theories of sources of ca

8/10/2019 Theories of Sources of CA

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Theories of Sources of Comparative Advantage

References:

Carbaugh: Chpt 3

Krugman: Chpt 7

Key Questions:

• What accounts for different CA in different countries?

• How does trade affect the relative welfare of the trading nations?

• How does trade affect the relative welfare of different sectors within

the same economy?•

1



(I) Overview of Theories of CA

• Two main theories: Ricardian and Heckscher-Ohlin

• Other theories: Imperfect competition, specific factor, product cycles etc

• What about theory of “competitive advantage”?

2



(II) Ricardian Trade Theory

“Differences in CA are caused by differences in relative labor productivity.

Country should export goods in sectors where its relative labor

productivities are higher than those in other countries.”

(A) Basic Model

Assumptions:

• 2 sectors (Food and Cloth)

• Single factor: Labor. Wage is the main component of national income.

• Multi-factor model: Other factors matter too -- could affect labor productivity

and offers more comprehensive explanation

3



Notation:

Labor productivity measured by Unit Labor Requirements (ULR): “Number of

labor units required to produce one unit of good” lF : unit labor requirement in Food production

lC : unit labor requirement in Cloth production

PF : price of Food

PC : price of Cloth

w: wage rate

Foreign country: same notations except with *

4



Equilibrium condition in production

Profit maximization: MC = MR (in perfect competition, AC = AR also)

• Home country: w lC = PC and w lF = PF

• Foreign country: w* lC* = P*C and w* lF* = P*F

APR in the two countries:

•

Home country: APR = Pc /PF = lc/lF • Foreign country: APR* = P*C /P*F = l*C/l*F

5



Food

Cloth

PPF

CIC

Ricardian Model: Autarky

A

6

APR: slope = lc / lf



Trade Equilibrium

• Ricardian theory: CAs between two countries are determined by the

difference between (lC / lF ) and (lC* / lF*)

• As long as (lC / lF ) and (lC* / lF*) are different, it is beneficial for the two

countries to specialize and trade

• After trade, the two APR should converge to one international price ratio, TOT

• Note that (lC / lF ) > (lC* / lF*) : Relative to foreign country, home has CA in food

production

• After trade, Home will export food and import cloth

7



(B) Wages and Productivity

Recall that in equilibrium

• Home country: w lC = PC and w lF = PF

• Foreign country: w* lC* = P*C and w* lF* = P*F

After trade, PC and P*C converge (as do PF and P*F )

Thus relative wages in 2 countries: w / w* = lC*/ lC = lF*/ lF

• Relative wages completely determined by relative labor productivity

– Home country with higher labor productivity can have high wages than

foreign country without losing export competitiveness.

• To increase competitiveness in the market, a country has to increase labor

productivity. What about wage cuts?

• What are the options if w lC > PC ?

9



What determines labor productivity?

• Technology and innovation?

• What determines technology and innovation: Government policy?

Education? Culture?

• Infrastructure: soft and hard infrastructure?

Some Misperceptions about Trade, Wages and CA

• Free trade is good only if home can stand up to foreign competition

• Trade based on low wage is unfair to other countries

• Trade leads to exploitation if home workers receive lower wages than

workers in foreign countries

10



(III) Heckscher-Ohlin Trade Theory

Theory:

• A country’s CA is determined by the relative proportion of various factors of

production that it is endowed with;

• A country should export goods which use intensively its abundant factors in

production, and import goods which use intensively its scarce factors in

production

Developed by Eli Heckscher and Bertil Ohlin (“Factor Proportions theory”)

A multi-factor model and hence can address income distribution effects of trade

11



(A) Key concepts:

• Abundant (scarce) factor: factor in which a country has a relatively larger

(smaller) supply compared with other countries – Factor abundance is country-specific. Need to know which two countries

are being compared

• Factor Intensity: If, at any given factor prices, the production of good F always

involves a higher capital/labor ratio than good C, the good F is considered

capital intensive.

H-O theory suggests: If 2 countries have different K/L ratios, they will have

different autarky price ratios and hence different CA in goods that are

produced with different factor intensities. If they specialize and export based

on that CA, both countries will gain (reach higher CICs)

Diagrammatical illustration

12



Homeland AbroadI1 I2 I3

A

A*

p

p*

Food Food

Clothing Clothing

I1 I2 I3

Two countries, with different PPF and autarky prices




A

C

P

P*

C*

A*

pW pW

Food Food

Clothing Clothing

I1 I2 I3

Trade takes place with equilibrium TOT




A

C

P

P*

C*

A*

exports imports

e

x p

im

p

pW pW

Food Food

Clothing Clothing

I1 I2 I3

Gains from Trade due to different PPF



(B) Product Price and Factor Price

• H-O theory suggests that, with trade, a country tends to export its abundant

factor, as embodied in its exported goods; and import the scarce factor, asembodied in the imported goods. This implies

•

• Trade in goods can be substitute for trade in factors

• Factor prices across countries tend to converge with trade (factor price

equalization theory)

• Policy implication: Restrictions in cross-border factor movements can be

overcome by trade in goods though this takes a longer time.

16



(C) Trade and Income Distribution

• Trade raises prices of abundant factors and lowers prices of scarce factors

(relatively) within a country (Stolper-Samuelson Theorem) – Friction caused by trade among different groups in the same economy

– Implications for protectionist trade policies

• Could trade widen income gap?

