Conclusions from Comparative Advantage theory

Pre-trade Px/Py post-trade Px/Py pre-trade Px/Py

in country A < in both A & B < in country B

• Both countries gain from increasing the price of exports relative to price
of imports.
• Countries, with free trade specialise in products they export.

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Some observed trade patterns between
developing (India)
and
developed (USA and Germany)
nations:

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 India- USA major trade items
Exports to USA
Pearls, precious stones, metals, coins
Pharmaceutical products*
Other made textile articles, sets, worn
clothing etc*
Mineral fuels, oils, distillation products, etc
Machinery, mechanical appliances, nuclear
reactors, boilers; parts thereof
Articles of apparel, accessories, not knit or
crochet*
Imports from USA
Machinery, nuclear reactors, boilers #
Pearls, precious stones, metals, coins
Electrical, electronic equipment #
Optical, photo, technical, medical, etc
apparatus #
Aircraft, spacecraft, and parts thereof #
Mineral fuels, oils, distillation products
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 India - Germany major trade items
Exports to Germany
Machinery, nuclear reactors, boilers, etc
Articles of apparel, accessories, knit or
crochet *
Organic chemicals
Articles of apparel, accessories, not knit or
crochet *
Vehicles other than railway or tramway rolling
stock, and parts and accessories thereof
Electrical, electronic equipment
Imports from Germany
Machinery, nuclear reactors, boilers
Electrical, electronic equipment
Optical, photo, technical, medical, etc
apparatus #
Vehicles other than railway, tramway #
Plastics and articles thereof #
Organic chemicals
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China – US trade

Skill composition of US- China Trade (1990)

Skill group (industry examples) % of China’s % of US export
export to US to China
Most skilled
Periodicals, office and computing machines 4.8 7.7
Aircraft and parts, industrial organic chemicals 2.6 48.8
Engines and turbines , fats and oils 3.9 21.3
Concrete, non electronic plumbing, and heating 11.5 4.3
Watches, clocks, toys, sports goods 18.9 6.3
Wood buildings blast furnaces, basis steel 8.2 1.3
Ship building and repair, furniture, fixtures 4.1 2.8
Cigarettes, motor vehicles, iron and steel foundries 5.2 1.8
Weaving, wool, leather tanning and finishing 17.2 0.4
Children’s outerwear, non rubber footwear 23.5 5.2
Least skilled
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Socks made in USA, clothes from Mexico
• USA imports almost 2/3 of its apparel consumption despite complex trade
restrictions.
• Most of the import comes from Mexico, China, Caribbean nations, India.
• Mexico, being a part of NAFTA, faces less restrictions and is the largest
exporter.
• Production is low skill labour intensive

• But, US produces 90% of its sock's consumption.

• With computer controlled knitting machines that run with little human
intervention.

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 Identifying that cost advantage could be due to factor
Factor Proportions abundance.
• 2 countries A and B
Theory • 2 products – x and y
• 2 factors of production – Labour (L) and Capital (K)

Other assumptions
• Perfect competition in product and factor market
• Identical consumption pattern in trading countries
• Uniform production technology across counties
• Wages and rents may be different across borders
Due to • Decreasing returns to factors (increasing opportunity
Eli Heckscher costs), but constant returns to scale
and
Bertil Ohlin
Factor abundance – comparing countries

Country A is a L abundant country relative to B if

[L available in A / K available in A] > [L available in B / K available in B]
LA/KA > LB/KB
If A is labour abundant, B must be capital abundant

Factor Intensity – comparing goods

Production of good X is L intensive relative to y, if

[L/K] required for unit x > [L/K] required for unit y Textile(x)
w/r
Lx/Kx > Ly/Ky Aircraft (y)
If x is labour intensive,
y must be capital intensive

K/L
• X is a relatively labour intensive product than Y
L req. for unit production of X / K req. for unit production of X
> L req. for unit production of Y / K req. for unit production of Y
Or Lx/Kx > Ly/Ky

