International 1 Chap 2

Instructor: Dr. Surajit Ghosal.
International
Economics I
CHAPTER TWO
THEORIES OF INTERNATIONAL TRADE
Introduction
While studying international trade, two obvious questions may be asked: first, why does
international trade takes place? And second, what is the condition under which trade is possible?
In today’s world of unlimited wants, no nation by itself can produce all the goods and services
which its peoples require for their consumption. Nature has distributed the factors of production
unequally over the surface of the earth. Countries differ in terms of natural resources, climatic
conditions, mineral resources and mines, labor and capital resources, technological capabilities,
entrepreneurial and managerial skill and a whole host of other variables which determine the
capacity of countries to produce goods and services. All these differences in production
possibilities leads to situations where some countries can produce some goods and services more
efficiently than others; and no country can produce all the goods and services in most efficient
manner, i.e., at the lowest cost of production. The classical economists were of the opinion that
international trade takes place due to difference in the costs. Therefore, a country specializes in
the production and export those goods and services in which it has an absolute or comparative
cost advantage; and it imports other goods and services in the production of which it has an
absolute or comparative disadvantage over other countries of the world. The basis for
international trade is the gain or profit to be made from exchange of goods and services. If there
are no gains to be obtained, according to classicalist, there would be no such trade between
countries. The classicalist theory of international trade is based on labor theory of value. Under
the labor theory of value, the value or the price of the commodities depends exclusively on the
amount of labor going to the production of commodities; by assuming that labor is the only
factors of production and it is homogeneous.
It is necessary to contrast these views with the early views-the pre-classicalist on international
trade. The so-called Mercantilists’ view, which was popular from the 16thc to the middle of
18thc, was that the wealth of the country is measured by the amount of gold and other precious
metal possessed. And they strongly believed that a nation could gain in trade only at the expense
of other nations .i.e., trade was zero-sum game.
Assosa University, FBE, Department of Economics, 2015 Page 1

Instructor: Dr. Surajit Ghosal. International
Economics I
The latter economists, Prof. Haberler developed a new theory of comparative advantage which is
based on opportunity cost in place of labor cost theory which has introduced by D. Ricardo. In
modern times, Swedish economists criticized this theorem of opportunity cost and develop a new
version of international trade which is generally known as the Heckscher-Ohlin version of
comparative cost.
Dear students! In this part, we will first examine the mercantilist views of international trade,
then the classical theory of international trade (as it was presented by Smith and Ricardo and
then extended by Prof. Harbler) and then we will briefly review the theory of international trade
given by Heckscher and Ohlin. Attempt has been also made to examine trade based on,
economies of scale, imperfect competition and dynamics of technology.
2.1 THE MERCANTILISTS’ VIEW ON TRADE
Modern trade theory is the product of an evolution of ideas in economic thought. In particular,
the writings of the Mercantilism, and later those of Adam Smith and David Ricardo, have been
instrumental in providing the framework of modern trade theory. First, we will have a look at the
Mercantilists’ view on trade. We give emphasis for the study of Mercantilism not because we are
interested in history of economic thought as such, but because it helps us understand the classical
view on international trade since they are regarded as reactions to the mercantilists’ view on
trade and the role of government. Moreover, their policy like import restriction has its own
implication for today’s economic activities.
Dear students! What is the concern of mercantilist trade theory? How a nation can accumulate
gold &silver (which were the mediums of exchange)?
Mercantilists were a group of writers who appeared in Europe (esp. in England) during the
period 1500 – 1800. They are concerned with the process of ‘nation building’ i.e. how to make
a given nation powerful economically and politically. The main feature of the mercantilist
doctrine was that a country could grow rich and prosperous by acquiring more and more precious
metals especially gold, and, therefore, all the efforts of the state should be directed to such
economic activities that help a country to acquire more and more precious metals. That means,
they advocated that the government should stimulate exports and restrict imports.

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In other words, for a nation to be powerful economically and politically, the nation should
accumulate as much of gold and precious metals (which were the medium of exchange at that
time) as possible.
To accumulate large amount of gold, and precious metals a country should export more and
import less. Increasing export will enable a country obtain large amount of gold and precious
metals; whereas decreasing imports will save the amount of gold and precious metals to be spent.
Thus, such more revenues than spending would contribute to a rise in domestic output and
employment. Moreover, with more gold and silver, rulers could mention larger and better armies
and consolidate their power at home; improved armies and naives also made it possible for them
to acquire more colonies.
According to the mercantilist school of economists, if international trade is not properly
regulated then people might exchange gold for commodities of daily use or require for a
luxurious living. This would lead to the depletion of the stock of precious metals within the
nation. Thus, exports were viewed favorably so long as they brought in gold but imports were
looked at with apprehension as depriving the country of its true source of riches, i.e., precious
metals.
Taxing imports was often justified as a way of creating jobs and income for the national
population. Imports were supposed to be bad because they had to be paid for, which might cause
the nation to lose gold or silver to foreigners if it imported a greater value of goods and services
than it sold to foreigners. Imports were also to be feared because those same foreign goods might
not be available in time of war.
Therefore, according to mercantilists, since not all nations could have an export surplus
simultaneously, a nation could only gain at the expense of the other nations i.e. they believed that
trade is a zero-sum game.
Criticisms
1. The first attack against mercantilists’ economic policies came from David Hume.
According to Hume, favorable trade balance was possible only in the short run, for over
time it would automatically be eliminated. For example, suppose England were to
achieve a trade surplus that resulted in an inflow of gold and silver. Because these

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precious metals constitute England’s money supply, their inflow would increase the
amount of money circulating in England. This would lead to a rise in prices of goods and
services in England relative to its trading partners. Higher prices of domestic goods
would therefore encourage English residents to purchase foreign produced goods, while
England’s exports would decline due to their increased prices. As a result the country’s
trade surplus would eventually be eliminated. Hence, Hume showed that mercantilists’
policies could provide at best only short-term economic advantages.
2. Mercantilists were also attacked for their static view of the world economy. They used
to view trade as a “gamble”. This meant that one nation’s gains from trade come at the
expense of its trading partners; not all nations could simultaneously enjoy the benefits of
international trade. This view of the mercantilists was criticized by Adam Smith, who
showed that the world’s economic pie is not a fixed quantity and international trade
permits benefit to all the trading partners.
2.2 THE CLASSICAL TRADE THEORIES

2.2.1 The theory of Absolute Advantage: Adam Smith
The classicals started their analysis with the simple truth that for two nations to trade with each
other voluntarily, both nations must gain. If one nation gained nothing or lost, it would simply
refuse to trade. But how does this mutually beneficial trade take place and where these gains do
from trade come is the question. In this section we are going to see the ideas of Adam Smith and
David Ricardo in answering the question.
Dear students! What is absolute cost advantage? What was Adam Smith’s view on international
trade? What determines the movements of goods &services among nations?
Have you tried? Good. Adam Smith, a classical economist, was a leading advocate of free trade
(open markets) on the grounds that it promotes international division of labor. According to him,
with free trade nations could concentrate their production on those goods they can produce most
cheaply, and import the remaining goods from other countries at relatively lower price.
Accepting the idea that cost differences govern the movement of goods among nations, Smith
sought to explain why production costs differ among nations. He maintained that productivities

