sources of comparative advantage © 2011 cengage learning. all rights reserved. may not be copied,...

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Sources of ComparativeAdvantage

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password protected website for classroom use‐

PowerPoint slides prepared by:Andreea ChiritescuEastern Illinois University


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Factor Endowments• Factor-endowment theory• Heckscher-Ohlin theory• Immediate basis for trade: difference between

pre-trade relative product prices of trading nations• Prices depend on the production possibilities

curves and tastes and preferences (demand conditions) in the trading countries• Production possibilities curves depend on

technology and resource endowments


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Factor Endowments• Factor-endowment theory• Ultimate determinants of comparative

advantage• Technology• Resource endowments• Demand

• Assumption: technology and demand are approximately the same between countries


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Factor Endowments• Factor-endowment theory• Resource-endowment ratio• Determines comparative advantage

• Export the product that uses a large amount of its relatively abundant resource• Import the product which in production uses

the relatively scarce resource


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Producing aircraft and textiles: factor endowments in the United States and China

TABLE 3.1


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Factor Endowments• Effect of resource endowments on

comparative advantage


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Capital stock per worker of selected countries, 1997*TABLE 3.2


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A country exports the good whose production is intensive in its relatively abundant factor. It imports the good whose production is intensive in its relatively scarce factor.

The factor-endowment theoryFIGURE 3.1


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Factor Endowments• Factor-endowment theory, U.S.-China trade• United States• Relatively abundant: human capital (skills),

scientific talent, and engineering talent are relatively abundant• Relatively scarce: unskilled labor is relatively scarce

• China• Relatively rich: unskilled labor• Relatively scarce: scientific and engineering talent


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Factor Endowments• Factor-endowment theory, U.S.-China trade• United States exports to China • Goods embodying relatively large amounts of

skilled labor and technology• Aircraft, software, pharmaceuticals, and high-tech

components of electrical machinery and equipment

• China exports to the United States• Goods for which a relatively large amount of

unskilled labor is used• Apparel, footwear, toys, and the final assembly of

electronic machinery and equipment


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U.S.-China trade: top ten products, 2007 (thousands of dollars)

TABLE 3.3


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Factor Endowments• Factor-Price Equalization• Redirect demand away from the scarce

resource• Toward the abundant resource in each nation

• Trade leads to factor-price equalization• The cheap resource becomes relatively more

expensive• The expensive resource becomes relatively less

expensive• Until price equalization occurs


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By forcing product prices into equality, international trade also tends to force factor prices into equality across countries.

The factor-price equalization theory (a)FIGURE 3.2


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By forcing product prices into equality, international trade also tends to force factor prices into equality across countries.

The factor-price equalization theory (b)FIGURE 3.2


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Factor Endowments• Factor-Price Equalization• Real world – no full factor-price equalization• Uneven ownership of human capital• Education, training, skill, and the like

• Not all countries use the same technology • New and better technology replaces older technologies

– faster in developed countries

• Transportation costs and trade barriers• Reduce the volume of trade


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Indexes of hourly compensation, manufacturing workers, 2006 (U.S.=100)

TABLE 3.4


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Factor Endowments• Stolper-Samuelson Theorem• Extension of the theory of factor-price

equalization• An increase in the price of a product • Increases the income earned by resources that are

used intensively in its production• A decrease in the price of a product • Reduces the income of the resources that it uses

intensively• Some people will suffer losses from free trade


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Factor Endowments• Magnification effect of Stolper-Samuelson

theorem• The change in the price of a resource• Is greater than the change in the price of the

good • That uses the resource relatively intensively in

its production process


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Factor Endowments• Policy implications of Stolper-Samuelson

theorem• Even though free trade may provide overall

gains for a country• There are winners and losers

• Owners of relatively abundant resources• Favor free trade

• Owners of relatively scarce factors• Favor trade restrictions


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TRADE CONFLICTS

Globalization drives changes for U.S. Automakers

• Big Three (GM, Ford, and Chrysler)• Higher production costs• Large pension obligations and health care costs• Hundreds of thousands of retirees