• Say, A is the labour abundant country relative to B

L supply in A/K supply in A > L supply in B/K supply in B

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• Consider that both countries have identical demand combination for products.
(one of the assumptions)
Demand for x in A/ Demand for y in A = Demand for x in B/Demand for y in B
Qxa/Qya = Qxb/Qyb = z say

• We also assume identical production technologies adopted in each country in

each product.
L demand in A/ K demand in A = Lx.Qxa + Ly.Qya / Kx.Qxa + Ky.Qya
= [Lx. (Qxa/Qya) + Ly] / [Kx. (Qxa/Qya) + Ky]
= [Lx.z + Ly] / [Kx.z + Ky]
L demand in B/ K demand Y in B = Lx.Qxb + Ly.Qyb / Kx.Qxb + Ky.Qyb
= [Lx. (Qxb/Qyb) + Ly] / [Kx. (Qxb/Qyb) + Ky]
= [Lx.z + Ly] / [Kx.z + Ky]
LD in A / KD in A = LD in B / KD in B

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 L supply in A/K supply in A > L supply in B/K supply in B

L demand in A/ K demand in A = L demand in B/ K demand Y in B

• Therefore wa/ra < wb/rb

Can we predict
where would the relative prices be higher
under autarky?

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Trade pattern is decided on the basis of relative prices.
Px/Py in A or Px/Py in B – which is higher?

Px/Py in A > or = or < Px/Py in B

If and only if ACx/ACy in A > or = or < ACx/ACy in B

If and only if
wa.Lx + ra.Kx /wa.Ly + ra.Ky > or = or < wb.Lx + rb.Kx /wb.Ly + rb.Ky

Given Lx/Kx > Ly/Ky and wa/ra < wb/rb

wa.Lx + ra.Kx /wa.Ly + ra.Ky < wb.Lx + rb.Kx /wb.Ly + rb.Ky
Therefore,
ACx/ACy in A < ACx/ACy in B
Px/Py in A < Px/Py in B

• This is the very condition for comparative advantage. And predictions on the basis
of Comparaive advantage theory holds good. 12
Country A: Px/Py in A < Px/Py in B Country B:
• Labour abundant nation • Capital abundant nation

• Tend to specialise in labour • Tend to specialise in Capital

intensive good X intensive good Y
• Export X, import Y • Export Y, import X

• Rise in Px / Py to the post trade • Fall in Px / Py to the post trade

international level (TOT ↑) international level (TOT ↑)

• Convergence in the price ratio

• Convergence in the price ratio across A and B
across A and B
• Gain in consumption possibilities
• Gain in consumption possibilities

• Rise in rental for capital, fall in

• Rise in workers wages, fall in workers wages
rental for capital
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 Changes in workers wages and rental to capital

Country A: Country B:
production shifts from Y to X production shifts from X to Y

Requirement of workers in X > Requirement of workers in Y < number

number of workers released from Y of workers released from X

Excess demand for workers raises wa Excess supply of workers reduces wa

Requirement of capital in Y < amount Requirement of capital in Y > amount

of Capital released from X of Capital released from X

Excess supply of capital reduces ra Excess demand for capital raises ra

• Hence the rise in workers wages, • Hence the rise in rental for capital,
fall in rental for capital fall in workers wages
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 Technology based comparative advantage
vis-à-vis
resource based comparative advantage

• Difference in relative prices between countries is the key to advantage

in both cases.
• Similar trade patterns predicted

• Technology based comparative advantage does not bring about income

convergence. Resource based advantage does.

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Reading

From reading material on module 1-

“Trade and Resources– The Heckscher-Ohlin Model ”

From web sources

• http://www.centralbanking.com/central-banking/feature/2411689/leaning-by-doing-has-
transformed-chinese-growth
Leaning by doing' has transformed Chinese growth

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