Econ.

2081: International Economics I

Instructor: Dr. Girma Estiphanos

THE SCOPE OF INTERNATIONAL ECONOMICS

Introduction

The discipline of economics is divided into two major

parts: microeconomics and macroeconomics.
Microeconomics is the study of individual units, such as
individual households, firms, and markets. Micro is a word
derived from a Greek root meaning “small.” Specifically,
microeconomics deals with the production, distribution,
and consumption of various goods and services and how
particular industries and markets work. Using
microeconomic theory, one can analyze the activities of
individual households and the behavior of individual
business firms in choosing what to produce and how much
to charge. Microeconomics relies heavily on partial
analysis, in which economists assume that all economic
conditions remain fixed, except those being studied in a
particular market. On the other hand, macroeconomics is
the study of the aggregate behavior in an economy. Macro
is a word derived from a Greek root meaning “large.” The
basic approach of macroeconomics is to look at the overall
trends in the economy rather than at the trends that affect
particular business firms, workers, or regions in the
economy. Special summary measures of the economic
activity such as the gross national product (GNP), the
saving rate, and the consumer price index give the “big
picture” of changes and trends. In macroeconomics, Partial
analysis is cumbersome. Therefore, economists simplify
along other dimensions, primarily by grouping all the
economy’s goods into a few major categories.

The most significant trend in this new millennium is global

interdependence. In other words, the transactions of one
country are related to the transactions of other countries.
These relationships form a complex flow of goods,
services, capital, labor, and technology between and /or
among countries. The factors that have contributed to these

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developments include, among others, technical progress in
transport and communications, increased returns to scale in
production, and high-income elasticity for differentiated
products. As most studies indicate, every country can
benefit from its interactions with other countries and can
enhance these benefits and lessen the costs of
interdependence through national policies that affect trade,
investment, the value of its currency, and the level of
national output. To reap these additional benefits, each
country should base its national policies on an objective
analysis of international economics.

Components of International Economics

International economics is a blend of microeconomics

and macroeconomics. It is concerned with the economic
interdependence among nations. The economic relations
among nations differ from the economic relations among
the various parts of a nation, thus giving rise to different
problems that require different tools of analysis. Therefore,
one must modify, adapt, extend, and integrate the

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microeconomic and macroeconomic tools appropriate for
the analysis of purely domestic problems. Specifically,
international economics comprises of international trade
theory, international trade policy (or international
commercial policy), and international monetary theory (the
balance of payments theory or the theory of international
finance).

International trade theory is concerned with the basis for

trade, the effects of trade, and the determinants of the value
and the volume of trade. It applies microeconomic models
to help understand the international economy. Its contents
are the same tools that are introduced in microeconomics
courses, including supply and demand analysis, firm and
consumer behavior, market structures, and the effects of
market distortions. International trade policy deals with the
factors that impede trade flows and the implications of such
impediments on the welfare of the trading partners.
International monetary theory mainly addresses issues of a
country’s balance of payments and the adjustment
mechanisms in the balance of payments disequilibria. In

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addition, it examines the determination of exchange rates
and the flow of financial capital across borders.
International monetary theory applies macroeconomic
models to help understand the international economy. Its
focus is on the interrelationships between aggregate
economic variables such as gross domestic product (GDP),
unemployment rates, inflation rates, trade balances,
exchange rates, interest rates, etc. Thus, international trade
theory and policies constitute the microeconomic aspects of
international economics, while international monetary
theory represents the macroeconomic aspect of
international economics.

The Importance of International Economics

International economics is growing in importance as a

field of study because of the rapid integration of
international economic markets. To be specific, businesses,
governments and consumers realize that their lives are
increasingly affected, not just by what goes on in their own
town, state or country, but by what are happening around

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the world. We often hear people saying that “the world is
getting smaller every day,” referring not only to the
increased speed and ease of transportation and
communications, but also to the increased use of
international markets to buy and sell goods, services, and
financial assets. Signs of these international transactions are
manifested in many circumstances. For example, the
clothes that we wear come from many production sources
of the world. The same can be said for the food that we eat,
the shoes that we wear, the appliances that we use, the
automobiles that we drive, and the many different services
that we consume.

Like all branches of economics, the study of international

economics is concerned with making a decision regarding
the use of scarce resources to meet the desired economic
objectives. It examines how international transactions
influence such things as social welfare, income distribution,
employment, growth, and price stability. Moreover, the
various policy instruments (for example, instruments of
fiscal and monetary policies) are examined and analyzed

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with due consideration given to their effects on the
economic performance and welfare. Thus, some knowledge
of international economics is necessary to understand about
what goes on around the world and to become informed
citizens, consumers, and producers.

International Economic Theories and Policies

In general, the purpose of economic theory is to analyze (or

explain) and predict (or forecast) an economic
phenomenon. By using a set of meaningful and consistent
assumptions, a theory aims at the simplification of the
phenomenon under the study. In other words, it abstracts
from the details of an economic event in order to isolate the
most important variables in explaining and predicting the
event. The series of assumptions in any particular case are
chosen carefully so as to be consistent, retain as much
realism as possible, and attain a reasonable degree of

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generality. Abstraction is necessary because the real
economic world is complex and, thus any attempt to study
it in its true form would lead to an analysis of
unmanageable dimensions. It should also be underlined that
abstraction does not imply unrealism, but a simplification
of reality.

International economic theory usually assumes a two–

nation, two –commodity, and two –factor world. It also
assumes absence of trade restrictions to begin with, perfect
mobility of factors within the nations but immobility
internationally, perfect competition in all commodity and
factor markets, and absence of transportation costs.
Although some of the assumptions seem restrictive, most of
the conclusions reached on the basis these simplifying
assumptions will also hold even when they are relaxed.
With the help of the simplifying assumptions stated above,
international economic theory examines the basis for trade,
the gains from trade, the reasons for trade, the effects of
trade restrictions, the policies directed at regulating the
flows of international payments and receipts, and the

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effects of these policies on a nation’s welfare. International
economic theory has enjoyed a long, continuous, and rich
development over the past two centuries, through the
contributions of the world’s most distinguished economists,
including Adam Smith, David Ricardo, John Stuart Mill,
Alfred Marshall, John Maynard Keynes, and Paul
Samuelso

Summary

1. In recent years, international transactions are

becoming increasingly important as countries seek to
obtain the many benefits that accompany the increased
exchange of goods, services, and factors. For all
practical purposes, all countries must accept the fact
that they are part of the world economy and, thus
cannot escape their role in the system of
interdependent trading nations.

2. The forces that have contributed to the increased

interdependence among nations include technical

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 progress in transport and communications, increased
returns to scale in production, and high-income
elasticity for differentiated products.

3. International economics deals with the pure theory of

trade, the theory of commercial policy, the balance of
payments and foreign exchange markets, and
adjustment in the balance of payments. The first two
are the microeconomic aspects of international
economics, while the latter two are the
macroeconomic aspects of international economics.
Thus, international economics is a blend of
microeconomics and macroeconomics.

4. International trade theory examines and analyzes the

basis for trade, the pattern of trade, and the gains from
trade; while international commercial policy studies
the reasons for and the results of trade
obstructions/restrictions to the free flow of goods and
services. On the other hand, international monetary
theory deals with the nation’s receipts and payments

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 and the adjustment mechanisms of the balance of
payments.

5. The real world economic phenomenon is confronted

with a mass of data. Therefore, in order to make it
meaningful, one has to abstract from the real world to
achieve a level of simplicity at which human action
may be analyzed. But in the process abstraction, the
analyst must be careful to preserve the essential
features of the real world problem. In other words,
simplification is necessary, but at the same time a
theory must capture the essence of the fundamental
economic problem it is designed to solve.

6. The two main purposes of economic theories are

analysis and prediction. Analysis implies the
explanation of the behavior of economic units such as
consumers, producers/firms, and government
agencies. Prediction implies the possibility of
forecasting the effects of changes in some magnitudes
in the economy.

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Glossary of Key Concepts and Terms

1. Microeconomics: The term used to describe those

parts of economics analysis whose concern is the
behavior of individual units, particularly consumers
and firms, rather than aggregate measures of the
economy such as unemployment, price index, and
national income.

2. Partial Analysis: The analysis of one economic unit

at a time, assuming that the others remain unaffected.
By contrast, general analysis takes into account nearly
all the repercussions that are related to any specific
economic disturbance which is being studied.

3. Macroeconomics: The study of the aggregate

behavior in an economy. While the economic life of a
country depends on millions of individual actions
taken by business firms, consumers, workers, and
government officials, macroeconomics focuses on the

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 overall consequences of these individual actions. The
key issues in macroeconomics are the economy’s total
output and its growth over time, the general price
index, unemployment, international trade, and
business cycles.