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of factor inputs represent the major determinant of production costs. Such productivities are
based on natural or enquired advantages such as:
 Natural advantages include factors relating to
- Climate
- Soil and mineral wealth, etc.
 The acquired advantages include
- Special skills and techniques, capital, etc.
Smith, thus, viewed the determination of competitive advantage from the supply side of the
market i.e. a given nation is said to have competitive advantage in production of a given
commodity if it can produce it at the lowest possible cost.
Smith’s concept of cost was founded up on the labor theory of value which assumes that within
each nation:
1. Labor is the only factor of production and is homogeneous(of same quality) and
2. The cost or price of a good depends exclusively up on the amount of labor required to
produce it.
For example, if the United States uses less labor to produce a yard of cloth than the United
Kingdom, U.S. production cost would be lower.
Adam Smith attacked the mercantilist views on what constituted the wealth of nations, and what
contributed to “nation building” or increasing the wealth and the welfare of nations. Smith was
the first economist to show that goods rather than gold or treasure was the true measure of the
wealth of the nation. He argued that the wealth of nation would expand most rapidly if the
government would abandon mercantilist controls over foreign trade. He believed that all nations
would gain from free trade and strongly advocated a policy of laissez-faire (i.e., as little
government interferences with the economic system as possible). Free trade would cause world
resources to be utilized more efficiently and would maximize world welfare.
Smith also exploded the mercantilist myth that in international trade one country can gain only at
cost of other countries. According to him trade between two nations in based on absolute
advantage. When one nation is more efficient than (or has an absolute advantage over) another in
the production of one commodity but if less efficient than (or has an absolute disadvantage with

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respect to) the other nation in producing a second commodity, then both nation can gain by each
specializing in the production of the commodity of its absolute advantage and exchange its part
of output with the other nation for the commodity of its absolute disadvantage. By this process,
resources are utilized in the most efficient way and the output of both commodities will rise. This
increase in the output of both commodities measures the gain form specialization in the
production which is available to divide between the two nations through trade.
Assumptions
1. 2 countries, 2 products and 1 factor of production (Labor)
Labor is homogeneous (of the same quality)
2. There exists constant returns to scale ( i.e. constant marginal opportunity cost conditions)
3. Both countries can produce both goods if they wish
4. Full employment of labor in both countries
5. Technology is fixed and transportation cost is zero
Smith’s trading principle was the principle of absolute advantage. In a two- nation, two –
product world, international trade and specialization will be beneficial when one nation has an
absolute cost advantage (that is, uses less labor to produce a unit of a product) in one good and
the other has an absolute cost advantage in the other good. Hence, for the world to benefit from
international trade and division of labor, each nation must have a good in production of which it
is absolutely more efficient than its trading partner. In such a case, a nation will import those
goods in which it has an absolute cost disadvantage; it will export those goods in which it has an
absolute cost advantage.
NB
 The case for absolute advantage implies each country produces more of something per
unit of resources used than the rest of the world. In other words, absolute advantage
occurs when a particular can produce more of a specific commodity than another country
using the same amount of resources.
 More specifically, absolute advantage exists when one country is good at producing one
item, while another country is good at producing another item.

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Consider the following example. Suppose workers in USA can produce 5 gallons of wine or
20 pounds of cheese in one hour, while workers in the United Kingdom can produce 15
gallons of wine or 10 pounds of cheese in one hour.
Table 1
Output per labor hour
Nation Wine Cheese
U.S (home) 5 gallons 20 pounds
U.K (foreign) 15 gallons 10 pounds
Home has absolute cost advantage in the production of cheese because her cheese producers are
more efficient than that of foreign and foreign has absolute cost advantage in the production of
wine. Thus, home should specialize in the production of cheese and foreign in the production of
wine.
According to smith, each nation benefits by specializing in the production of the good that it
produces at a lower cost than the other nation, while importing the good that it produces at a
higher cost. Because the world uses its resources more efficiently as the result of specializing
according to the principle of absolute advantage, there occurs an increase in the world output,
which is distributed to the two nations through trade. Thus, according to Smith, international
trade benefits both the trading partners (instead of a single nation) provided that each nation has
an absolute cost advantage in one commodity.
Activity
What is absolute cost advantage for both home & foreign nations from table below?
Nation Wine Cheese
Home 40 15
Foreign 20 30

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Gains from trade

Suppose countries A and B are endowed with X amounts of factors of production such that
country A can produce either 100 units of Rubber or 50 units of Textile or any other mix of both
goods in between. Country B can produce either 50 units of Rubber or 100 units of Textile or
any other mix in between.
From the above production possibilities (or supply conditions) it is quite clear that country A has
an absolute advantage in the production of rubber, and country B has an absolute advantage in
the production of textile. This means there is symmetrical factor distribution between the two
countries so that there is scope for specialization in production and also a scope for establishing
mutually beneficial trade between the two countries.
Let us see how that happens.
A. Autarky (closed economy) situation

In a situation of autarky or no trade between the two countries, each country can produce and
consume independently of the other country, such a combination of Rubber and Textile as shown
below.
Table 2 Production and Consumption under autarky
Rubber Textile Total Output

A 50 units 25 units 75 units
B 25 units 50 units 75 units
World 75 units 75 units 150 units

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From the table we can see that country A produces and consumes 50 units of rubber and 25 units
of textile. Thus, its total production is 75 units and this is the maximum consumption level if we
assume that saving is zero. Country B produces 25 units of rubber and 50 units of textile. So its
total production is 75 units and total consumption will also be 75 units assuming saving is zero.
For our simple world of two countries, therefore, world production and consumption will be 150
units.
Dear learner, what do you think would happen if there is a possibility to trade between these
nations?
B. Open economy situation
Opening up of trade gives the two countries the opportunity to specialize in production. Country
A would specialize in the production and export of rubber because in this line of production it
has an absolute advantage over country B and country B will be will specialize in the production
and export of textile because has absolute advantage over Country A in this particular line of
production.
Table 3 Production level with trade
Rubber Textile Total Output
A 100 units 0 100 units
B 0 100 units 100 units
World 100 units 100 units 200 units
After the trade establishment, Country A produces only rubber and B produce only textile. Now,
Country A produces 100 units of rubber and this is also the new total production of Country A
after trade. In the same way, Country B produces 100 units of textile and it is the new total
production of B after trade.
 After trade both countries become richer by 25 units than their situation without trade.
The world’s total output has also increased from 150 units before trade to 200 units after
trade, thus, a gain of 50 units. This is what we call the production gain from
International Trade.
What about consumption gains?

