International Economics Assignment

Absolute Advantage Theory

Absolute advantage is the ability of a country, individual, company or region to produce a good
or service at a lower cost per unit than the cost at which any other entity produces that same good
or service. Entities with absolute advantages can produce a product or service using a smaller
number of inputs and/or using a more efficient process than other entities producing the same
product or service.

Absolute advantage is predominantly a theory of international trade in which a country can

produce a good more efficiently than other countries. Countries that have an absolute advantage
can decide to specialize in producing and selling that specific product or service, using the funds
generated to purchase other goods and services that it does specialize in producing. The idea of
absolute advantage was pioneered by Adam Smith in the late 18th century as part of his division
of labor doctrine.

For example, the United States may produce 700 million gallons of wine per year, while Italy
produces 4 billion gallons of wine per year. Italy has an absolute advantage because it produces
many more gallons of wine – the output – in the same amount of time – the input – as the United
States.

However, absolute advantage also explains why it makes sense for countries, individuals and
businesses to trade with one another. Since each has advantages in producing certain products
and services, they can both benefit from trade. So, if Jane can produce a painting in five hours
while Kate needs nine hours to produce a comparable painting, Jane has an absolute advantage
over Kate in painting. Remember Kate has an absolute advantage over Jane in knitting sweaters.
If both Jane and Kate specialize in the products they have an absolute advantage in and buy the
products they don't have an absolute advantage in from the other entity, they will both be better
off.

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Comparative Advantage Theory

The theory of comparative advantage is an economic theory about the work gains from trade for
individuals, firms, or nations that arise from differences in their factor
endowments or technological progress. In an economic model, agents have a comparative
advantage over others in producing a particular good if they can produce that good at a lower
relative opportunity cost or autarky price, i.e. at a lower relative marginal cost prior to trade.

One does not compare the monetary costs of production or even the resource costs (labor needed
per unit of output) of production. Instead, one must compare the opportunity costs of producing
goods across countries. The closely related law or principle of comparative advantage holds that
under free trade, an agent will produce more of and consume less of a good for which they have
a comparative advantage.

David Ricardo developed the classical theory of comparative advantage in 1817 to explain why
countries engage in international trade even when one country's workers are more efficient at
producing every single good than workers in other countries. He demonstrated that if two
countries capable of producing two commodities engage in the free market, then each country
will increase its overall consumption by exporting the good for which it has a comparative
advantage while importing the other good, provided that there exist differences in labor
productivity between both countries. 

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 H–O model

The Heckscher-Ohlin (HO hereafter) model is a better description of the world economy after
WWII. (Some trade is explained by the factor abundance and others by comparative advantages.)
It is based on the assumption that trading countries adopt the same production technologies. It
was first conceived by two Swedish economists, Eli Heckscher (1919) and Bertil Ohlin.

Rudimentary concepts were further developed and added later by Paul Samuelson and Ronald
Jones among others. There are four major components of the HO model:

1. Factor Price Equalization Theorem,

2. Stolper-Samuelson Theorem,
3. Rybczynski Theorem, and
4. Heckscher-Ohlin Trade Theorem.

Due to the difficulty of predicting the pattern of trade in a world of many goods, instead of the
Heckscher-Ohlin Theorem, the Heckscher-Ohlin-Vanek Theorem that predicts the factor content
of trade received attention in recent years.

The Heckscher–Ohlin model (H–O model) is a general equilibrium mathematical model

of international trade, developed by Eli Heckscher and Bertil Ohlin at the Stockholm School of
Economics. It builds on David Ricardo'stheory of comparative advantage by predicting patterns
of commerce and production based on the factor endowments of a trading region.

H-O model in this paper seems useful for analysing the real world, although, as in all empirical
work, judgement is needed in using it, including on when and how to combine it with elements
of non-H-O theories. The model can surely be improved, but the main scope for further work is
in applying it empirically. Perhaps the biggest opportunity is for better analysis of the effects of
trade costs, with more of a distinction than in earlier research between independent and
proportional costs.

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 Leontief's paradox 

Leontief's paradox in economics is that the country with the world's highest capital-per worker
has a lower capital/labor ratio in exports than in imports.
This econometric find was the result of Wassily W. Leontief's attempt to test the Heckscher–
Ohlin theory empirically. In 1953, Leontief found that the United States—the most capital-
abundant country in the world-exported commodities that were more labor-intensive than
capital-intensive, in contradiction with Heckscher–Ohlin theory ("H–O theory").

Measurements

 In 1971 Robert Baldwin showed that U.S. imports were 27% more capital-intensive than

U.S. exports in the 1962 trade data, using a measure similar to Leontief's.

 In 1980 Edward Leamer questioned Leontief's original methodology for comparing factor

contents of an equal dollar value of imports and exports (i.e. on real exchange rate grounds).
However, he acknowledged that the U.S. paradox still appears in Baldwin's data for 1962 when
using a corrected method comparing factor contents of net exports and domestic consumption

 A 1999 survey of the econometric literature by Elhanan Helpman concluded that the

paradox persists, but some studies in non-US trade were instead consistent with the H–O theory.

 In 2005 Kwok & Yu used an updated methodology to argue for a lower or zero paradox
in U.S. trade statistics, though the paradox is still derived in other developed.
Responses to the paradox

For many economists, Leontief's paradox undermined the validity of the Heckscher–Ohlin

theorem (H–O) theory, which predicted that trade patterns would be based on
countries' comparative advantage in certain factors of production (such as capital and labor).

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Many economists have dismissed the H-O theory in favor of a more Ricardian model where
technological differences determine comparative advantage.
These economists argue that the United States has an advantage in highly skilled labor more so
than capital. This can be seen as viewing "capital" more broadly, to include human capital. Using
this definition, the exports of the United States are very (human) capital-intensive, and not
particularly intensive in (unskilled) labor.

Some explanations for the paradox dismiss the importance of comparative advantage as a
determinant of trade. For instance, the Linder hypothesis states that demand plays a more
important role than comparative advantage as a determinant of trade—with the hypothesis that
countries which share similar demands will be more likely to trade. For instance, both the United
States and Germany are developed countries with a significant demand for cars, so both have
large automotive industries. Rather than one country dominating the industry with a comparative
advantage, both countries trade different brands of cars between them. Similarly, New Trade
Theory argues that comparative advantages can develop separately from factor endowment
variation (e.g., in industrial increasing returns to scale).