4. Global Interdependence: The situation in which no

country can inhabit an economic island. In other
words, one country’s economic activities are
intimately linked with the economic activities of other
countries. These relationships form a complex flow of
goods, services, capital, labor, and technology. As the
world economy becomes increasingly integrated,
every country must come in terms with the increased
interdependence.

5. Technical progress: Technology changes as

knowledge of new and more efficient method of
production becomes available. Furthermore, new
inventions may result in increased efficiency of
production. At the same time, some techniques may

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 become inefficient (obsolete) and drop out from the
production function. All these changes in technology
constitute what is refereed to as technical progress.
Technical progress may also be due to product
innovation. For example, assuming two factors of
production, labor and capital, technical progress may
take the following three forms: i) capital – deepening
(capital – using or labor - saving) technical progress,
where the technical progress increases the marginal
product of capital by more than the marginal product
of labor, ii) labor – deepening (labor – using or capital
– saving)) technical progress, where increases the
marginal product of labor increases by more than the
marginal product of capital, and iii) neutral technical
progress, where the technical progress increases the
marginal products of both capital and labor by the
same proportion.
6. Returns to Scale: The rate at which output changes as
the quantities of all inputs are varied. This is a long –
run phenomenon of the theory of production. There
are three cases. First, if output increases by a greater

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 proportion than the increase in inputs, then there is an
increasing return to scale. Secondly, if output
increases by a smaller proportion than the increase in
inputs, then there is a decreasing return to scale.
Finally, if output and inputs increase by the same
proportion, then there is a constant return to scale.
7. Income Elasticity: The proportionate change in the
quantity demanded of a commodity resulting from a
proportionate change in income. Economic theory
postulates that the percentage of income spent on food
declines as income increases. This is known as
Engel’s Law, an empirical law of consumption
developed by Ernst Engel. It is sometimes used as a
measure of welfare and of the development stage of an
economy, the lower the proportion, the higher is the
welfare.

8. Differentiated Products: Similar, but not identical

products such as automobiles, typewriters, and
cigarettes produced by different manufacturers in the
same industry. There are two types of product

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 differentiation, horizontal and vertical. Horizontal
differentiation of goods occurs when varieties differ in
their characteristics such as color or taste, for
example, the color of a wine or the taste of the wine.
On the other hand, vertical differentiation of products
occurs when varieties differ in their quality such as
superior or inferior products, appealing to consumers’
incomes.

9. International Economics: That part of economics,

which deals with transactions between countries in the
fields of goods and services, financial flows, and
factor movements. It is conventionally divided into
two subject areas, pure theory and monetary theory. In
the former, attention is focused on real magnitudes
such as gains from trade, terms of trade, and pattern of
trade, while the latter is preoccupied with financial
magnitudes such as the determination of the exchange
rate between currencies and with adjustment
mechanisms for attaining equilibrium in the balance of
payments.

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10. Investment: The production of output requires
the inputs of labor, capital, and technology. The term
capital here refers to the accumulation of stocks of
machinery, factories, and other durable factors of
production. Investment is the flow of output in a given
period that is used to maintain or increase the capital
stock in the economy. By increasing the capital stock,
investment spending augments the future productive
power of the economy. In other words, investment is
the flow of expenditures devoted to projects producing
goods, which are not intended for immediate
consumption. Thus, investment theory is inter -
temporal, that is, the motivation for investment now is
to increase production possibilities in the future.

11. International Trade Theory: That part of

international economics, which analyzes the basis for
trade and the gains from trade. It applies
microeconomic models to help understand the
international economy. Specifically, it tries to answer

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 the following key questions: i) why do countries trade
with one another? ii) what specific benefits can a
country obtain through international trade? iii) which
country produces good (s)? iv) why do countries
export and import certain goods? v) at what price do
countries exchange exports and imports? and vi) how
does international trade differ from interregional
trade?

12. International Trade Policy: That part of

international economics, which examines the reasons
for the various trade obstructions and the effects of
such obstructions on the welfare of the world in
general and the trading partners in particular.
Although it is argued that free trade maximizes world
output and benefits all nations, all nations impose
some restrictions on the free flow of international
trade. Since these restrictions and regulations deal
with the nation’s trade or commerce, they are
generally known as trade or commercial policies.

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 13. International Finance: The study of international
economics encompasses not only micro issues related to the
exchange of goods and services between countries but also
macro issues regarding the interaction of international
transactions with aggregate variables such as income,
money, and prices. Thus, international finance (also known
as international monetary police or the balance of payments
theory) is that part of international economics which deals
with problems of payments and the adjustment mechanism
to balance of payments disequilibria. It applies
macroeconomic models to hep understand the international
economy.

14. Balance of Payments: A summary statement of

the entire international
transactions of the residents of a nation with the
rest of the world during

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 a particular period of time, usually a calendar year.
In keeping track of a
year’s international transaction for a country, a
variety of procedures can be
applied. However, the most common principle is
the use double entry
bookkeeping. This means that each international
transaction is recorded twice,
once as a credit and once as a debit of equal
amount. Credit transactions
are those that involve the receipt of payments from
foreigners, while debit
transactions are those that involve payments to
foreigners. The balance of
payments has two basic components, the current
account and the capital
account, and two additional components, the
official reserve account and net
errors and omissions ( the balancing item or
statistical discrepancy).

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15. Adjustment in the Balance of Payments: If total
credits exceed total debits, then there is a surplus in
the balance of payments, while if total debits exceed
total credits, then there is a deficit in the balance of
payments. A surplus or deficit in the balance of
payments may arise for many reasons, including short-
run (or cyclical) reasons and long-run (or structural)
reasons. However, a deficit nation cannot continue to
run deficits indefinitely, and a surplus nation is not
willing to continue to run surpluses indefinitely. This
gives rise for the need of adjustment. Adjustment in
the balance of payments refers to the process by which
balance of payments disequilibria are corrected.
Adjustment mechanisms can be classified as
automatic and policy. Automatic adjustment
mechanisms are those, which are activated by the
balance of payments disequilibria without any
government action, while policy adjustment
mechanisms involve government intervention.

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16. Economic Theory and Economic Model:
Economic theory aims at the construction of models
which describe the economic behavior of individual
units (for example, consumers, firms, and government
agencies) and their interactions which create the
economic system of a region, a country, or the world
as a whole. A model is a simplified representation of a
real situation. It includes the main features of the real
situation, which it represents. A model implies
abstraction from reality, which is achieved by a set of
meaningful and consistent assumptions, which aim at
the simplification of the phenomenon or behavioral
pattern that the model is designed to study. The degree
of abstraction from reality depends on the purpose for
which the model is constructed. Abstraction is
necessary because the real economic world is complex
and any attempt to study it in its true form would lead
to an analysis of unmanageable dimensions. The
validity of a model may be judged on the basis of
several criteria, including its predictive power, the
consistency and realism of its assumptions, the extent

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of information it provides, its generality (that is, the
range of cases to which it applies) and its simplicity.
The two main purposes of a model are analysis and
prediction.

17. Abstraction: A simplification of reality.

Abstraction from reality is achieved by a set of
meaningful and consistent assumptions, which aim at
the simplification of the phenomenon or behavioral
pattern. The degree of abstraction from reality depends
on the purpose for which the model is constructed.
Abstraction is necessary because the real economic
world is complex and any attempt to study it in its true
form would lead to an analysis of unmanageable
dimensions.

18. Theory and Assumptions: A theory need not fit

all the facts. This bothers beginning students of
economics – it should not. Assuming away real world
phenomenon does not express naiveté. Rather, it
expresses a realization that in order to see and

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comprehend relationships between particular variables
it is necessary to simplify and isolate. One must
abstract from the multitude of economic and other data
in the real world. For example, in the theory of
production, one may assume that the firms seek to
maximize their profits and that the government has no
influence on the variables being considered. One
needs these assumptions in order to simplify, and in
order to develop theories that yield reliable and
meaningful predictions about the phenomenon not yet
observed.

19. Analysis: Implies the explanation of the behavior

of economic units, consumers or producers. Based on
a set of assumptions, one derives certain “laws” which
describe and explain with an adequate degree of
generality the behavior of consumers and producers.

20. Prediction: Implies the possibility of forecasting

the effects of changes in some magnitudes in the
economy. For example, a model of supply might be

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 used to predict the effects of imposition of a tax on the
sales of firms.

Review Questions and Practical Exercises

1. “Microeconomics is the study of the small picture of

the economy.” Explain and give examples.

2. What do you understand by “partial analysis” and

“general analysis?” Explain.

3. “Macroeconomics is the study of the big picture of the

economy.” Explain and give examples.

4. a) What is meant by “global interdependence?”

b) List and explain the major factors that have
contributed to global interdependence.

5. a) What is meant by “international economics?”

b) What are the components of international
economics? Explain.

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 c) Why is it important to study international
economics?