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 The world’s consumption gains to the two countries depend upon the terms of trade
(TOT) i.e. how many units of rubber are exchanged for one unit of textile between
Countries A and B.
Case 1- Trade at TOT= 1:1

At this TOT Country A agree with B to exchange 1 unit of rubber for 1 unit of textile. Then
depending upon the taste pattern in the two countries and upon how much or how little they want
to trade each other’s goods, the consumption gains can be determined.
Let us say Country A, after trade, has produced 100 units of rubber. Consumers in country A
want to consume 60 units of rubber, which means that this country can export 40 units of rubber
to Country B in exchange for 40 units of textile imports.
Table 4 Consumption shares after international trade at TOT = 1:1
Rubber Textile Total Consumption Consumption gains
M
A 60 units 40 units 100 units 25 units
M
B 40 units 60 units 100 units 25 units
World 100 units 100 units 200 units 50 units
As a result the consumption level of each country increases by 25 units than their situation
without trade. Country A’s consumption gain has been equal to 25 units (100 units after trade –
75 units before trade).
Similarly, B’s consumption gain is 25 units (100 units after trade – 75 units before trade). The
entire world’s consumption gain has been 50 units (200 units after trade – 150 units before
trade).
Case 2- Trade at TOT = 4:3

At this TOT 4 units of rubber are exchanged for 3 units of textile in the international market.
This would result in a situation of consumption gains such as the one represented below.

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Table 5 Consumption shares after trade at TOT = 4:3

Rubber Textile Total Consumption Consumption gains
M
A 60 units 30 units 90 units 15 units
M
B 40 units 70 units 110 units 35 units
World 100 units 100 units 200 units 50 units
After trade, country A produces 100 units of rubber; at the terms of trade 4:3, country A retain 60
units of rubber for its own consumption and export 40 units of rubber and import 30units of
textile, this means, country A’s consumption share of rubber and textile is 60 + 30 and B’s
consumption share of two goods would be 40 + 70, as you can see in table above.
Country A’s consumption gain has been equal to 15 units (90 units after trade – 75 units before
trade).
Similarly, B’s consumption gain is 35 units (110 units after trade – 75 units before trade). The
entire world’s consumption gain has been 50 units (200 units after trade – 150 units before trade)
Example 2
With reference to the table below,
A. Indicate in what commodity the U.S and The U.K have an absolute advantage.
B. How much would the U.S and the U.K gain if 6W were exchanged for 6C?
C. What if 6W were exchanged for 3C? (Homework)
U.S U.K
Wheat (Quintals/hour) 6 1
Cloth (Meters/hour) 1 3
Solutions
A. U.S has an absolute advantage in wheat production while U.K has an absolute advantage
in cloth production
B. If U.S exchanged 6W for 6C with U.K, U.S would gain 5C or would save 5 labor-hours
(since U.S can only exchange 6W for 1C domestically). The 6W which U.K receives
from U.S is equivalent to or would have required 6 labor-hours to produce in U.K. Thee
same 6 labor-hours can produce 18C in U.K. By exchanging 6C (which requires only 2
labor-hours to produce) for 6W, U.K thus gains 12C or saves 4 labor-hours.

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2.2.2 Theory of Comparative Advantage: David Ricardo
What is comparative advantage? What determines trade among nations? What will be the
directions of movements of goods &services among nations?
Dear students! You have seen how Adam Smith’s absolute cost advantage determines trade
among nations. Now let us see how the theory of comparative advantage determines trade among
nations. According to Adam Smith, mutually beneficial trade requires each nation to have
absolute cost advantage in the production of at least one commodity that it can export to its
trading partner. But what if a nation is more efficient than its trading partner in the production
of all goods?
Dissatisfied with this looseness in smith’s theory, David Ricardo (1772 – 1823) developed the
principle of comparative advantage to show that mutually beneficial trade can occur even when
one nation is absolutely more efficient in the production of all goods.
Like Smith, Ricardo emphasized the supply side of the market. That is, the immediate basis for
trade is stemmed from cost differences between nations, which were under laid by their natural
and acquired advantages.
In general, according to Ricardo’s comparative advantage principle, even if a nation has
an absolute cost disadvantage in the production of both goods; a basis for mutually
beneficial trade may still exist. The less efficient nation should specialize in and export
that good in which it is relatively less inefficient (where its absolute disadvantage is the
least) and the more efficient nation should specialize in and export that good in which it
is relatively more efficient (where its absolute advantage is the greatest). OR
Even if a nation had an absolute advantage in the production of both commodities with
respect to the other nation, mutually advantageous trade could still take place. The less
efficient nation should specialize in the production and export of the commodity in which
its absolute disadvantage is less. This is the commodity in which the nation has a
comparative advantage. On the other hand, the nation should import the commodity in
which its absolute disadvantage is greater. This is the area of its comparative
disadvantage. This is known as the law of comparative advantage, one of the most
famous still unchallenged laws of economics.

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To demonstrate the principle of comparative advantage, Ricardo used the following simplifying
assumption;
1. The world consists of two nations (home &foreign), each using a single input (labor) to
produce two commodities (wine &cheese). I.e. two – nations, two-commodities, and a
single input.
2. In each nation, labor is the only input (the labor theory of value).Each nation has a fixed
endowment of labor, and labor is fully employed and homogeneous.
3. Labor can move freely among industries with in a nation but is incapable of moving
between nations.
4. The level of technology is fixed for both nations. Different nations may use different
technologies, but all firms within each nation utilize a common production method for
each commodity.
5. Unit costs do not vary with the level of production (constant returns to scale) and are
proportional to the amount of labor used.
6. Perfect competition prevails in all markets. That is,
7. Free trade occurs between counties; that is, no government barriers to trade exist.
8. Transport costs are zero.
Let’s see Ricardo’s comparative advantage if one nation (home) has absolute cost advantage in
the production of both goods (cheese & wine).
Assume that in one hour’s time, home workers can produce 40 gallons of wine or 40 pounds of
cheese, while foreign Workers can produce 20 gallons of wine or 10 pounds of cheese.
The following table summarizes the illustration.
Nation Wine Cheese
U.S (home) 40 gallons 40 pounds
U.K (foreign) 20 gallons 10 pounds
According to A. smith’s principle of absolute advantage, there is no basis for mutually beneficial
specialization and trade, because home is more efficient in the production of both goods.

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Ricardo’s principle of comparative advantage, however, recognizes that the home is four times
40 40
as efficient in cheese production ( 10 = 4) but only twice as efficient in wine production ( 20 = 2).
The home thus has a greater absolute advantage in cheese than in wine, while the foreign has a
smaller absolute disadvantage in wine than in cheese. Hence, home has a comparative advantage
in cheese production and specializes in it, and foreign has a comparative advantage in wine
production and specializes in it. Each nation exports that good in which it has a comparative
advantage and the output gains from specialization will be distributed to the two nations through
the process of trade.
2.2.3 Comparative advantage in money terms
Although Ricardo’s comparative advantage principle is used to explain international trade
patterns, people are not generally concerned with which nation has a comparative advantage
when they purchase something. The buyer relies on price, after allowing for quality differences,
to tell which nation has the comparative advantage. It is helpful, then, to illustrate how the
principle of comparative advantage works in terms of money. Consider the following example
which restates the above example of comparative advantage model.
Recall that,
- Home has an absolute advantage in both goods
- Home has a comparative advantage in the production of cheese, where as foreign has a
comparative advantage in the production wine.
Suppose the wage rate is $ 20 per hour in the home and $ 8 in foreign. If home workers can
produce 40 pounds of cheese in an hour, the average cost of producing a pound of cheese is $
20
0.50 ($ 40 pounds = 0.50 per pound); similarly, the average cost of producing a gallon of wine in
the home is $ 0.50. Because Ricardian theory assumes that markets are perfectly competitive, in
the long run a product’s price equals its average cost of production.
8
Similarly, the average cost of producing a pound of cheese in foreign is $0.8( 10 pounds = $0.8),
and the average cost of producing a gallon of wine in foreign is $0.40.
The following table summarizes per the unit costs/prices of wine and cheese in both counties,
given the wage rates.