• 2008, GM spent $4.8 billion on health care• $1,500 higher cost per vehicle

• Higher hourly wages: $30 (and $30 in benefits)• Toyota, Honda• Health care costs - $200 per vehicle• Hourly wages: $24 (and $24 in benefits)


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Labor-cost gap per vehicle hurts competitiveness of big three automakers

TABLE 3.5


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Factor Endowments• International trade - substitute for migration?• Immigrants • Help the economy grow• Increasing the size of the labor force• Take low skilled jobs few native-born Americans are

available to work• Take jobs that contribute to the United States being

a leader in technological innovation


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Factor Endowments• International trade• Substitute for the movement of resources from

one country to another• International movements in resources are not

essential• International trade in products can achieve the

same result• Complement labor migration, short and near-

long terms• Expanding trade – some unemployed workers• Forced to seek employment abroad


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Factor Endowments• Specific-factors theory• Income distribution effects of trade• In the short term• When resources are immobile among industries

• 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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Does Trade Make the Poor Even Poorer?

• Wage gap: skilled and unskilled workers• Some combination of trade, technology,

education, immigration, and union weakness• Income inequality - pervasive• Wages of skilled workers “relative” to those of

unskilled workers• Outcome of the interaction between supply and

demand in the labor market


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• Wage ratio • Wage of skilled workers divided by the wage of

unskilled workers• Labor ratio• Quantity of skilled workers available divided by

the quantity of unskilled workers


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Inequality of wages between skilled and unskilled workers

FIGURE 3.3

By increasing the demand for skilled relative to unskilled workers, expanding trade or technological improvements result in greater inequality of wages between skilled and unskilled workers. Also, immigration of unskilled workers intensifies wage inequality by decreasing the supply of skilled workers relative to unskilled workers. However, expanding opportunities for college education results in an increase in the supply of skilled relative to unskilled workers, thus reducing wage inequality. In the figure, the wage ratio equals wage of skilled workers/wage of unskilled workers. The labor ratio equals the quantity of skilled workers/quantity of unskilled workers.


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• International trade and technological change• Increase in the demand curve of skilled workers

relative to unskilled workers• Higher degrees of wage inequality

• Immigration • Decrease in the supply of skilled workers

relative to unskilled workers• Higher wage inequality


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• Education and training• Increase in the supply curve of skilled workers

relative to unskilled workers• Reduce the wage inequality

• Sources of wage inequality• Trade and immigration• Small effects

• Domestic sources, especially technology


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TRADE CONFLICTS

Does a “flat world” make Ricardo wrong?

• Critiques of globalization• The world has become “flat”• Comparative advantages dwindled / or dried up• China and India – economic development; more

similar to U.S.• A level playing field

• Internet, wireless technology, search engines, other innovations.• United States could become worse off with trade


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TRADE CONFLICTS

Does a “flat world” make Ricardo wrong?

• Problems with this critique• Globalization - increased international

economic interdependence• Ignores the ways in which modern trade differs

from Ricardo’s simple model• The world is not flat at all


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Skill as Source of Comparative Advantage

• U.S. • Relatively capital abundant• Relatively labor scarce• Factor-endowment theory• Export capital-intensive goods• Import-competing goods will be labor intensive


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• Leontief paradox• Capital/labor ratios, 200 export industries and

import-competing industries, 1947• Capital/labor ratio for U.S. export industries • Lower than that of its import-competing industries

• Exports - less capital intensive than import-competing goods• Import-competing goods - more capital

intensive than U.S. exports


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Factor content of U.S. Trade: capital and labor requirements per million dollars of U.S. Exports and import substitutes

TABLE 3.6


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• Exports of the U.S.• Not intensive in physical capital• Intensive in human capital• Skill intensive

• 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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The figure suggests that countries that are abundant in skilled labor capture larger shares of U.S. imports in industries that intensively use those factors. Conversely, countries that are abundant in unskilled labor capture larger shares of U.S. imports in industries that intensively use those factors.

Education, skill intensity, and U.S. import shares, 1998

FIGURE 3.4


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Increasing Returns to Scale• Increasing-returns trade theory• Nations with similar factor endowments• Negligible comparative-advantage differences

• May find it beneficial to trade • Because they can take advantage of massive

economies of scale• Produce that good in great quantity at low average

unit costs• Trade those low-cost goods to other nations


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By adding to the size of the domestic market, international trade permits longer production runs by domestic firms, which can lead to greater efficiency and reductions in unit costs.