6. a) What are the purposes of economic theories in

general and international economic theories in
particular?
b) What are the purposes of assumptions in the
construction of theories?

7. Suppose you are an economic advisor to the Ethiopian

government. What do you advise the government in
order to reap the additional benefits from the global
interdependence and to lessen its costs?

8. Give practical examples that can illustrate

international transactions.

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27
INTERNATIONAL TRADE THEORIES

Historical Development of Modern Trade Theory

Modern trade theory is the product of an evolution of ideas

in economic thought. History of economic thought is the
study of the heritage left by writers on economic subjects
over many years. This historical approach is useful not
because one is interested in “history of economic thought”
as such but because it is a convenient way of introducing
the concepts and the theories of international trade from
simple to a more advanced level. In particular, the writings
of the Mercantilists, Adam Smith, and David Ricardo have
been instrumental in providing the framework of modern
trade theory. A major task of modern trade theory is to
answer the following questions: 1) What constitutes the
basis for trade, that is, why do nations export and import
certain products? 2) At what terms of trade (relative prices)
are products exchanged in the world market? and 3) What

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are the gains from international trade in terms of production
and consumption?

The Mercantilists’ View on Trade

During the seventeenth and eighteenth centuries, a group of

writers who were concerned with the process of nation
building appeared in Europe. They wrote essays and
pamphlets on international trade that advocated an
economic philosophy known as mercantilism. In particular,
the advocates of this philosophy appeared in such countries
as England, Spain, France, Portugal, and the Netherlands.
The doctrine of mercantilism is based on the premise that a
nation can regulate its domestic and international affairs so
as to promote its own interests. According to this doctrine,
the solution lies in a strong foreign sector. If a country
could achieve a favorable trade balance (a surplus of
exports over imports), it
would enjoy payments received from the rest of the world
in the form of precious metals, primarily gold and silver.
Underlying the mercantilists’ view of international trade

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was the belief that a country’s wealth was based on the
holdings of precious metals (bullion or specie). Such
revenues would contribute to increased spending and a rise
in domestic output and employment. To promote a
favorable trade balance, the mercantilists advocated
government regulation of trade. In other words, tariffs,
quotas, and other commercial policies were proposed to
minimize imports in order to protect a nation’s trade
position. This situation implied that international trade was
a zero – sum game, in which one country’s economic gain
was achieved at the expense of another.

Mercantilism cannot be classified as a formal school of

thought, but rather as a collection of similar attitudes
towards domestic economic activity and the role of
international trade. The early mercantilists were
practitioners rather than theorists, and their interest was in
economic policy rather than analysis. Although
mercantilism has its own limitations, the doctrine has at
least two modern features. First, it was highly nationalistic,
giving relative importance to the well – being of the home

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nation rather than the foreign nation. Today, there are
public officials who argue that exports are “good” because
they create jobs in a country, and imports are “not good” as
they take jobs from the same country. Secondly,
mercantilism favored the regulation and planning of
economic activity as an effective means of fostering the
goals of the nation. This is also manifested in today’s world
in different forms.

By the late eighteenth century, the economic policies of the

mercantilists were under attack by the early Classical
writers such as David Hume and Adam Smith. There were
at least three challenges to mercantilism. The first
challenge was by David Hume (in his Political Discourse,
1752) with his development of the price – specie – flow
mechanism. According to Hume, the accumulation of gold
by means of a trade surplus would lead to an increase in the
money supply and therefore to an increase in prices and
wages. These increases would reduce the competitiveness
of the country with a surplus. At the same time, the loss of
gold in the deficit country would reduce its money supply,

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prices, and wages, and increases its competitiveness. Thus,
it is not possible for a nation to continue to maintain a
positive trade balance indefinitely.

To explain the price – specie – flow mechanism, David

Hume used the example of England and its trading partners
for illustration. If, for instance, England were to achieve a
trade surplus, then this would result in an inflow of gold
and silver. Because these precious metals would constitute
part of England’s money supply, their inflow would
increase the amount of money in circulation. This would
lead to a rise in England’s price level relative to that of its
trading partners. Therefore, English residents would be
encouraged to purchase foreign – produced goods, while
England’s exports would decline. As a result, the country’s
trade surplus would eventually be eliminated. Thus,
according to David Hume’s price – specie flow doctrine, a
favorable trade balance was possible only in the short run
and not in the long run.

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The second challenge to mercantilists’ ideas came from
Adam Smith, who perceived that a nation’s wealth was
reflected in its productive capacity (that is, its ability to
produce final goods and services), and not in its holdings of
precious metals. According to Smith, attention should be
given to enlarging the production of goods and services
rather than acquiring specie. He believed that growth in
productive capacity was fostered best in an environment
where people were free to pursue their own interest.
Specifically, he felt that self-interest would lead individuals
to specialize in and exchange goods and services based on
their own special abilities. Smith advocated a policy of
laissez faire, which allows individuals to pursue their own
activities within the bounds of law and order and respect
for property rights. The proper role of the government was
to see that the market was free to function by removing the
barriers to effective operation of the “invisible hand” of the
market.

The third challenge to mercantilism was its static view of

the world economy. The economic activity in this setting

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can be viewed as a zero-sum game in which one nation
gains at the expense of its trading partner. Adam Smith
advocated a dynamic view of the world economy, which
suggested that both trading partners could simultaneously
enjoy higher levels of consumption and production with
free trade. In other words, he argued that mutually
beneficial trade can be achieved based on what he referred
to as “absolute advantage.” The fact that trade was
mutually beneficial and was a positive – sum game (that is,
all players can receive a positive pay off in the game) was a
powerful argument for expanding trade and reducing the
many trade controls that characterized the Mercantilist
period.

The Classical Trade Theories

Classical economics refers to the economic thought of the

period from the mid-eighteenth to the mid-nineteenth
century. The principal exponents of this economic thought
were Adam Smith, David Ricardo, Jean Baptist Say, and
John Stuart Mill. Classical economic theory was essentially

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about growth and development and set out to investigate
the nature and causes of the wealth of nations and the
distribution of the national product among the factors of
production. The analysis took place within the framework
of growing population, finite resources, and free
competition in a private enterprise economy. The emphasis
lay on capital accumulation, expansion of markets, and
division of labor.

In their methodology, the classical economists fell into two

camps. There were those who followed the inductive
method (for example, Adam Smith). This group formulated
premises on the basis of empiricism, derived empirical
laws, reasoned on the basis of these and tested the result
against other empirical data. There was a second group who
followed the deductive method (for example, David
Ricardo). This group was interested in making hypothetical
premises, deducing conclusions from them and making no
attempt to verify the results.

Adam Smith’s Principle of Absolute Advantage

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Adam Smith (1723 – 1790) was a Scottish philosopher and
an economist, educated at the universities of Glasgow and
Oxford and subsequently a Professor of Moral Philosophy
at the Glasgow University. He wrote over a wide area of
which economics was only a part. His main preoccupation
was with economic growth, concluding that division of
labor and specialization resulted in increased output,
technical progress and capital accumulation. He was a
leading advocate of free trade on the grounds that it
promoted the international division of labor. According to
Smith, nations could concentrate their production on goods
that they could make most cheaply, with all the consequent
benefits of the division of labor. Though he argued for
laissez faire, Smith recognized the need for government
intervention, particularly to protect infant industries and
industries that are important for national defense. Laissez
faire is a doctrine that advocated that the economic affairs
of society are best guided by the decisions of individuals.
The idea has its basis in the writings of the physiocrats, but

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its analytic foundations lie in the work of Adam smith and
the classical school.

In 1776, Adam Smith published his famous book, The

Wealth of Nations, in which he attacked the mercantilist
view on trade and advocated free trade as the best policy
for all nations. According to Smith, trade between two
nations is based on absolute advantage. To explain the
concept of absolute advantage, he used a simple analogy.
He argued that the tailor does not make his own shoes, but
exchanges a suit for shoes from a shoemaker. Through
exchange, both the shoemaker and the tailor gain. In the
same manner, a country could gain by trading with other
countries. Assuming a two-country and two-product model,
international trade and specialization will be beneficial
when one country has an absolute advantage (that is, can
produce a good using fewer resources) in the production of
one product, whereas the other country has the absolute
cost advantage in the production of the other product.
Smith felt that it was far better for a country to import
goods that could be produced overseas more efficiently

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than to manufacture them at home. In other words,
countries would import goods in the production of which
they had an absolute disadvantage against the exporting
country. On the other hand, countries would export goods
in the production of which they had an absolute advantage
over the importing country. Thus, according to Smith, trade
is a positive – sum game, in which all players can receive a
positive payoff in the game.