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Per unit price(cost)

Nation Cheese Wine
Home $ 0.50 $ 0.50
Foreign $ 0.80 $ 0. 40
Comparing the costs of production between the two countries, we see that foreign has a lower
cost in the production of wine but higher costs in cheese production than home. The foreign thus
has a comparative advantage in wine and home has a comparative advantage in cheese.
We conclude that even though the foreign is not as efficient as the home in the production of
wine (or cheese), its lower wage rate more than compensates for its inefficiency. Given the wage
rates, the foreign selling price is lower than the home selling price, and foreign exports wine to
the home.
2.2.4 Comparative advantage and Opportunity cost
Do you say Ricardo’s comparative advantage principle is realistic? Ricardo’s law of comparative
advantage suggested that specialization and trade can lead to gains for both nations when
comparative advantage exists. His theory, however, depends on the restrictive assumption of
labor theory of value, in which labor was assumed to be the only factor input. In practice,
however, labor is only one of several factor inputs.
Recognizing the short comings of the labor theory of value, modern trade theory provides a more
generalized theory of comparative advantage. It explains the theory by using production
possibility schedule (pps), also called a transformation schedule. This schedule shows various
alternative combinations of two goods that a nation can produce when all of its factor inputs
(land, labor, capital and entrepreneurship) are used in their most efficient manner. It illustrates
the maximum output possibilities of a nation.
Figure 2.1 illustrates hypothetical PPS for US and Canada. By fully using all the available inputs
with the best available technology during a given time period, the U.S. could produce either 60
bushels of wheat or 120 autos or certain combinations of the two products. Similarly, Canada

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could produce either 160 bushels of wheat or 80 autos or certain combinations of the two
products.
How does the production possibility schedule suggest the concept of comparative advantage?
The answer lies in the slope of the PPS, which is called Marginal rate of transformation (MRT).
The MRT shows the amount of one product a nation must sacrifice to get one additional unit of
the other product:
wheat
MRT = Autos
Figure 2.1 Comparative Advantage in terms of production possibility frontier
Wheat Wheat
United States 160 Canada
60
120 Aut 80 Auto

o
This rate of sacrifice is sometimes called the opportunity cost of a product. The MRT of wheat
into autos gives the amount of wheat that must be sacrificed for each additional auto produced.
- In U.S the opportunity cost of each auto produced is 0.5 bushels of wheat.
- In Canada the relative cost of each auto produced is 2 bushels of wheat.
Hence, it costs low bushels of wheat to produce one auto in U.S. than in Canada, implying
that U.S has a comparative advantage in production of autos. Similarly, Canada has a
comparative advantage in production of wheat.
2.2.5 Trading under constant - cost conditions

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This section illustrates the principle of comparative advantage under constant opportunity cost
condition. The discussion focuses on two questions:
1. What are the basis for trade and the direction of trade?
2. What are the potential gains from free trade for a single nation and the world as a whole?
The fact that the PPS is linear indicates that the relative costs of the two products do not change
as the economy shifts its production from all wheat to all autos or somewhere in between. That
is, the opportunity cost of producing one more unit of auto is equal amount of wheat no matter
what level of auto the country is producing.
There are two reasons for constant costs:

1. The factors of production are perfect substitutes for each other.
2. All units of a given factor are of the same quality. That is, as a country transfers resources
from the production of wheat into the production of autos, or vice versa, the country will
not have to resort to resources that are less well suited for the production of the
commodity. Therefore, the country must sacrifice exactly the same amount of wheat for
each additional auto produced; regardless of how many autos it is already producing.
2.2.5.1 Basis for trade and direction of trade

Referring to figure 2.2, assume that in autarky (with the absence of trade),
- The U.S prefers to produce and consume at point A on its production possibility schedule
( i.e. 40 autos and 40 bushels of wheat)

- Canada produces and consumes at point A’ on its PPS (i.e. 40 autos and 80 bushels of
wheat )
Figure 2.2 Production possibility schedule, the basis for trade and the direction of trade
Wheat U.S Wheat Canada
160 B’
60 80 A’

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A
40
B
40 Autos Autos
120 40 60 80 160
What is production gain of trade? The slopes of the PPSs indicate that the relative cost of
producing one auto is only 0.5 bushels of wheat in U.S, but 2 bushels of wheat in Canada.
As for the direction of trade, we find U.S specializing in and exporting autos, and Canada
specializing in and exporting wheat.
2.2.5.2 Production gains from specialization

The slope of PPS suggests the comparative advantage of a country. Accordingly, U.S. has a
comparative advantage in the production of autos (because she sacrifices only 0.5 bushels of
wheat for each auto produced) and Canada has a comparative advantage in the production of
wheat.
U.S., thus, move from point A to B, totally specializing in auto and Canada moves from point A’
to B’, totally specializing in the production of wheat.
Taking advantage of specialization can result in production gains for both countries.
Prior to specialization:
- U.S produces 40 autos & 40 bushels of wheat, and
- Canada produces 40 autos & 80 bushels of wheat
- The world output is 80 autos and 120 bushels of wheat
But with complete specialization:
- U.S produces 120 autos & no wheat, and
- Canada produces no autos, but 160 bushels of wheat
- The world output is 120 autos and 160 bushels of wheat
Combining these results, we find that both nations together have experienced a net production
gain of 40 autos and 40 bushels of wheat under conditions of complete specialization.
Generally speaking, specialization enables the world to efficiently utilize her scarce resources,
thus resulting in higher world output. The PPS indicates that U.S. resources are more efficient in

Economics I
the production of autos, (but less efficient in the production of wheat) than Canada. Hence, when
U.S. specializes in the production of autos, (and Canada in the production of wheat) resources of
both countries will be used in their efficient manner.
Can you explain consumption gain from trade? In the absence of trade, the consumption
alternative of U.S and Canada were limited to points along their domestic PPSs, (specifically, the
point where their PPSs, are tangent to the highest indifference curve) i.e. A and A’ respectively.
But with specialization and free trade the two nations achieve consumption points outside their
domestic PPSs, i.e. they can thus consume more of wheat and autos, reaching a higher
indifference curves, II.
2.2.5.3 Consumptions gains from trade

Refer to figure 2.3 below.
Figure 2.3 Consumption gains from trade
wheat
Whea
t
U.S. t Canada
160
t
100 C’
80 A’
60
C
II
A I
40 II
I t
t 40 60 80 160 Auto
auto
40 60
The post trade consumption points that a nation can achieve is determined by the terms of trade
(the exchange rate of the products in the market). Under constant – cost conditions, slope of PPs
defines the domestic rate of transformation (domestic terms of trade). For a country to consume
at some point out of its PPs, it must be able to exchange its export goods internationally at terms
of trade more favorable than the domestic terms of trade.