Economies of scale as a basis for tradeFIGURE 3.5


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External Economies of Scale• External economies of scale• The average cost of the typical firm decreases• As the output of the industry within this area

increases• Concentration of an industry’s firms in a

particular geographic • Larger pools of a specialized type of worker

• New knowledge about production technology spreads among firms in the area


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Overlapping Demands as a Basis for Trade

• Theory of overlapping demands, Linder, 1960s• Factor-endowment theory - explains trade in

primary products and agricultural goods• Not trade in manufactured goods

• Force influencing manufactured-good trade• Domestic demand conditions

• Firms within a country – manufacture goods for which there is a large domestic market• A nation’s exports - extension of the production for

the domestic market


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• Theory of overlapping demands, Linder, 1960s• Consumer demand - conditioned strongly by

income levels• A country’s average or per capita income will yield a

particular pattern of demand• Nations with high per capita incomes will demand

high-quality manufactured goods (luxuries)• Nations with low per capita incomes will demand

lower-quality goods (necessities)


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• Theory of overlapping demands, Linder, 1960s• Nations with similar per capita incomes • Overlapping demand structures• Consume similar types of manufactured goods

• Wealthy (industrial) nations• More likely to trade with other wealthy nations

• Poor (developing) nations• More likely to trade with other poor nations


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Intra-industry Trade• Intra-industry specialization, trade• Production of particular products or groups of

products within a given industry• The opening up of trade does not generally

result in the elimination or wholesale contraction of entire industries within a nation• The range of products produced and sold by

each nation changes• Emphasized by advanced industrial nations


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Intra-industry Trade• Intra-industry specialization, trade• Involves flows of goods with similar factor

requirements• Conducted mostly among industrial countries• Similar resource endowments

• Firms – oligopolies• Trade in homogeneous goods• Transportation costs• Seasonal


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Intra-industry Trade• Intra-industry specialization, trade• Trade in differentiated products• Unmet need• Overlapping demand segments in trading nations• Economies of scale

• Fewer adjustment problems


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Intra-industry trade examples: selected U.S. exports and imports, 2007 (in millions of dollars)

TABLE 3.7


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Technology: The Product Cycle Theory• Technological innovations • Different nations, at different rates of speed• Result in:• New methods of producing existing commodities• Production of new commodities• Commodity improvements

• Often transitory


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Technology: The Product Cycle Theory• Product life cycle theory• Predictable trade cycle:1. Manufactured good is introduced to home

market2. Domestic industry shows export strength.3. Foreign production begins4. Domestic industry loses competitive

advantage5. Import competition begins


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Technology: The Product Cycle Theory• International product cycle• U.S. and Japanese radio manufacturers• U.S. and Japanese pocket calculators

manufacturers


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Dynamic Comparative Advantage: Industrial Policy

• Dynamic comparative advantage • Comparative advantage in a particular industry• Can be created• Mobilization of skilled labor, technology, and capital

• Industrial policy• Government is actively involved in creating

comparative advantage• Strategy to revitalize, improve, and develop an

industry


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Dynamic Comparative Advantage: Industrial Policy

• Industrial policy• Antitrust immunity, tax incentives, R&D

subsidies, loan guarantees, low-interest-rate loans, trade protection• Requires government to identify the “winners” • And encourage resources to move into industries

with the highest growth prospects


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Government Subsidies Support Boeing and Airbus

• Industrial policy• Government subsidies – commercial jetliner

industry• World’s manufacturers of commercial jetliners • Oligopolistic market• Dominated by• Boeing of the United States• Airbus Company of Europe


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• Boeing, United States • “Airbus receives unfair subsidies from