To illustrate the mutual gains from trade, the following

simplifying assumptions were used:
a) There are only two countries and two goods,
b) Labor is the only factor of production, and it is
homogeneous and fixed in amount,
c) Labor theory of value, i.e., the value or price of a
good is equal to the amount of labor time used in
the production of the good,

38
 d) Labor is mobile within a country, but immobile
internationally,
e) Labor is fully employed in both countries,
f) The level of technology used to produce the goods
is constant,
g) Transportation costs are zero,
h) Money is not used as a medium of exchange, rather
the two countries engage in barter trade, i.e., goods
are exchanged for other goods, and
i) The institutional setting is perfect competition.

Given the above assumptions, Table 1 demonstrates that

mutually beneficial trade is possible between, say, the
United Sates of America (U.S. A.) and the United Kingdom
(U. K.) on the basis of absolute advantage.

Table 1
Labor Requirements and Absolute
Advantage

U.S.A. U. K.

39
 Wheat (bushels / 6 1
labor - hour
Cloth (yards / labor 4 5
– hour

Source: Salvatore, D. International Economics, 1995,

p.30

As Table 1 shows, one hour of labor time produces 6

bushels of wheat in the U. S. A, while the same labor time
produces 1 bushel of wheat in the U. K. On the other hand,
one hour of labor time produces 4 yards of cloth in the U.
S. A., while the same labor time produces 5 yards of cloth
in the U. K. This example illustrates that the U.S. A. has an
absolute advantage (or is more efficient) in the production
of wheat, while the U. K. has an absolute advantage in the
production of cloth. With free trade, the U. S. A.
specializes in the production of wheat and exchanges it for
British cloth, while the U. K. specializes in the production
of cloth and exchanges it for American wheat. According to
Smith, both countries could benefit from trade and, thus

40
trade was not a zero – sum game, as the mercantilists had
believed.

In his analysis of trade, Adam Smith maintained the view

that productivities of factor inputs represent the major
determinant of production cost. Such productivities are
based on natural and acquired advantages. The former
include such factors as climate, soil, and mineral wealth,
whereas the latter include special skills and techniques.
Given a natural or acquired advantage in the production of
a good, Smith reasoned that a nation would produce that
good at lower cost, becoming more competitive than its
trading partner. Therefore, Smith viewed the determination
of competitive advantage from the supply side of the
market. Following this line of argument, one can cite
examples, such as Brazil exporting coffee, South Africa
exporting diamonds, and Saudi Arabia exporting oil.

There are at least two major weaknesses in Smith’s analysis

of international trade. First, the initial assumptions that
labor is the only factor of production and that it is

41
homogeneous could be challenged. In other words, labor is
neither the only factor of production nor is it homogeneous.
However, it should be underlined that rejecting the
assumptions does not necessarily imply rejecting the law of
absolute advantage. Secondly, Smith’s concept of absolute
advantage explains only a small part of the world trade,
such as those between developed and developing countries.
Most of the world trade; especially trade among developed
countries cannot be explained by absolute advantage. Thus,
Smith’s analysis is not very deep and leaves some
unanswered questions. For example, what will happen if a
nation is more efficient than its trading
partner in the production of both goods? In other words,
what will happen if one country has an absolute advantage
in the production of both goods? This task was left to
David Ricardo, a British economist, who formulated the
principle of comparative advantage, sometimes refereed to
as the principle of comparative costs.

David Ricardo’s Principle of Comparative Advantage

42
David Ricardo (1772 – 1823) was a British economist who
is best remembered for his theory of Rent and his theory of
Comparative Cost. He started work in his father’s
stockbroker’s office, and then began his own successful
career in securities and real estate. His interest in
economics was aroused from reading Smith’s book, “The
Wealth of Nations” in 1799. He is credited for formalizing
the concept of comparative advantage. The original idea of
comparative advantage dates to the early part of the
nineteenth century. Although the model describing the
theory is commonly refereed to as the “Ricardian model,”
the original description of the idea can be found in an
Essay on the External Corn Trade by Robert Torrens in
1815. David Ricardo formalized the idea by using a simple
numerical example in his 1817 book titled, The Principles
of Political Economy and Taxation.” In what follows,
attempts are made to present the assumptions of Ricardo’s
model and the definition of comparative advantage. This
will then be followed by numerical example for illustration.

43
The following are the assumptions of Ricardo’s law of
comparative advantage:

a) Two-countries, two-goods, and labor as the

only factor of production,
b) The goods are homogeneous (identical) across
firms and countries, and labor is homogeneous
within a country but heterogeneous (non –
identical) across countries,
c) The factor of production is mobile between
alternative uses and within a country, but
immobile internationally,
d) The labor theory of value is employed, i.e., the
cost of a good is determined by the amount of
labor used to produce,
e) The level of technology is fixed with constant
costs of production,
f) There is full employment,
g) The economy is characterized by perfect
competition and free trade,

44
 h) There are no government-imposed obstacles to
economic activity, and
i) Transportation costs are zero.

According to Ricardo’s principle of comparative

advantage, even if a nation is more efficient (that is, has an
absolute advantage) than the other nation in the production
of both goods, there is still a basis for mutually beneficial
trade. The more efficient nation should specialize in the
production of and export of the good in which its absolute
advantage is greater and import the good in which its
absolute advantage is smaller. Similarly, the less efficient
nation should specialize in the production of and export of
the good in which its absolute disadvantage is smaller and
import the good in which its absolute disadvantage is
greater. To make his point, Ricardo imagined two
countries, England and Portugal, producing two goods,
cloth and wine, using labor as the sole input in production.
Furthermore, he introduced the concept of opportunity cost,
which is defined as the next best alternative forgone. Table
3.2 illustrates Ricardo’s law of comparative advantage.

45
 Table 2
David Ricardo’s Principle of
Comparative Advantage
Labor Cost of Production (in Hours)

1 Unit of Wine 1 Unit of Cloth

Portugal 80 Hours of Labor 90 Hours of

/ Barrel Labor / Yard

England 120 Hours of 100 Hours of

Labor / Barrel labor / Yard

Source: Sodersten, B. and G. Reed. International

Economics, 1994, p.6.
As can be observed from Table 2 above, in Portugal, it
takes 80 hours of labor to produce 1 unit of wine, while it
takes 90 hours of labor to produce 1 unit of cloth. In
England, it takes 120 hours of labor to produce 1 unit of
wine, while it takes 100 hours of labor to produce 1 unit of

46
cloth. Thus, according to this example, Portugal has an
absolute advantage (that is, uses fewer labor hours) in the
production of both goods. From Adam Smith’s perspective,
there is no basis for trade because Portugal is more efficient
in the production of both goods, and England has an
absolute disadvantage in both goods. Ricardo, however,
pointed out that Portugal is relatively more efficient in the
production of wine than of cloth and that England’s relative
disadvantage is smaller in cloth. In other words, wine is
relatively cheaper (or cloth is relatively more expensive) in
Portugal, while cloth is relatively cheaper (or wine is
relatively more expensive) in England. This situation is
illustrated by using the concept of opportunity cost (relative
cost) as indicated in Table 3, which is derived from Table
2. In this context, the opportunity cost of cloth production
is defined as the amount of wine that must be given up in
order to produce one more unit of cloth.

Table 3

47
 David Ricardo’s Principle of
Comparative Advantage
Opportunity Cost of Production

1 Unit of Wine 1 Unit of Cloth

Portugal 80/90 = 8/9 = 90/80 = 9/8 =

0.88* 1.125

England 120/100 = 100/120 = 10/12

12/10 = 1.2 = 0.83**

Source: Sodersten, B. and G. Reed. International

Economics, 1994, p.6.

Table 3 shows that, in Portugal, 1 unit of wine is equivalent

to 0.88 units of cloth, while 1 unit of cloth is equivalent to
1.125 units of wine. On the other hand, in England, 1 unit

48
of wine is equivalent to 1.2 units of cloth, while 1 unit of
cloth is equivalent to 0.83 units of wine. Therefore,
Portugal has a comparative advantage in the production of
wine because the opportunity cost of wine in terms of cloth
is lower in Portugal (as indicated by a single asterisk in
Table 3 above). Similarly, England has a comparative
advantage in the production of cloth because the
opportunity cost of cloth in terms of wine is lower in
England (as indicated by double asterisk in Table 3 above).
Thus, according to Ricardo, even when one country has an
absolute advantage (that is, more efficient) in the
production of both goods, a mutually beneficial trade can
still exist because of the differences in opportunity costs (or
relative costs).

David Ricardo’s principle of comparative advantage can

also be demonstrated by using the production possibility
schedules. The production possibility schedule is a table
that shows alternative combinations of two products that a
country can produce at a given point in time given its
resource base, level of technology, full utilization of

49
resources, and economically efficient production. All these
conditions are met in the earlier list of assumptions.
Furthermore, the constant – cost assumption implies that
the opportunity cost of production is the same at the various
levels of production. Thus, the graph of the production
possibility schedule (known as the production possibility
frontier or transformation curve) is a straight line whose
slope represents the opportunity cost of production. Table 4
gives hypothetical production possibility schedules of
wheat (in million bushels per year) and cloth (in million
yards per year) for the Unites States and the United
Kingdom.