Economics I
Suppose both nations agree on the terms of trade (TOT) of 1:1 ratio, where by 1 auto is
exchanged for one 1 bushels of wheat. This TOT is represented by line tt in the figure. This line
is called the trading possibilities line (note that it has a slope of negative one).
Given this TOT, suppose U.S decides to export 60 autos to Canada in return for 60 bushels of
wheat. Now,
- U.S will reach the consumption point of C (consumes 60 autos and 60 bushels of wheat)
- Canada will move from A’ to C’ (consuming 100 bushels of wheat and 60 autos)
Thus, both countries could reach a higher indifference curve (II) or they could consume more of
both commodities
2.2.5.4 Distributing the gains from trade
In our example we have seen the TOT agreed on will benefit both nations. Note that the
consumption gains from trade are not always distributed equally between countries. The
distribution of gains depends on the position of the international terms of trade line relative to the
PPs of countries. For example, the closer the international TOT is located to the U.S. PPs, the
smaller are the U.S consumption gains from trade. At the extreme, if the international TOT were
to coincide with the U.S domestic rate of transformation, the U.S. would not realize any gains
from trade. This is because the U.S post trade consumption would lie along her PPs.
The domestic transformation rates of U.S and Canada sets a limit within which the international
TOT must fall. The exact (actual) location of TOT depends on the relative demand of the two
nations for the products in question.
2.3 THE NEOCLASSICAL TRADE THEORY

2.3.1 Factor – Endowment Theory (Heckscher – Ohlin Theory)
To explain the role of resource differences in trade, this section examines a model in which
resource differences are the only source of trade. Of all the possible reasons for differences in
comparative advantage among nations, H-O theory isolates the difference in relative factor
abundance or factor endowments among nations as the basic cause or determinant of
comparative advantage and international trade. That international trade is largely driven by

Economics I
differences in countries' resources is one of the most influential theories in international

economics. Developed by two Swedish economists, Eli Heckscher and Bertil Ohlin (Ohlin
received the Nobel Prize in economics in 1977), the theory is often referred to as the Heckscher-
Ohlin theory. Because the theory emphasizes the interplay between the proportions in which
different factors of production are available in different countries and the proportions in which
they are used in producing different goods, it is also referred to as the factor-proportions
theory.
Assumptions of the Theory

The Heckscher-Ohlin theory based on the following assumptions:
1. There are two nations, two commodities (Wheat and Cloth), and two factors of
production (labor and capital).
2. Both nations use the same technology in production
3. Both commodities are produced under constant returns to scale in both nations
4. There is perfect competition in both commodities and factor markets in both nations.
5. There is perfect factor mobility within each nation but no international factor mobility
6. There are no transportation costs, tariffs or other obstructions to the free flow of
international trade
7. All resources are fully employed in both nations
8. Both nations have the same preferences and tastes
The factor endowment theory states that a nation will export the commodity whose production
requires the intensive use of the nation’s relatively abundant and cheap factor and import the
commodity whose production requires the intensive use of the nation’s relatively scarce and
expensive factor. In short, the relatively labor-rich nation exports the relatively labor-intensive
commodity and imports the relatively capital-intensive commodity.
According to the H- O theory, relative price levels differ among nations because:

Economics I
a. the nations have different relative endowments of factor inputs and

b. Different commodities require that the factor inputs be used with different intensities in
their production.
Given these circumstances, a nation will have a comparative advantage in and exports that
commodity for which a large amount of relatively abundant (cheap) input is used; and will
import that commodity in the production of which the relatively scarce (expensive)input is
used. That is why the land abundant countries (such as Australia) export land – intensive
goods, such as meat, while labor abundant nations (such as China and South Korea) export
labor intensive goods, such as textiles.
Factor Intensity, Factor abundance

Dear student, since the H-O theory to be presented latter is expressed in terms of factor intensity
and factor abundance, it is crucial that the meaning of these terms be very clear and precise.
A. Factor intensity
In a world of two commodities (X and Y) and two factors (labor and capital), we say that
commodity Y is capital intensive if the capita-l labor ratio (K/L) used in the production of Y is
greater than K/L used in the production of X.
For example, to produce one unit of Y, it requires two unit of capital (2K) and two unit of labor
(2L). Thus the K/L ration is 1. If at the same 1K and 4L are required to produce one unit of X,
K/L= ¼ . Since K/L = 1 for Y and K/L = ¼ for X, we can say that Y is K intensive and X is L
intensive.
Dear student, note that it is not the absolute amount of capital and labor used in the production of
commodities X and Y that is important in measuring the capital and labor intensive of the two
commodities, but the amount of K per unit of L (i.e., K/L).
For example, suppose that 3K and 12 (instead of 1K and 4L) are required to produce 1X. even
though 3K is required to produce 1X, while 2K for 1Y, commodity Y still be the K intensive
commodity because K/L is higher for (K/L = 2/2 = 1) than for X (K/L = 3/12 = ¼ )
B. Factor abundance

Economics I
There are two ways of defining factor abundance; one in terms of physical unit, another way is in
terms of relative factor prices.
According to the definition of physical units, N2 is K abundant if the ratio of total amount of
capital to total amount of labor (TK/TL) available in N2 is greater than N1. Note that it is not the
absolute amount of K and L available in each nation that is important but the ratio TK/TL. Thus
N2 can have less capital than N1 and still be the K abundant nation if TK/TL in N2 exceeds
TK/TL in N1.
According to definition in terms of factor prices, N2 in K abundant, if the ratio of the rental price
of K to the price of labor time (Pk/PL) is lower in N2 than in N1. Since the rental price of k is
usually interest rate(r) while price of labor time is wage (w), PK/PL = r/w. Dear learner, once
again, it is not the absolute level of r that determine K abundance in the Nation, but r/w.
Suppose, r may be higher in N2 than in N1, but nation 2 still be K abundant nation if r/w is
lower than in N1.
2.3.1.1 Factor Prices and Input Choices

What input choice will producers actually make? It depends on the relative cost of land and
labor. If land rents are high and wages low, producers will choose to produce using relatively
little land and a lot of labor; if rents are low and wages high, they will save on labor and use a lot
of land. If w is the wage rate per hour of labor and r the cost of one hectare of land, then the input
choice will depend on the ratio of these two factor prices, w/r. The relationship between factor
prices and the ratio of land to labor use in production of wheat is shown in Figure 2.4 as the
curve WW.
There is a corresponding relationship between w/r and the land-labor ratio in cloth production.
This relationship is shown in Figure 2.4 as the curve CC. As drawn, CC lies to the left of WW
indicating that at any given factor prices production of wheat will always use a higher ratio of
land to labor than production of cloth. When this is true, we say that production of wheat is land-
intensive, while production of cloth is labor-intensive.
FIG 2.4 Relationship between w/r &T/L

Economics I
CC
w/r
WWW
T/L
In each sector, the ratio of land to labor used in production depends on the cost of labor relative to the cost of land,
w/r. The curve WW shows the land-labor ratio choices in wheat production, the curve CC the corresponding
choices in cloth production. At any given wage-rental ratio, wheat production uses a higher land-labor ratio; when
this is the case, we say that wheat production is land-intensive and that cloth production is labor-intensive.
2.3.1.2 Factor price and goods price