European governments”• Allegedly: • Loans for the development of new aircraft• Below-market interest rates• 70-90% of an aircraft’s development cost• Repay the loans after it delivers an aircraft• Can avoid repaying the loans in full if sales of its

aircraft fall short


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• Airbus• Defended its subsidies• Prevent U.S. from holding a worldwide monopoly in

commercial jetliners• “Boeing benefits from government assistance” • Indirect subsidies• Support aeronautics and propulsion research –

government organizations


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• Airbus• Indirect subsidies• Support for commercial jetliner innovation -

military-sponsored research and military procurement• Subcontracts part of the production of its jetliners

to Japan and China• Receive substantial governmental subsidies

• Tax breaks


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Government Regulatory Policies• Government regulations • Workplace safety• Occupational Safety and Health Administration

• Product safety• Consumer Product Safety Commission

• Clean environment• Environmental Protection Agency

• May improve the wellbeing of the public• Can result in higher costs for domestic firms


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U.S. Steelmakers complain about regulatory burdensTABLE 3.8Below are some examples of U.S. regulations affecting domestic steel producers:

•Health Care. U.S. steel companies spent more than $1.5 billion for health care in 2003 for workers, retirees, and dependents. This adversely affects the competitiveness of U.S. steel companies vis-à-vis foreign competitors, many of whose health care costs are borne by government through general tax revenues.

•OSHA. The complexity and cost of compliance with Occupational Safety and Health Administration (OSHA) regulations continue to increase. Many OSHA rules do not have a sound scientific or medical basis and thus are impractical and cost ineffective.

•Electricity Policy. Electricity is a major component of steel-manufacturing costs, but it cannot be purchased on a competitive basis as are other commodities.

•Global Climate Change. Efforts by the United States to achieve a seven percent decrease in greenhouse gas emissions from 1990 levels by the year 2012, as dictated by the Kyoto Protocol, could result in $5 billion in extra annual energy costs for U.S. steel companies.

•Clean Air. Proposed tighter standards for pollutants could place much of the United States—including many steel industry sites—in nonattainment areas. The result would be enormous new costs for steel, with no comparable requirements for U.S. trading partners.


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The imposition of government regulations (clean environment, workplace safety, product safety) on U.S. steel companies leads to higher costs and a decrease in market supply. This imposition detracts from the competitiveness of U.S. steel companies and reduces their share of the U.S. steel market.

Trade effects of governmental regulationsFIGURE 3.6


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Transportation Costs• Transportation costs• Costs of moving goods• Freight charges• Packing and handling expenses• Insurance premiums• An obstacle to trade• Impede the realization of gains from trade

liberalization


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Transportation Costs• Differences across countries in transport costs• Source of comparative advantage• Affect the volume and composition of trade

• Trade effects of transportation costs• The high-cost importing country• Produce more, consume less, and import less

• The low- cost exporting country • Produce less, consume more, and export less


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In the absence of transportation costs, free trade results in the equalization of prices of traded goods, as well as resource prices, in the trading nations. With the introduction of transportation costs, the low cost exporting nation produces less, consumes more, and exports less; the high cost importing nation produces more, consumes less, and imports less. The degree of specialization in production between the two nations decreases as do the gains from trade.

Free trade under increasing-cost conditionsFIGURE 3.7


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Transportation Costs• Transportation costs• Reduce the volume of trade• Reduce the degree of specialization in

production • Reduce the gains from trade• One possible reason for international wage

differential


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Transportation Costs• Falling transportation costs since 1965• Imports - more competitive in U.S. markets• Higher volume of trade for U.S.• Due to technological improvements• Large dry-bulk containers• Large scale tankers• Containerization• Wide-bodied jets• Telecommunications


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Size of transportation costs, selected countries, 2007TABLE 3.9


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Transportation Costs• Growing international trade• Falling transportation costs • Worldwide decrease in trade barriers• Economic opening of nations that have

traditionally been minor players


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TRADE CONFLICTS Rising energy costs hinder trade flows

• Rising sensitivity to increased energy costs• Shift toward containerization • Speed • Transport costs


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TRADE CONFLICTS Rising energy costs hinder trade flows

• Rising shipping costs• Trade should be both dampened and diverted • Substitute goods - from closer locations • Sizable surcharges on domestic shipments by

train and truck• Congested domestic transportation systems • May slow the outsourcing of goods in the

future


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Transportation Costs• Terrorist attack• Added costs• Slowdowns for U.S. freight system• Security can become a new kind of trade

barrier

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