Table 4

Production Possibility Schedules for wheat and Cloth

in the United States and the United Kingdom

50
 United States United Kingdom
Wheat Wheat
Cloth Cloth
180 60
0 0
150 50
20 20
120 40
40 40
90 30
60 60
60 20
80 80
30 10
100 100
0 0
120 120

Source: Salvatore, D. International

Economics. 1995, p.38

51
As shown in the production possibility schedules above (in
Table 4), the United States can produce alternative
combinations of wheat and cloth such as 180 wheat and 0
cloth, 150 wheat and 20 cloth, or 120 wheat and 40 cloth,
down to 0 wheat and 120 cloth. This representation implies
that, for each 30 million bushels of wheat per year that the
United States gives up, just enough resources are released
to produce an additional 20 million yards of cloth per year.
In other words, 30 wheat = 20 cloth (in the sense that both
require the same amount of resources). Thus, the
opportunity cost of 1 unit of wheat in the United Sates is 1
wheat = 2/3 cloth. On the other hand, the United Kingdom
can produce alternative combinations of wheat and cloth
such as 60 wheat and 0 cloth, 50 wheat and 20 cloth, or 40
wheat and 40 cloth, down to 0 wheat and 120 cloth. Here,
for each 10 million bushels of wheat per year that the
United Kingdom gives up, enough resources are released to
produce an additional 20 million yards of cloth per year.
Thus, the opportunity cost of wheat in the United Kingdom
is 1 wheat = 2 cloth. By comparing the opportunity costs in
the United States and the United Kingdom, the following

52
can be concluded. The opportunity cost of wheat in the
United States is 2/3 in terms of cloth, while the opportunity
cost of wheat in the United Kingdom is 2 in terms of cloth.
Thus, the United States has a comparative advantage in the
production of wheat because its opportunity cost is lower
than that of the United Kingdom. Since the opportunity cost
of cloth in terms of wheat is simply the reciprocals of the
above results, the United Kingdom has a comparative
advantage in the production of cloth. In other words, the
opportunity cost of cloth in the United States is 3/2 = 1.5 in
terms of wheat, while the opportunity cost of cloth in the
United Kingdom is ½ = 0.5 in terms of wheat. Thus, the
opportunity cost of cloth in terms of wheat is lower in the
United Kingdom than that of the United States.

There are at least two major challenges to Ricardo’ initial

assumptions in the formulation of the law of comparative
costs. First, labor is neither the only factor of production
nor is it used in the same proportion in the production of all
commodities. In addition, labor is not all one type, i.e.,
skills and qualities differ. Secondly, there is empirical

53
objection to Ricardo’s assumption of constant costs of
production. Later writers argued that many industries are
characterized by increasing opportunity costs (or
decreasing returns to scale), so that more and more of other
commodities had to be given up to produce each
succeeding extra unit of one commodity. In other words,
economic resources are not completely adaptable to
alternative uses. It should be underlined, however, that
rejecting the explanations for the assumptions does not
necessarily imply rejecting the law of comparative
advantage. Today, Ricardo’s law of comparative costs is
one of the most famous and influential principles of
economics.

The Neoclassical Trade Theory

Economists in the Classical school developed the basic

propositions regarding the nature and impact of
international trade in the late eighteenth and nineteenth
centuries. However, their analyses were limited
considerably by the labor theory of value and the

54
assumption of constant costs. The development of
neoclassical economic theory in the late nineteenth and
early twentieth centuries provided tools for analyzing the
impact of international trade in a more rigorous and less
restrictive manner. The term neoclassical derives from the
view that writers were extending and improving on the
basic foundations of the classical economists.

In Ricardo’s model, it has been shown that mutually

beneficial trade can be achieved through the principle of
comparative advantage (or comparative cost). In addition to
understanding the principle of comparative advantage, one
also needs to understand why each country has a
comparative advantage or disadvantage in the production of
various goods. What determines a country’s comparative
advantage is of considerable significance since the location
of international production facilities and the pattern of trade
throughout the world is not random. The next discussion
addresses the following two major questions:
a) What determines a country’s comparative
advantage?

55
 b) How does international trade affect the payments or
returns to the factors of production such as labor
and capital?

The Heckscher – Ohlin (H – O) Model

Eli F. Heckscher (1879 – 1952) was a Swedish economist

and economic historian. In 1919, he published a brief
article that contained the core idea of what determines
nations’ trade patterns. A clear overall explanation was
developed and publicized in the 1930s by Heckscher’s
student, Bertil Ohlin (1899 – 1979). Many elaborations (in
terms of mathematical derivations) of the H – O model
were provided by Paul Samuelson, an American economist
and a Noble price winner in economics in 1976, after the
1930s and thus sometimes the model is refereed to as the
Heckscher – Ohlin – Samuelson (HOS) model. Eli
Heckscher and Bertil Ohlin accepted the fact that
international trade is based on differences in comparative
costs, but attempted to explain the factors, which make for
the differences in comparative costs.

56
The H – O model is based on the following simplifying
assumptions:
a) A two-country, two – good, and two – factor model,
b) The supply of the two factors of production is
given,
c) The factors of production are mobile domestically,
but immobile internationally,
d) The technology available to produce the two goods
is the same in both countries and each good is
produced under constant returns to scale,
e) The trading partners have the same tastes and
preferences (or demand conditions),
f) Perfect competition in both the product and factor
markets, and
g) Absence of transportation costs, tariffs, and other
obstructions to trade.

The H – O model (or neoclassical model) is the dominant

model of comparative advantage in modern economics.

57
According to David Ricardo and Adam Smith, trade
between nations takes place because of the difference in the
productivity of labor, the only factor of production. The H
– O model, on the other hand, goes further to explain the
basis for trade as factor endowment and factor intensity.
Specifically, the theory argues that relative price levels
differ among nations because they have different relative
endowments of factors (that is, supplies of factor of
production) of production and that different commodities
require differing intensities (that is, degree of factor use) of
factor inputs in their production.

There are four main theorems in the H – O model: the

Hekscher – Ohlin theorem, the Stolper – Samuelson
theorem, the Rybczynski theorem, and the factor – price
equalization theorem. The Stolper – Samuelson and
Rybczynski theorems describe relationships between
variables in the model while the H – O and factor – price
equalization theorems present some of the key results of the
model. Applications of these theorems also allow one to
derive some other important implications of the model.

58
The Heckscher – Ohlin Theorem

Assuming two factors of production, labor and capital, in

two countries, the H – O theorem postulates that a labor –
abundant (or capital – scarce) country will have a
comparative advantage in the production of and export of
labor – intensive goods, while a capital – abundant (or
labor – scarce) country will have a comparative advantage
in the production of and export of capital – intensive goods.
Thus, through trade, a labor – abundant country will export
labor – intensive goods (because labor is cheap or wages
are low) and import capital -intensive goods, while a capital
– abundant country will export capital – intensive goods
(because capital is cheap or rental costs are low) and import
labor-intensive goods.

59
A labor – abundant country is one that is well endowed
with labor relative to the other country. This gives the
country a propensity for producing the good which use
relatively more labor in the production process, that is, the
labor – intensive good. As a result, if these two countries
were not trading initially, that is, they were in autarky, the
price of the labor- intensive good in the labor – abundant
country would be bid down (due to extra supply) relative to
the price of the good in the other country. Similarly, in the
capital – abundant country, the price of the capital –
intensive good would be bid down relative to the price of
that good in the labor – abundant country. Thus, the H – O
theorem demonstrates that a difference in resource
endowments as defined by national abundances is one
reason that international trade may occur.

The Stolper – Samuelson Theorem

The Stolper – Samuelson theorem describes the

relationship between changes in output, or goods, prices
and changes in factor prices such as wage rates and rental

60
rates within the context of the H – O model. The theorem
states that if the price of the labor-intensive good rises, then
the price of labor (that is, wage rate), the factor used
intensively in that industry, will rise, while the price of
capital (that is, rental rate) will fall. Similarly, if the price
of the capital-intensive good were to rise, then the rental
rate would rise while the wage rate would fall. Since prices
change in a country when trade liberalization occurs, the
magnification effect can be applied to yield an interesting
and important result. Thus, a movement to free trade will
cause the real return of a country’s relatively abundant
factor to rise, while the real return of the country’s
relatively scarce factor will fall.