Suppose for a moment that the economy produces both cloth and wheat. (This need not be the
case if the economy engages in international trade, because it might specialize completely in
producing one good or the other; but let us temporarily ignore this possibility.) Then competition
among producers in each sector will ensure that the price of each good equals its cost of
production. The cost of producing a good depends on factor prices: If the rental rate on land is
higher, then other things equal the price of any good whose production involves land input will
also have to be higher. The importance of a particular factor price to the cost of producing a good
depends, however, on how much of that factor the good's production involves. If cloth
production makes use of very little land, then a rise in the price of land will not have much effect
on the price of cloth; whereas if wheat production uses a great deal of land, a rise in land prices
will have a large effect on its price. We can therefore conclude that there is a one-to-one
relationship between the ratio of the wage rate to the rental rate, w/r, and the ratio of the price of
cloth to that of wheat, PC/PW. This relationship is illustrated by the upward-sloping curve SS in
Figure 2.5

Economics I
FIG 2.5 Relationship between relative price of cloth &relative price of factor inputs
PC/PF
SS
w/r
Because cloth production is labor-intensive while wheat production is land-intensive, there is a one-to-one
relationship between the factor price ratio w/r and the relative price of cloth PC/Pw; the higher the relative
cost of labor, the higher must be the relative price of the labor-intensive good. The relationship is
illustrated by the curve SS.
By putting these two diagrams together, we see what may seem at first to be a surprising
linkage of the prices of goods to the ratio of land to labor used in the production of each
good. Suppose that the relative price of cloth is (PC/PW)1 (left panel of Figure 2.6); if the
economy produces both goods, the ratio of the wage rate to the rental rate on land must
equal (w/r)1. This ratio then implies that the ratios of land to labor employed in the
production of cloth and wheat must be (Tc/Lc)1 and (T /L )1 respectively (right panel). If
w w
the relative price of cloth were to rise to the level indicated by (PC/PW)2, the ratio of the
wage rate to the rental rate on land would rise to (w/r)2. Because land is now relatively cheaper
the ratios of land to labor employed in the production of cloth and wheat would therefore rise to
(Tc/Lc)2 and (Tw/Lw)2.
FIG 2.6 From Goods prices to Input choices
w/r

Economics I
CC
SS WW
(w/r)2
(w/r)1
T/L
PC/PF (PC/Pw)2 (PC/Pw)1 (Tc/Lc)1 ( Tw/Lw)1 (Tc/Lc)2 (Tw/Lw)2
Given the relative price of cloth (Pc/P F)1, the ratio of the wage rate to the rental rate on land must equal
(w/r)1.This wage-rental ratio then implies that the ratios of land to labor employed in the production of
cloth and wheat must be (TC/LC)1 and (Tw/Lw)1 If the relative price of cloth rises to (Pc/P F)2,the wage-
rental ratio must rise to (w/r) 2.This will cause the land-labor ratio used in the production of both goods to
rise.
We can learn one more important lesson from this diagram. The left panel already tells us that an
increase in the price of cloth relative to that of wheat will raise the income of workers relative to
that of landowners. But it is possible to make a stronger statement: Such a change in relative
prices will unambiguously raise the purchasing power of workers and lower the purchasing
power of landowners, by raising real wages and lowering real rents in terms of both goods. How
do we know this? When PC/PW increases, the ratio of land to labor rises in both cloth and food
production. In a competitive economy factors of production are paid their marginal product—the
real wage of workers in terms of cloth is equal to the marginal productivity of labor in cloth
production, and so on. When the ratio of land to labor rises in producing either good, the
marginal product of labor in terms of that good increases—so workers find their real wage higher
in terms of both goods. On the other hand, the marginal product of land falls in both industries,
so landowners find their real income lower in terms of both goods.
In this model, then, changes in relative prices have strong effects on income distribution. Not
only does a change in goods prices change the distribution of income; it always changes it so
much that owners of one factor of production gain while owners of the other are made worse off.

Economics I
Dear learner! We have seen the relationship between relative price of inputs &relative price of
goods and relationship between price of output & land to labor ratio. Now let’s see how land
&labor can be allocated in two factor economy.
2.3.1.3 Resources and Output
A convenient way to analyze the allocation of resources in a two-factor economy is to use a "box
diagram" like Figure 2.7. The width of the box represents the economy's total supply of labor;
the height of the box is total supply of land. The allocation of resources between two industries
can be represented by a single point within the box, such as point 1. We measure the use of labor
and land in the cloth sector as the horizontal and vertical distances of such a point from Oc; thus
at point 1 OCLC is the labor used in cloth production and OCTC is the land used in cloth
production. We measure inputs into the wheat sector starting from the opposite corner: OwLw is
the labor, OWTW the land used in wheat production.
How can we determine the location of this resource allocation point? From Figure 2.6 we know
that given goods prices, we can determine the ratio of land to labor in cloth production, TC/LC.
Draw a straight line from Oc whose slope equals that land-labor ratio, such as the line OcC;
point 1 must lie on this line. Similarly, the known land-labor ratio in wheat production
determines the slope of another line, OWW; point 1 must also lie on this line.
(OWW is steeper than OcC, because, as we saw earlier, the ratio of land to labor is higher in
wheat than in cloth production.) Thus the economy's resource allocation is identified by the point
at which the two lines representing land-labor ratios cross-here, at point 1. Given the prices of
cloth and wheat and the supplies of land and labor, then, it is possible to determine how much of
each resource the economy devotes to the production of each good; and thus also to determine
the economy's output of each good.
FIG 2.7 Land &Labor allocation in both sectors

Economics I
Labor used in food production
LW OW
Land
Land
used
used
Land used in cloth production
in in
food
food
production
production
C
T1
Tc TW
1
W
Oc
Lc
Labor used in cloth production
In short, the sides of the box measure the economy's total supplies of labor (horizontal axis) and land
(vertical axis). Inputs into cloth production are measured from the lower-left corner; inputs into wheat
production from the upper-right corner. Given the land-labor ratio in cloth production, Tc/Lc, the cloth
industry's employment of resources must lie on the line 0cC, which is a line drawn from the origin with the
slope Tc/Lc. Similarly, the wheat industry's employment of resources must lie on the line OWW. The
allocation of resources can therefore be read off from point1, where these lines intersect .
The next question is how these outputs change when the economy's resources change.
The initially surprising answer is shown in Figure 2.8, which shows what happens when the
economy's supply of land is increased, holding both goods prices and the labor supply fixed.
With the increased supply of land the box is taller. This means that inputs into wheat production
can no longer be measured from OW (now labeled OW1), but must be measured from the corner of
the new, enlarged box, OW2., and the original line O1FF1 must be replaced with O2FF2. The
resource allocation point must therefore move from 1 to 2. What is surprising about this result?
FIG 2.8 The effect of change in supply of land

Economics I
Labor used in wheat production
L2W L1W
O2W
Land used in food production

