CHAPTER 3: SOURCES OF COMPARATIVE ADVANTAGE

OVERVIEW: SOME THINGS WE WILL DISCUSS

▸ Factor-Endowments as a Source of Comparative Advantage

▸ Is the Factor-Endowment Theory a Good Predictor of Trade Patterns?

▸ Skill as a Source of Comparative Advantage

▸ Economies of Scale and Comparative Advantage

▸ Overlapping Demands as a Basis for Trade

▸ Intra-Industry Trade

▸ Technology as a Source of Comparative Advantage: The Product Cycle Theory

▸ Dynamic Comparative Advantage: Industrial Policy

▸ WTO Rules that Illegal Government Subsidies Support Boeing and Airbus

▸ Government Regulatory Policies and Comparative Advantage

▸ Transportation Costs & Comparative Advantage

CHAPTER 3: SOURCES OF COMPARATIVE ADVANTAGE

FACTOR ENDOWMENTS
▸ Ricardian theory takes for granted that relative labor
productivity, labor costs and product prices differed in 2
countries before trade.

▸ But Ricardo’s assumption of labor as the only factor of

production ruled out an explanation of how trade affects
the distribution of income among factors of production
within a nation, & why some favor trade, and some oppose
it.

▸ Heckscher & Ohlin formulated a theory to answer these

questions
CHAPTER 3: SOURCES OF COMPARATIVE ADVANTAGE

FACTOR ENDOWMENTS
▸ Factor-endowment theory (Heckscher-Ohlin theory):

▸ The immediate basis for trade is difference between pre-

trade relative product prices of trading nations.

▸ Prices depend on the production possibilities curves

and tastes and preferences (demand conditions) in the
trading countries.
CHAPTER 3: SOURCES OF COMPARATIVE ADVANTAGE

FACTOR ENDOWMENTS
▸ Assumption: technology and demand are approximately the
same between countries

▸ Production possibilities curves depend on technology and

resource endowments

▸ Capital/Labor Ratio

▸ Determines comparative advantage

▸ A country exports a good that uses a large amount of its

relatively abundant resource

▸ A country imports a good which (in production) uses its

relatively scarce resource
CHAPTER 3: SOURCES OF COMPARATIVE ADVANTAGE

FACTOR ENDOWMENTS
▸ Capital/Labor Ratio

▸ Determines comparative advantage

▸ A country exports a good that uses a large amount of

its relatively abundant resource

▸ A country imports a good which (in production) uses

its relatively scarce resource

▸ EXAMPLE:

▸ US has a lot of capital so we will export things that are

capital intensive to make like cars and planes.
CHAPTER 3: SOURCES OF COMPARATIVE ADVANTAGE

FACTOR ENDOWMENTS
▸ Effect of resource endowments on comparative advantage
CHAPTER 3: SOURCES OF COMPARATIVE ADVANTAGE

FACTOR ENDOWMENTS
▸ Capital/Labor Ratio

▸ The amount of capital per worker varies A LOT.

CHAPTER 3: SOURCES OF COMPARATIVE ADVANTAGE

FACTOR ENDOWMENTS
▸ Visualizing the Factor-Endowment Theory

▸ Figure 3.1shows the production possibilities curve of the

U.S. is skewed toward aircraft, while that of China is
skewed toward textiles
CHAPTER 3: SOURCES OF COMPARATIVE ADVANTAGE

FACTOR ENDOWMENTS
▸ Capital/Labor Ratio
CHAPTER 3: SOURCES OF COMPARATIVE ADVANTAGE

FACTOR ENDOWMENTS
▸ Weakness:

▸ The factor-endowment theory does not explain two-way

trade, nor why wealthy countries with similar
endowments trade more intensively than others with
different endowments

▸ This is a big one. Our largest trading partners are

other industrialized countries like the EU and Canada.
CHAPTER 3: SOURCES OF COMPARATIVE ADVANTAGE

FACTOR ENDOWMENTS
▸ Factor-Price Equalization

▸ Redirects demand away from the scarce resource towards the

abundant resource in each nation

▸ Trade leads to factor-price equalization

▸ The cheap resource becomes relatively more expensive

▸ The expensive resource becomes relatively less expensive

▸ Eventually, price equalization occurs

▸ In other words capital and labor prices should equalize.