The Factor – Price Equalization Theorem

The factor – price equalization theorem postulates that

international trade will bring about equalization (or
convergence) in the relative and absolute returns to
homogeneous factors across nations. In other words,
international trade will cause the return labor (that is, wage

61
rate) to be the same in all the trading nations. Similarly,
international trade will cause the returns to capital (rental
rates) to be the same in all the trading nations. The theorem
derives from the assumptions of the model, that the two
countries share the same production technology and that
markets are perfectly competitive. In a perfectly
competitive market, factors are paid on the basis of the
value of their marginal productivity, which in turn depends
upon the output prices of the goods. Thus, when prices
differ between countries, so will their marginal
productivities and hence so will their wages and rents.
However, once goods prices are equalized, as they are in
free trade, the values of marginal products are also
equalized between countries and hence the countries must
also share the same wage rates and rental rates. As such,
international trade is a substitute for the international
mobility of factors. One should note, however, that factor-
price equalization is unlikely because it assumes the same
technology between countries, which is unlikely in the real
world.

62
The Rybczynski Theorem

The Rybczynski theorem demonstrates the relationship

between changes in national factor endowments and
changes in the outputs of the final goods within the context
of the H – O model. It states that an increase in a country’s
endowment of a factor will cause an increase in output of
the good which uses that factor intensively, and a decrease
in the output of the other good. For example, if the U.S.
experiences an increase in capital equipment, then that
would cause an increase in output of the capital – intensive
good, steel, and a decrease in the output of the labor –
intensive good, clothing. The theorem is useful in
addressing issues such as investment, population growth
and hence labor force growth, immigration and emigration,
all within the context of the H – O model

An Evaluation of the H – O Model

The gist of the H – O model (or factor – endowment and

factor-intensity theory) is that comparative advantage and

63
international trade occur because countries are endowed
with different factors and the production of goods requires
different proportions of these factors. There are mixed
views among economists regarding the validity of this
theory. Some economists are of the view that certain
refinements are required on the H – O theory in order to
explain the current trade patterns. Others are seeking to
replace the theory with a different approach. In what
follows, attempts are made to present two opposing views
on the H – O theory of comparative advantage.

The first view holds that the trade patterns of the 1980s do
fit into the H – O theory. For example, Japan had an export
advantage in technology – intensive products such as
transport equipment, machinery, chemicals, and computers
because it had abundant supply of scientific personnel. On
the other hand, Japan depended on imports of natural
resource –intensive primary products because it had scarce
resources for the production of such products. The second
view reflects the challenges to the H – O theory of
comparative advantage. It argues that, even with identical

64
endowments, technology, tastes, and income distribution,
trade can take place owing to increasing returns to the firm.
The typical example in this regard is intra-industry trade (or
trade in differentiated products). The advocates of these
views utilize models of imperfect competition and
economies of scale to substantiate their arguments.

Another challenge to the H – O theory was an empirical

testing that was done by Wassily W. Leontie in 1954.
Leontief received the Nobel in 1973 for his contribution on
input – output table. He applied input – output technique to
examine the structure of US foreign trade. He examined the
factor composition of US exports and US imports. He
considered that the US is capital abundant and thus should
export capital – intensive products. His surprising
conclusion was that US exports were labor-intensive, and
US import substitutes were capital – intensive. Thus, his
finding appeared to refute the H-O model, resulting in what
is now refereed to as the “Leontief Paradox.” Leontief’s
findings caused considerable dismay among economists,
leading to the conclusion that something was either wrong

65
with the empirical test or with the basic theory. It turned
out to be both, resulting in a better understanding of how
factor abundance influences international trade. The next
discussions highlight some of the explanations of the
Leontief paradox.

The most important explanation for the Leontief paradox

has to do with the skill level of the US workforce and its
high technology. Leontief’s test, which found that US
exports were labor intensive, was based on the simple two-
factor version of the factor - proportions model. This
simple model assumes that labor is homogeneous.
However, much of the US labor force is highly skilled or
possesses human capital (knowledge and skills) compared
to other countries. Therefore, what needs to be considered
is what constitutes a factor of production? Physical capital
can be used as a factor as it was described in the simple
version of the H – O theory, but the same cannot be said for
labor. In other words, the knowledge and skills that the
labor force (human capital) possesses should be treated as a
separate factor of production. Thus, it is reasonable to

66
argue that the basic logic embodied in the factor-
proportions theory is correct. What is required is to broaden
the concept of factors of production in order to include
factors other than labor and capital.

The New Trade Theories

The point of departure in discussing the new trade theories

is relaxing some of the major assumptions of the H – O
theory. In other words, relaxing most of the assumptions of
the theory only modifies but does not invalidate the theory.
However, relaxing the assumptions of constant economies
of scale and perfect competition requires the introduction of
new trade theories which explain the significant portion of
international trade that have not been explained by the H –
O theory. The next discussion focuses on these new trade
theories.

Trade Based on Differentiated Products (or Intra –

Industry Trade)

67
There is a substantial portion of trade that the H – O model
does not explain. Countries can trade similar goods with
one another, known as intra - industry trade or trade in
differentiated products. Differentiated products refer to
similar, but not identical products such as automobiles,
cigarettes, television sets, and typewriters. For example,
Canada and the US have a large trading relationship based
on exporting and importing automobiles to and from each
another. This implies that a country simultaneously has a
comparative advantage and a comparative disadvantage in
the same good.

There are at least three major reasons for product

differentiation. First, Many varieties of a product exist
because produces attempt to distinguish their products in
the minds of consumers in order to achieve brand loyalty.
In addition, consumers themselves want a broad range of
characteristics in a product from which to choose. Since
consumer tastes differ in innumerable way, some intra –
industry trade emerges because of product differentiation.
Secondly, in a physically large country, such as the US,

68
transport costs for a product may play a role in causing
intra – industry trade, especially if the product has large
bulk relative to its value. For example, if a given product is
manufactured both in the eastern part of Canada and in
California, a buyer in Maine (US’s state which is closer to
Canada) may buy the Canadian product rather the
California product because the transport costs are lower. At
the same time, a buyer in Mexico may purchase the
California product. Thus, the US is both exporting and
importing the good. Finally, differing distributions of
income can lead to intra – industry trade. For instance,
producers may cater to “majority” tastes (in terms of
income) within their nation, leaving “minority” tastes to be
satisfied by imports.

Trade Based on Economies 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. However, with

69
increasing returns to scale, mutually beneficial trade can
take place even if the two nations are identical in every
respect. Increasing returns to scale refers to the production
situation where output grows proportionately more than the
increase in the use of inputs or factors of production. For
example, if all inputs are doubled, output is more than
doubled; and if all inputs are tripled, then 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 become possible. In other words, each
worker can specialize in performing a simple repetitive
task, resulting in increased productivity. Furthermore, a
larger scale of operation may permit the introduction of
more specialized and productive machinery than would be
feasible at a smaller – scale of operation. Thus, mutually
beneficial trade is possible based on increasing returns to
scale.

Trade Based on Technological Gaps and Product Cycles

70
According to the technological gap model, trade among
industrialized countries is based on the introduction of new
products and new production processes. The innovating
nation shall have a temporary monopoly in terms of patents
and copyrights, which are granted to stimulate the flow of
inventions. For example, the US exports a large number of
new high - technology products. However, as other
countries acquire the new technology, they will be in a
position to produce the products at lower labor costs. In the
meantime, the US producers may have introduced still
newer products and newer production processes and may
be able to export these products based on the new
technological gap established. One shortcoming of the
technological gap model is that it does not explain the
reasons for and the size of the gap.

A generalization and extension of the technological gap

model is what is refereed to as the product cycle model.
According to this model, changes in technology and the
subsequent introduction of new products can change the
pattern of exports and imports. The basic idea behind the

71
product cycle model is that certain countries, primarily
industrialized countries, specialize in the production of new
goods based on technological innovations, while other
countries, mostly developing countries, specialize in the
production of the already well – established goods.
Furthermore, the model postulates that the introduction of
new products usually requires highly skilled labor in the
production process. As the product matures and acquires
mass acceptance, its production becomes standardized,
requiring less skilled labor. In this process, the comparative
advantage shifts from the advanced nation that originally
introduced the product to the less advanced nation with
relatively cheaper labor. This may be accompanied by
foreign direct investment from the innovating nation to the
nation with cheaper labor. It should be pointed out that,
while the technological gap model emphasizes the time lag
in the imitation process, the product cycle model stresses
the standardization process.

Summary

72
1. This chapter examined the development of trade
theory from the mercantilists to Adam Smith, David
Ricardo, Heckscher – Ohlin, and the new trade
theories. It tried to answer three basic questions: a)
what is the basis for trade? b) what are the gains from
trade? and c) what is the pattern of trade?

2. The mercantilists emphasized the desirability of an

export surplus in international trade as a means of
acquiring specie (primarily, gold and silver) to add to
the wealth of a country. They believed that a nation
could gain in international trade only at the expense of
other nations. This implied that international trade was
a zero – sum game where exports were positive and
imports were negative. Thus, they advocated
incentives for exports, restrictions on imports, and
strict government regulation of all economic activities.
Over time, the concept of wealth and the role of trade,
and the whole Mercantilist system of economic
thought, were challenged by writers such as David

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 Hume and Adam Smith. Mercantilism broke down
because it lost intellectual respectability.