–Trade generally reduces income inequality within a country

– But trade could also worsen income inequality within a country

depending on the pre-trade relative prices – if abundant factors are

already more highly paid than scarce factors.

• Broader definition of “labor” and “capital”

17



(IV) Imperfect Competition and Scale Economies and Trade

(A) Overview

Ricardian and HO theories

• Assume constant return to scale (CRTS) in production and perfect competition

• CA and trade pattern changes only with changes in resource endowments

and/or technologies

•Explain only inter-industry trade among countries with different resourceendowments or technologies

In reality, we observe

• Existence of imperfect competition and increasing returns to scale (IRTS)

•

CA and trade pattern can change over time even without changes in resourcesor technology

• Widespread intra-industry trade among economies with similar resource

endowments and technologies

18



Increasing Returns to Scale (IRTS)

Allowing for imperfect competition and IRTS helps provide more comprehensive

explanation of trade patterns

“Production becomes more efficient the larger the scale i.e. increase in inputs

leads to more than proportionate increase in output”

• Average cost (AC) curve is downward sloping

Internal IRTS: “Average cost of production (AC) depends on size of individual

firms, not necessarily size of industry”

• Often results in monopolistic market structure (i.e. monopoly, oligopoly or

monopolistic competition) to capture scale economies

External IRTS: “Average cost of production (AC) depends on size of the industry,not necessarily size of individual firms”

• Individual firms may remain perfectly competitive

• No advantage in being a large firm. There can be many small firms in the

industry e.g. Silicon Valley

19



(B) Internal Increasing Returns to Scale and CA

Assumptions

• 2 countries, 2 goods (manufacturing and food)• Home: capital abundant; Foreign: labor abundant

• Manufacturing: capital intensive; Food: labor intensive

• Internal IRTS in manufacturing

Results in monopolistic competition, with firms producing differentiatedproducts within the same industry

Trade Equilibrium

H-O theory: suggests

• Home exports manufacturing, imports food

• Foreign exports food, imports manufacturing

20



With Internal IRTS

• Trade increases the total market size, allows firms in both countries to

specialize within a certain range of products and exploits Internal IRTS

• Home still exports manufacturing, but NOT the whole range; Foreign also

exports some manufacturing goods (See Diagram)

• Two parts of trade

– Inter-industry trade: based on traditional CA

– Intra-industry trade: based on Internal IRTS

• Relative importance of the 2 types of trade depends on similarity/differences

between the 2 countries

– The more similar (in endowments or technology), the more important isintra-industry trade

– Similarity in technology or resource endowment will not rule out trade

21



Trade in a World Without Increasing Returns

22



Trade with Increasing Returns and Monopolistic Competition

23



Policy Implications

• Help explains a sizeable part of international trade in the world, especially

similarly endowed economies e.g. European countries

• Developed economies become more “similar” over time, yet trade volume

does not diminish. Implications for Asia?

• Industrial adjustment problems are less severe in intra-industry trade: inter-

industry requires movement of resources from different industries. – Certain factors esp labor are not mobile (either occupationally or

geographically) in short run; structural unemployment severe

• Effects on income redistribution less severe (since intra-industry trade takes

place within same industry and involves the same factors); makes free trade

policy more acceptable politically

24



Indexes of Intra-Industry Trade for U.S. Industries, 2009

25



(C) External Increasing Returns to Scale and CA

Sources of External IRTS

Derived from “agglomeration effect” that may arise from

• Specialized suppliers

• Labor market pooling

• Knowledge spillover

Important for “innovation-driven” businesses

26



Implications for Trade Pattern

External IRTS tends to result in geographical concentration of production as

countries get “locked in” to a particular production (See Diagrams)• As production scale increases, agglomeration effect takes place, AC falls and

CA strengthened

• More firms attracted to same locality, production expands further. Other

countries find it hard to enter and compete with incumbent

• Cross-border mobility of factors of production (e.g. capital and labor) willreinforce the effect of external IRTS i.e. more rapid agglomeration

• Examples; London as global financial center; Hollywood as global film

production center

27



External Economies Before Trade

28



Trade and Prices

29



Implications of Geographical Concentration of Production

• External IRTS could lead to “winner-takes-all” outcome

• Initial position matters.

– Concept of first mover advantage

• What accounts for initial advantage? Natural CA?

–

Accident of history? – Resources needed for production is available in a particular country only

– Large domestic market size helps as it brings down AC

• Government policies can play a role in acquiring first mover advantage

–Strategic industrial policy?

30



Implications for Trade Policy

External IRTS makes it less easy to advocate free trade policy

• A form of market failure

• Initial government help may be needed to break into market (See Diagram)

– Once home country breaks into market, could wrestle the whole market

from incumbent producer: “winner takes all” for home country

– Justification for “strategic” policy (protectionist policy) to secure “critical

mass” and “first mover advantage”

– Competition among governments to establish first mover advantage

through various subsidies

31



External Economics and Specialization

32



• Protectionist policy (import substitution) might increase national welfare?

(See Diagram)

•

Some caveats – Difficult to estimate benefits of External IRTS

– Retaliation by other countries

33



External Economics and Losses from Trade

34

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