▸ But in real world, no full factor-price equalization

CHAPTER 3: SOURCES OF COMPARATIVE ADVANTAGE

FACTOR ENDOWMENTS
▸ Who (what producers) gains from trade?

▸ The Stolper-Samuelson Theorem (Extension of factor-price equalization

theory)

▸ An increase in the price of goods (exports)

▸ Increases the income earned by resources that are used intensively in

its production

▸ A decrease in the price of goods (imports)

▸ Reduces the income of the resources that it uses less intensively

▸ Magni cation effect:

▸ change in price of resource is greater than change in the price of good

that uses the resource intensively
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CHAPTER 3: SOURCES OF COMPARATIVE ADVANTAGE

FACTOR ENDOWMENTS
▸ Who (what producers) gains from trade?

▸ The Stolper-Samuelson Theorem (Extension of factor-price

equalization theory)

▸ NOTE: the gains/losses go to the scarce resource even

those not being used in export.

▸ Example: chinese fast food workers….

▸ or American fast food workers?

CHAPTER 3: SOURCES OF COMPARATIVE ADVANTAGE

FACTOR ENDOWMENTS
▸ All these theories assume factors of production are not mobile.
But the difference in factor endowments can lead to immigration.

▸ Rather than the cheap labor of say mexico resulting in mexico making
labor intensive products - perhaps the labor moves to the country
scarce in that resource (labor) like the US.

▸ Some argue free trade can reduce migration.

▸ So if Trump new trade deals with Mexico reduces production of

cars in Mexico and more built in the US - what will that do to his
immigration plans?

▸ Alternatively if Trump is very successful at blocking immigation

what might that do to food production in California?
CHAPTER 3: SOURCES OF COMPARATIVE ADVANTAGE

FACTOR ENDOWMENTS
▸ Can trade reduce immigration?

▸ If goods can move then the cheap labor will attract

production of labor intensive goods driving up labor
prices and reducing desire to migrate.

▸ This was one argument for NAFTA.

CHAPTER 3: SOURCES OF COMPARATIVE ADVANTAGE

FACTOR ENDOWMENTS
▸ Speci c-factors theory

▸ Analyzes the income distribution effects of trade in the short

term, when resources are immobile among industries

▸ Speci c factors:

▸ Workers acquire skills for speci c occupations, not easily

transferable to other industries

▸ Resources speci c to import-competing industries lose

as a result of trade

▸ Resources speci c to export industries gain as a result of

trade
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CHAPTER 3: SOURCES OF COMPARATIVE ADVANTAGE

FACTOR ENDOWMENTS
▸ Speci c-factors theory

▸ Analyzes the income distribution effects of trade in the short

term, when resources are immobile among industries

▸ Speci c factors:

▸ Workers acquire skills for speci c occupations, not easily

transferable to other industries

▸ Resources speci c to import-competing industries lose

as a result of trade

▸ Resources speci c to export industries gain as a result of

trade
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CHAPTER 3: SOURCES OF COMPARATIVE ADVANTAGE

FACTOR ENDOWMENTS
▸ Speci c-factors theory

▸ The chapter further goes into differences in types of labor -

high skill low skill.

▸ One way to think about this is high skill labor is really capital.

▸ A college graduate (engineer) is really a piece of human

capital. Free trade will result in export of capital intensive
goods in a country with a lot of capital driving up the price of
capital and lowering the price of labor.

▸ THIS IS WHAT WE SEE IN U.S. and creates more inequality

when measured at the worker level.
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CHAPTER 3: SOURCES OF COMPARATIVE ADVANTAGE

FACTOR ENDOWMENTS
▸ Speci c-factors theory

▸ THIS IS WHAT WE SEE IN U.S. and creates more

inequality when measured at the worker level.