3. Adam Smith’s concept of absolute advantage was

instrumental in altering views on the nature of and the
potential gains from trade. Assuming a two – nation,
two – commodity, and the labor theory of value, Smith
concluded that mutually beneficial trade is possible
based on absolute advantage. According to Smith’s
principle of absolute advantage, each country should
specialize in and export those commodities that it
produces more efficiently (i.e., with fewer labor input
requirement) and should import those commodities
that it produces less efficiently (that is, with higher
labor input requirement). This implied that
international trade was a positive – sum game where
both nations could mutually benefit from trade. Smith
argued that the role of the government was to see that
markets function properly, by removing barriers to
effective operation of the “invisible hand” of the
market. However, there were few exceptions to

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 Smith’s “laissez faire” policy. For example, the
protection of infant industries and industries that are
important for national defense were among the few
exceptions.

4. Today, Smith’s principle of absolute advantage

explains only a small portion of international trade
such as those between developed and developing
countries. Most of world trade such as those among
developed countries could not be explained by
absolute advantage. David Ricardo expanded on the
concept of absolute advantage by introducing the
concept of comparative advantage. According to
Ricardo’s principle of comparative advantage, even
when one country is more efficient (or has an absolute
advantage) than the other nation in the production of
both goods, mutually beneficial trade could still take
place. He argued that the more efficient nation should
specialize in and export the good in which its absolute
advantage is greater, and import the good in which its
absolute advantage is smaller. Similarly, the less

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 efficient nation should specialize in and export of the
good in which its absolute disadvantage is smaller,
and import the good in which its absolute
disadvantage is greater. Ricardo introduced the
concept of opportunity cost to illustrate this case as
applied to his popular examples of two goods, wine
and cloth, in two countries, Portugal and the England.

5. The Classical economists (for example, Adam Smith

and David Ricardo) developed the basic propositions
regarding the nature and impact of international trade.
However, they were limited considerably in their
analyses by the assumptions of the labor theory of
value and constant costs. The development of the
neoclassical economic theory in the late nineteenth
and early twentieth centuries provided tools for
analyzing the impact of international trade in a more
rigorous and less restrictive manner. The application
of neoclassical theory to international trade issues and
later refinements of these ides constitute the basic
contemporary theory of trade.

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6. The Neoclassical model goes one step further (as
compared to the Classical) to extend the analyses in
two directions. First, it tries to explain the reasons for
the difference in relative commodity prices and
comparative advantage between the two nations.
Secondly, it attempts to analyze the effect of
international trade on the earnings of the factors of
production in the two trading nations. According to
classical economists, comparative advantage was
based on the difference in the productivity of labor
(the only factor of production they considered) among
nations, but they did not provide explanation for such
a difference. Two Swedish economists, Eli F.
Heckscher and Bertil Ohlin (H – O), undertook the
task of providing those explanations. Many
elaborations of the model were provided by Paul
Samuelson, an American economist and a Nobel price
winner in economics in 1976, after the 1930s and thus
sometimes the model is refereed to as the Heckscher –
Ohlin – Samuelson (H – O- S) model.

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7. There are four main theorems in the H – O model: the
Heckscher – Ohlin theorem, the Stolper – Samuelson
theorem, the Rybczynski theorem, and the factor –
price equalization theorem. The Stolper – Samuelson
and Rybczynski theorems describe relationships
between variables in the model while the H – O and
factor – price equalization theorems present some of
the key results of the model. Applications of these
theorems also allow one to derive some other
important implications of the model.

8. On the basis of the simplifying assumptions that have

been stated in the text, the Heckscher – Ohlin (H – O)
theorem may be stated as follows. A nation will export
the commodity whose production requires the
intensive use of the nation’s relatively abundant and
cheap factor of production and import the commodity
whose production requires the intensive use of the
nation’s relatively scarce and expensive factor of
production. For example, assuming two factors of

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 production, labor and capital, the theorem states that
the relatively labor – rich nation exports the relatively
labor – intensive commodity (because wage is lower),
and imports the relatively capital – intensive
commodity (because rental cot of capital is higher).
Similarly, the relatively capital – rich nation exports
the relatively capital – intensive commodity (because
rental cost of capital is lower), and imports labor –
intensive commodity (because wage is higher). Thus,
the H – O theorem emphasizes factor endowments and
factor intensities as the bases for international trade.
For this reason, the theorem is often refereed to as
factor – endowment and factor proportion theory.

9. There were mixed view on the theoretical and

empirical validities of the H – O theorem of
international trade. Some writers hold the view that
the trade patterns of the 1980s do fit into the H – O
model, by citing the examples of Japan and the U. S.
Others argued that the H – O theory should be refined
and / or replaced, especially because of its restrictive

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 assumptions such as similar tastes and preferences,
and constant returns to scale production function. The
major challenge to the H – O theory was the empirical
testing that was done by Wassily W. Leontief in 1954.
Leontief’s findings refuted the H – O theorem,
resulting in what is now refereed to as the “Leontief
Paradox.” Consequently, refinements were made to
the H – O theory of international trade, leading to the
new trade theories, which are based on differentiated
products, economies of scale, technological gap, and
product cycles.

10. Trade based on differentiated products (or intra –

industry trade) is a proposition that argues that
countries can trade similar (but not identical) products
with one another. In other words, countries can
simultaneously export and import similar goods. For
example, the US both exports and imports
automobiles, cigarettes, chemicals, and many other
industrial products.

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11. Trade based on economies of scale emanates
from the fact that trade can take place between two
countries because of scale economies, regardless of
the same endowments, technology, and tastes.
Economies of scale arise because division of labor and
specialization become possible when the scale of
operation is sufficiently great. In other words,
efficiency and productivity increase with a large scale
of operation.

12. Technological gap model postulates that a great

deal of the exports of industrial nations is based on the
introduction of new products and new production
processes. Product cycle model is a generalization and
extension of the technological gap model. It postulates
that the comparative advantage in introducing new
products lies in the high – technology nations but
ultimately shifts to cheap- labor nations once the
product acquires mass acceptance. Technological gap
model emphasizes the time lag in the imitation

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 process, while the product cycle model stresses the
standardization process.

Glossary of Key Concepts and Terms

1. History of Economic Thought: The study of the

heritage left by writers on economic subjects over
many years

2. Mercantilism: A philosophy that was popular in

countries such as Britain, Spain, France, and the
Netherlands during the seventeenth and eighteenth
centuries. The essence of mercantilism was statecraft.
It is based on the premise that a country can promote
its self – interest by discouraging imports and
encouraging exports in order to increase its wealth.
Furthermore, a country’s wealth was based on its
holdings of precious metals, primarily gold and silver.
The doctrine of mercantilism had many features: it
was highly nationalistic, it favored the regulation and

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 planning of economic activity as an effective means of
fostering the goals of the nation, and it favored
positive trade balance.

3. Favorable Trade Balance: The excess of exports

over imports or favorable balance of trade.

4. Zero – Sum Game: A game in which one person’s

winnings are matched by the losses of the other player.
In the context of international trade, it is a situation in
which one country’s economic gain is achieved at the
expense of the other.

5. Price – Specie – Flow Mechanism: A proposition

forwarded by David Hume to challenge the
mercantilists’ view on international trade regarding the
maintenance of favorable trade balance. Hume argued
that the accumulation of gold by means of a trade surplus
would lead to an increase in the money supply and
therefore to an increase in prices and wages. This would
reduce the competitiveness of the country with a surplus.

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 On the other hand, the loss of gold in the deficit country
would reduce its money supply, prices, and wages and
therefore increases its competitiveness. Thus, it is not
possible for a nation to continue to maintain a positive
trade balance indefinitely.

6. Physiocrats: A doctrine which developed in France in

the eighteenth century as a reaction against mercantilism.
The founder and leader of the physiocratic school was
Francois Quesnay (1694 – 1774). The physiocrats
developed the idea of natural order. They argued that
governments should never extend their interference in
economic affairs beyond the minimum essentials of
protecting life and property. They were opposed to almost
all feudal, mercantilist, and government restrictions. This is
the basis for the famous phrase “laissez faire, laissez
passer” – let it be, let it go. The physiocrats thought that
only agriculture was productive, for it produces a surplus a
net product above the cost of production. They looked at
the economy as a whole and analyzed the circular flow of
wealth.

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7. Laissez – Faire: A doctrine that advocated that the
economic affairs of society are best guided by the decisions
of individuals to the virtual exclusion of collective
authority. The idea has its basis in the writings of the
Physiocrats, but its analytic foundations of the idea lie in
the work of Adam Smith and the classical school. Smith
argued that individuals acting purely out of self-interest
would be a progressive force for the maximization of the
total wealth of a nation. The role of the authorities, given
this aim, should be permissive, creating a legal defensive
apparatus sufficient to allow individual action. Interference
with the free working of this natural order will reduce the
growth of wealth and misdirect resources.

