  1965 = 10%, 2000 = 4%

• Due to:

- Economy less transportation intensive - finished products more important now than raw materials

- Improved transportation productivity (technology)

• Large dry-bulk containers

• Large scale tankers

• Containerization

• Wide-bodied jets

• Telecommunications