O1W
Land used in cloth production
1 C
T1C
T1W
2
T2C T2W
W2
W1
Oc L2c L1c
Labor used in cloth production
Notice that the quantities of labor and land used in cloth production actually fall, from L1c and
T1c to L2c, and T2c. Thus an increase in the economy's supply of land will, holding prices
constant, lead to a fall in the output of the labor intensive good. What happens to the land and
labor no longer used in cloth production? It is now used in the wheat sector, whose output must
have risen.
In short, an increased land supply makes the box representing the economy's resources taller; resources
allocated to food production must now be measured from O2W. If goods prices remain unchanged, and thus
factor prices and land-labor ratios remain the same, resources allocation moves from point 1 to point 2,
with more land and more labor devoted to wheat production. The output of clothing falls, while output of
wheat rises more than proportionately to the increase in land supply.
Relative Prices and the Pattern of Trade
Suppose Home is labor-abundant and Foreign is land-abundant. Because trade leads to a
convergence of relative prices, one of the other things that will be equal is the price of cloth
relative to food. Because the countries differ in their factor abundances, however, for any given
ratio of the price of cloth to that of wheat Home will produce a higher ratio of cloth to wheat than

Economics I
Foreign will: Home will have a larger relative supply of cloth. Home's relative supply curve,
then, lies to the right of Foreign's.
The relative supply schedules of Home (RS) and Foreign (RS*) are illustrated in Figure 2.9. The
relative demand curve, which we have assumed to be the same for both countries, is shown as
RD. If there were no international trade, the equilibrium for Home would be at point 1, the
equilibrium for Foreign at point 3. That is, in the absence of trade he relative price of cloth would
be lower in Home than in Foreign.
When Home and Foreign trade with each other, their relative prices converge. The relative price
of cloth rises in Home and declines in Foreign, and a new world relative price of cloth is
established at a point somewhere between the pre trade relative prices, say at point 2. In Home,
the rise in the relative price of cloth leads to a rise in the production of cloth and a decline in
relative consumption, so Home becomes an exporter of cloth and an importer of food.
Conversely, the decline in the relative price of cloth in Foreign leads it to become an importer of
cloth and an exporter of food.
To sum up what we have learned about the pattern of trade: Home has a higher ratio of labor to
land than Foreign; that is, Home is abundant in labor and Foreign is abundant in land. Cloth
production uses a higher ratio of labor to land in its production than food; that is, cloth is labor-
intensive and food is land-intensive. Home, the labor-abundant country, exports cloth, the labor-
intensive good; Foreign, the land-abundant country, exports food, the land-intensive good. The
general statement of the result is: Countries tend to export goods whose production is intensive
in factors with which they are abundantly endowed.
FIG 2.9 Trade leads to convergence of relative prices

Economics I
Pc/PF RS*
RS
RD
Relative quantity of cloth

Qc+Qc*/Qw+Qw*
In the absence of trade, Home's equilibrium would be at point 1, where domestic relative supply RS intersects the
relative demand curve RD. Similarly, Foreign's equilibrium would be at point 3. Trade leads to a world relative
price that lies between the pretrade prices, e.g., at point 2.
Activity
Explain the effect of increase in supply of labor holding prices of output &supply of land
constant.
Activity How does the Heckscher-Ohlin theory differ from the Ricardian theory in
explaining the trade patterns?
2.3.1.4 Empirical Validity of H-O theory

A. The Leontief paradox
Dear learner! We have seen trade pattern explained by H-O factor endowment theory. Now let’s
see Leontief paradox. The first comprehensive and detailed investigation of the H-O theory was
the one undertaken by Wassily Leontief. It had been widely recognized that in the U.S capital
was relatively abundant and labor was relatively scarce. According to the factor endowment
theory, one would expect that U.S should export capital intensive goods and its import
competing (import) goods should be labor intensive.

Economics I
In 1954, Leontief tested this proposition by analyzing the capital/labor ratios for some 200 export
industries and import competing industries in U.S based 1947 data. Contrary to the H-O theory
prediction, Leontief’s study has shown that the capital/labor ratio for US export industries was
lower (about $14,000 per worker year) than that of its import competing industries (about
$18,000per worker year). Leontief concluded that exports were less capital – intensive than
import competing goods! These findings, which contradicted the predictions of the H-O theory,
became known as the Leontief paradox.
Leontief’s paradoxical results simulated similar studies in other countries such as Japan, Canada,
India and Germany. The result of these studies became again a paradox. All studies disproved
the H-O theory.
B. Recently (1990), a research was made on the validity of H-O theory by taking the U.S. trade
with China by two economists, Sachs and Shatz.
It is a widely held fact that human capital (skilled labor) is abundant, but unskilled labor is scarce
in U.S. Conversely, China is rich in unskilled labor.
Thus, the H-O theory predicts that the U.S will export to China goods for which a large amount
of skilled labor is used; and China will export to US goods for which a large amount of unskilled
labor is used.
The researchers did the following to test the H.O theory
- They took 131 sample industries
- They divided these industries in to 10 groups according to their skill intensity such that
the industries of group one embodied the highest number of skilled workers and the
industries of group 10 were the least skill intensive.
The result of the study strongly confirmed (supported) the H-O theory conclusion. U.S exports to
China were concentrated in the higher skilled industries: 78 percent of U.S exports to China were
originated from the three most skill- intensive groups of industries. Conversely, Chinese exports
to the U.S fell in to the lower skill industries: 41 percent of Chinese exports to U.S were
originated from the two least skill – intensive groups of industries.

Economics I
C. Researchers at the World Bank have also made an empirical test on the H-O theory.
They took the export data of 126 developing and industrial nations in 1985. They analyzed the
relationship between the skill/land ratio, and manufactured export/ primary export ratio for the
selected countries. The regression line suggested that there exists a strong positive relation
between the two ratios. It suggested that, nations endowed with relatively large amounts of
skilled workers tend to emphasize the export of manufactured goods. Conversely, land abundant
nation tend to emphasize exports of primary products.
Concluding Remarks
In spite of the appeal of the factor endowment theory, not all empirical tests support its
prediction. The consensus among economists appears to be that factor endowments explain only
a portion of trade patterns. Other determinants of trade patterns include technology, economies of
scale and economic policies of nations.
2.3.2 The factor price equalization theorem

In the previous chapter and earlier in this chapter, we have seen that free trade tends to equalize
commodity prices among trading partners. Can the same be said for factor prices?
A nation with trade finds output expanding in its comparative advantage industries, which uses a
lot of the cheap, abundant factor. As a result of the rise in demand for the abundant factor its
price increases. At the same time, the scarce, expensive factor is being realized from the
comparative disadvantage industries and its price falls along with its demand.
Because this process occurs at the same time in both nations, each nation experiences a rise in
the price of the abundant factor and a fall in the price of the scarce factor.
If china has a comparative advantage in cloth (labor intensive good) and specializes in the
production of it, then Canada reduces the production of cloth. When china continues to specialize
in cloth, the demand for labor tends to rise and the price of labor gets higher and higher. On the
other hand, as Canada reduces the production of cloth, the demand for labor decreases and labor
becomes cheaper. Thus, trade tends to equalize the price of labor in the two nations.
Similarly, the price of land is higher in china than Canada under autarky. But, as Canada
specializes in wheat and reduces the production of wheat, the price of land increases in Canada
and decreases in china. Thus, with trade the price of land tends to equalize in the two nations.