8. Positive – Sum Game: A game in which all players can

receive a positive payoff in the game. In the context of
international trade, it is a situation in which all the trading
partners can mutually benefit from trade.

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9. Absolute Advantage: Is the basis for trade according to
Adam smith. Smith argued that each nation should
specialize in the production of those commodities that it
could produce more efficiently than other nations, and
should import those commodities that it could produce less
efficiently. According to Smith, this international
specialization of factors of production would result in an
increase in world output, which would be shared by the
trading partners.

10. Efficiency: A concept that was developed at the turn of

the twentieth century by the Italian – French economist
Vilfredo Pareto and is sometimes known as Pareto –
efficiency or Pareto – optimality. The term can be
described in two ways: efficiency of production and
efficiency of an economic system. In the former case, a
plant may be said to be efficient if all its resources (for
example, land, labor, capital, and entrepreneurial skills) are
used well. This would imply that a given level of output is
being produced with the least resource cost. In other words,
the given productive resources are being used to produce

86
output with a maximum value. In the later case, an
economic system is said to be efficient if the resources are
being used and goods and services are being distributed in
such a way that it is impossible to make anyone in the
system better off without making someone else worse off.

11. Comparative Advantage: Is the basis for trade

according to David Ricardo. Ricardo began by extending
Smith’s idea of absolute advantage to his principle of
comparative advantage. Assuming two – nations, two-
commodities, and one factor of production (labor), a
comparative advantage exists whenever the relative labor
requirements differ between the two nations. In other
words, when the relative labor requirements are different,
the internal opportunity cost (that is, the next best
alternative forgone) of the two commodities is different in
the two countries. Thus, Ricardo argued that, even if one
nation is less efficient than (has an absolute disadvantage
with respect to) the other nation in the production of both
commodities, there is still a basis for mutually beneficial
trade. The less efficient nation should specialize in the

87
production of and export the commodity in which its
absolute disadvantage is smaller (or comparative advantage
is greater), and import the commodity in which its absolute
disadvantage is greater (or comparative advantage is
lower). Ricardo demonstrated his case by using his popular
example of two countries, England and Portugal, and two
goods, cloth and wine.

12. Opportunity Cost: It is the most fundamental concept

in economics. The opportunity cost of an action is the value
of the forgone alternative action. Opportunity cost can only
arise in a world where the resources available to meet
wants are limited so that all wants cannot be satisfied. If
resources were limitless, no action would be at the expense
of any other and thus, the opportunity cost would be zero.
Clearly. In a real world of scarcity, opportunity cost is
positive. For example, in the theory of production, the
opportunity cost of one commodity (say, cloth) is the
amount of another commodity (say, wine) that must be
given up or sacrificed in order to release just enough factors

88
of production or resources to enable the production of one
additional unit of cloth.

13. The Production Possibility Schedule: The tabular

presentation of alternative combinations of the two
commodities that a nation can produce by fully utilizing all
of its resources with the best technology available to it.

14. The Production Possibility Frontier (PPF): The

graphical translation of the production possibility schedule.
It is also refereed to as the production possibility curve or
transformation curve. The PPF reflects all combinations of
two products that a country can produce at a given point in
time given its resource base, level of technology, full
utilization of resources, and economically efficient
production.

15. Labor Theory of value: A theory employed by the

classical economists (for example, David Ricardo and
especially Karl Marx) to explain the determination of
relative prices on the basis of the quantities of labor

89
embodied in the production of the commodities. According
to this theory, the cost or price of a commodity is
determined by or can be inferred exclusively from its labor
content.

16. Factor Endowment: The supplies (or quantities) of

factors of production. In other words, it is the levels of
availability of factors in an area or country. These are
usually defined as land, labor, capital, and entrepreneurial
skills. The different relative abundance of factors of
production is the basis for explaining comparative
advantage in the H – O approach to international trade.

17. Factor Proportion: The degree of factor use or the

ratio in which factors of production are combined. In the
case of two factors, labor and capital, it is the ratio of labor
to capital or capital to labor.

18. Labor – Intensive Commodity: The commodity with

the higher labor – capital ratio (L/K) at all relative factor
prices.

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19. Capital – Intensive Commodity: The commodity with
the higher capital – labor ratio (K/L) at all relative factor
prices.

20. Leontief Paradox: The empirical findings that US

import substitutes were more capital intensive than US
exports. This is contrary to the H – O model of
international trade, which predicts that, as the most capital
– abundant nation, the US should export capital – intensive
products and import labor – intensive products.

21. Intra – Industry Trade: International trade in the

differentiated products of the same industry or broad
product group. Product differentiation can take two forms:
horizontal and vertical. Horizontal differentiation is based
on certain characteristics such as, for example, color or
taste of a wine. Vertical differentiation is based on quality,
appealing to consumer’s income.

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22. Economies of Scale: The production situation where
output grows proportionately more than the increase in the
use of inputs or factors of production. Economies of scale
arise because of division of labor and specialization,
resulting from a sufficiently large scale of operation. In
other words, division of labor and specialization increases
efficiency and productivity.

23. Technological gap Model: The hypothesis that a

portion of international trade is based on the introduction of
new products using new production processes.

24. Product Cycle Model: The hypothesis that new

products introduced by advanced nations and produced
with skilled labor eventually become standardized and can
be produced in other nations with less skilled labor.

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Review Questions and Practical Exercises

1. Why are the pure theory of international trade and the

theory of commercial policy refereed to as the
microeconomic aspects of international economics?
Explain.

2. Why are the studies of the balance of payments and of

the process of adjustment to the balance of payments
disequilibria refereed to as the macroeconomic aspects
of international economics?

3. What are the basic questions that one seeks to answer

in international trade theories?

4. a) What were the mercantilists’ views on international

trade and what policies did they advocate in
international trade?
b) How does the concept of national wealth differ
from today’s view?

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 c) What are the contributions of the mercantilists to
international trade?
d) What were the major challenges to mercantilists’
views on international trade?

5. a) What were the bases for and the pattern of trade

according to Adam Smith?
b) What policies did Adam Smith advocate in
international trade?
c) What did Adam Smith think about the proper role
of the government in the economic life of the nation?
What were some of the exceptions in his analysis?
d) By using your own example, illustrate Adam
Smith’s principle of absolute advantage.
e) What are the major contributions of Adam Smith to
international trade theory and what are the major
weaknesses in his analysis of international trade?

94
 6. a) What do you understand by the concept of the
“invisible hand?” Explain.
b) What do you understand by the concept of “laissez
faire” and who originated the concept?
c) How do you evaluate the concept of “laissez faire”
in today’s world?

7. a) What were the bases for and the pattern of trade

according to David Ricardo?
b) State and explain David Ricardo’s principle of
comparative advantage.
c) Illustrate the principle of comparative advantage by
using the concept of opportunity cost (you may use
tables and graphs).
d) In what way was Ricardo’s principle of
comparative advantage superior to Adam Smith’s
principle of absolute advantage?
e) What are the major contributions of David Ricardo
to international trade theory and what were the major
weaknesses in his analysis of international trade?

95
 8. a) What do you understand by the “neoclassical trade
theory?”
b) How does the neoclassical trade theory of
international trade depart from the classical trade
theories? Explain.

9. a) State and explain the H – O theorem of

international trade. What are the
assumptions of the theorem and what are the
weaknesses of the theorem?
b) What are the basic determinants of comparative
advantage in the H – O
approach to international trade?
c) What does the factor-price equalization theorem
postulate? What is its
relationship to the international mobility of factors
of production?
d) What is meant by the Leontief paradox? What are
some of the possible
explanations for the paradox?

96
 10. a) What is meant by “labor – abundance?” Give
examples.
b) What is meant by “capital – abundance?” Give
examples.
c) What is meant by “labor – intensive” commodity?
Give examples.
d) What is meant by “capital – intensive”
commodity? Give examples.
e) What is meant by “labor-capital ratio” or “capital
– labor ratio?”

11. a) How do the new trade theories depart from the

classical and the neoclassical
trade theories? Explain.
b) What are the bases for trade in intra – industry
trade? Explain this situation
by providing practical examples.
c) What are the bases for trade in scale
economies? Explain this situation by
providing practical examples.

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 d) What are the bases for trade in technological gap
and product cycle models?
Explain this situation by providing practical
examples.

12. Make your own critical evaluation of the following

views (principles or theories)
of international trade:
a) Mercantilists’ views
b) Adam Smith’s law/principle of absolute
advantage
c) David Ricardo’s law/principle of
comparative advantage
d) The H – O theorem
e) The new trade theories

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