Economics I
We conclude that by redirecting demand away from the scarce factor and toward the abundant
factor in each nation, trade leads toward factor price equalization. In each nation, the cheaper
factor becomes more expensive, and the expensive factor becomes cheaper. Note that, the factor
prices tend to equalize without actual movement of factors.
Though the factor endowment theory suggested that free trade tends to equalize the factor prices
among trading nations, in the real world, differences in factor prices do exist. Ohilin (1933)
argued that full factor price equalization cannot occur in practice. Ohilin asserted that free trade
brings about only a tendency towards factor price equalization, and only partial factor price
equalization is possible.
So long as the assumptions underlying the factor endowment theory are not completely born out
in the real world, we should not expect that trade can fully equalize the factor prices. For
example, the existence transport costs and trade barriers, market imperfections and different
technological capabilities limit the extent to which the factor prices and commodity prices can be
equal.
2.4 THE NEW TRADE THEORIES

2.4.1 Trade based on Economics of Scale
One of the assumptions of the H-O model was that both commodities were produced under
conditions of constant returns to scale in the two nations (assumption 4). With increasing returns
to scale, mutually beneficial trade can take place even when the two nations are identical in
every respect. This is a type of trade that the H-O model does not explain.
Dear student! How trades benefit nations with increasing opportunity cost?
Have you tried? Good. Increasing returns to scale refers to the production situation where output
grows proportionately more than the increase in inputs or factors of production. That is, if all
inputs are doubled, output is more than doubled. If all in puts are tripled, output is more than
tripled. Increasing returns to scale may occur because at a larger scale of operation a greater
division of labor and specialization becomes possible. That is, each worker can specialize in
performing a simple repetitive task with a resulting increase in productivity. Furthermore, a
larger scale of operation may permit the introduction of more specialized and productive
machinery that would be feasible at a larger scale of operation.

Economics I
The following figure shows how mutually beneficial trade can be based on increasing returns to
scale. If the two nations are assumed to be identical in every respect, we can use a single
production frontier and a single indifference map to refer to both nations, increasing returns to
scale result in production frontier that are convex from the origin, or inward-bending. With
identical production frontier and indifference maps, the no-trade equilibrium relative commodity
prices in the two nations are also identical. In the figure, this is P X/PY = PA in both nations and is
given by the slope of the common tangent to the production frontier and indifference curve 1 at
point A.
With trade, Nation 1 could specialize completely in the production of commodity X and produce
at point B. Nation 2 would then specialize completely in the production of commodity Y and
produce at point B’. By then exchanging 60X for 60Y with each other, each nation would end up
consuming at point E on indifference curve II, thus gaining 20X and 20Y. These gains from trade
arise from economies of scale in the production of only one commodity in each nation. In the
absence of trade, the two nations would not specialize in the production of only one commodity
because each nation wants to consume both commodities.
Y
120 B'
100
80
E
60
ll
40 A
1
20
PA
B
0 20 40 60 80 100 120 X
FIG 2.9 Trade based on economies of scale
2.4.2 Trade based on dynamic technological differences

2.4.2.1 Posner’s technology gap model

Economics I
According to the technological gap model sketched by posner in 1961, a great deal of the trade
among industrialized counties is based on the introduction of new products and new production
processes. These give the innovating firm and nation a temporary monopoly in the world market.
Such a temporary monopoly is often based on patents and copyrights, which are granted to
stimulate the flow of inventions.
Dear student! Why advanced nations always introduce new product in the market than
developing nations?
Have you got the reason why? Well done. As the most technologically advanced nation, the
United States exports a large number of new high-technology products. However, as foreign
producers acquire the new technology, they eventually are able to conquer markets abroad, and
even the U.S. market for the product, because of their lower labor costs. In the meantime, U.S.
producers may have introduced still newer products and production processes and may be able to
export these products based on the new technological gap established.
2.4.2.2 Vernon’s product cycle model

A generalization and extension of the technological gap model is the product cycle model, which
was full developed by Vernon in 1996. According to this model, when a new product is
introduced, it usually requires highly skilled labor to produce, as the product matures and. As the
product matures and acquires mass acceptance it becomes standardized; it can then be produced
by mass production techniques and less skilled labor. Therefore, comparative advantage in the
product shifts from the advanced nation that originally introduced it to less advanced nations
where labor is relatively cheaper. This may be accompanied by foreign direct investments from
the innovating nation to nations with cheaper labor.
2.4.3 Trade based on differentiated products

Although the H-O theory is retained, there is a substantial portion of international trade that the
basic H-O model doesn’t explain. Some of this is intra-industry trade or trade based on
differentiated products. Differentiated products refer to similar but not identical, products (such
as automobiles, cigarettes and typewriters) produced by the same industry or broad product
group in various nations. Intra-industry trade arises as producers cater to majority tastes within
their nation, leaving minority tastes to be satisfied by imports. Related to this is the sharp

Economics I
increase in international trade in product parts and components as MNCs produce parts and
assemble them in different nations in order to minimize production costs.
For example, U.S imports and exports the automobiles, typewriters, cigarettes and many other
industrial products. German automobiles appeal to the majority of the car buyers in Germany,
but an important minority in Germany still prefers French, Italian or British cars. Trade in parts
and components arises when, for example, German and Japanese camera manufacturers ship
parts to be assembled in Singapore to take advantage of much cheaper labor there.

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Instructor: Dr. Surajit Ghosal.

Assosa University, FBE, Department of Economics, 2015 Page 1

2.1 THE MERCANTILISTS’ VIEW ON TRADE

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2.2 THE CLASSICAL TRADE THEORIES

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U.K (foreign) 15 gallons 10 pounds

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Gains from trade

A. Autarky (closed economy) situation

Rubber Textile Total Output

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What about consumption gains?

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Case 1- Trade at TOT= 1:1

World 100 units 100 units 200 units 50 units

Case 2- Trade at TOT = 4:3

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Table 5 Consumption shares after trade at TOT = 4:3

World 100 units 100 units 200 units 50 units

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2.2.2 Theory of Comparative Advantage: David Ricardo

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Per unit price(cost)

2.2.4 Comparative advantage and Opportunity cost

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Figure 2.1 Comparative Advantage in terms of production possibility frontier

120 Aut 80 Auto

2.2.5 Trading under constant - cost conditions

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There are two reasons for constant costs:

2.2.5.1 Basis for trade and direction of trade

( i.e. 40 autos and 40 bushels of wheat)

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2.2.5.2 Production gains from specialization

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2.2.5.3 Consumptions gains from trade

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2.2.5.4 Distributing the gains from trade

2.3 THE NEOCLASSICAL TRADE THEORY

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differences in countries' resources is one of the most influential theories in international

Assumptions of the Theory

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a. the nations have different relative endowments of factor inputs and

Factor Intensity, Factor abundance

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2.3.1.1 Factor Prices and Input Choices

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2.3.1.2 Factor price and goods price

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2.3.1.3 Resources and Output

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Labor used in food production

Labor used in cloth production

FIG 2.8 The effect of change in supply of land

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