▸ US abundant capital less labor

▸ Free trade specializes in Capital intensive production

▸ drives up price of capital drives down price of

labor

▸ Looks like on an individual level creating

divergence in people’s wages who have capital
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CHAPTER 3: SOURCES OF COMPARATIVE ADVANTAGE

ECONOMIES OF SCALE AND COMPARATIVE ADVANTAGE

▸ Economies of Scale exist when –

▸ Expansions of the scale of production cause total

production costs to increase less proportionately than
output.

▸ Long-run average costs of production decrease

▸ Economies of scale classi ed as –

▸ Internal

▸ External
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CHAPTER 3: SOURCES OF COMPARATIVE ADVANTAGE

ECONOMIES OF SCALE AND COMPARATIVE ADVANTAGE

CHAPTER 3: SOURCES OF COMPARATIVE ADVANTAGE

ECONOMIES OF SCALE AND COMPARATIVE ADVANTAGE

▸ Internal Economies of Scale

▸ At the rm-level as output increases average cost

decreases

▸ Provide additional cost incentives for specialization in

production

▸ Home market effect:

▸ Industries locate near largest market, to exclusion of

small market areas, which may become
unindustrialized
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CHAPTER 3: SOURCES OF COMPARATIVE ADVANTAGE

ECONOMIES OF SCALE AND COMPARATIVE ADVANTAGE

▸ External Economies of Scale

▸ The average cost of the typical rm decreases as the output of

the industry in this area increases

▸ Concentration of an industry’s rms in a particular geographic

attracts larger pools of a specialized type of worker; New
knowledge about production technology spreads among rms
in the area

▸ Expanding industry a source of growth, tax revenues; R&D at

universities bene t businesses

▸ Clusters of component suppliers close to center of

manufacturing
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CHAPTER 3: SOURCES OF COMPARATIVE ADVANTAGE

ECONOMIES OF SCALE AND COMPARATIVE ADVANTAGE

▸ External Economies of Scale

▸ Examples of External Economies of scale?

CHAPTER 3: SOURCES OF COMPARATIVE ADVANTAGE

ECONOMIES OF SCALE AND COMPARATIVE ADVANTAGE

▸ Theory of overlapping demands:

▸ Factor-endowment theory - explains trade in primary products and

agricultural goods

▸ Not trade in manufactured goods

▸ What is in uencing manufactured-good trade?

▸ Domestic demand conditions

▸ Firms within a country – manufacture goods for which there is a large

domestic market

▸ external economies of scale at work

▸ A nation’s exports - extension of the production for the domestic market

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CHAPTER 3: SOURCES OF COMPARATIVE ADVANTAGE

ECONOMIES OF SCALE AND COMPARATIVE ADVANTAGE

▸ Theory of overlapping demands (cont.)

▸ Consumer demand - conditioned strongly by income levels

▸ A country’s average or per capita income will yield a

particular pattern of demand

▸ Nations with high per capita incomes will demand high-

quality manufactured goods (luxuries)

▸ Nations with low per capita incomes will demand lower-

quality goods (necessities)

▸ This helps explain why US trades with other rich countries.

CHAPTER 3: SOURCES OF COMPARATIVE ADVANTAGE

ECONOMIES OF SCALE AND COMPARATIVE ADVANTAGE

▸ Intra-industry trade

▸ The exchange between nations of products of different

industries

▸ Based on inter-industry specialization

▸ Each nation specializes in a particular industry in which it

enjoys a comparative advantage

▸ Industrial countries have practiced intra-industry

specialization:

▸ Focusing on the production of particular products within a

given industry
CHAPTER 3: SOURCES OF COMPARATIVE ADVANTAGE

ECONOMIES OF SCALE AND COMPARATIVE ADVANTAGE

▸ Intra-industry trade

▸ Advanced industrial nations emphasize intra-industry

trade

▸ Two way trade in a similar commodity

▸ Existence of intra-industry trade is incompatible with

models of comparative advantage discussed

▸ Intra-industry trade involves ows of goods with similar

factor requirements

▸ Most such trade conducted among industrial countries

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CHAPTER 3: SOURCES OF COMPARATIVE ADVANTAGE

ECONOMIES OF SCALE AND COMPARATIVE ADVANTAGE

▸ Intra-industry trade

▸
CHAPTER 3: SOURCES OF COMPARATIVE ADVANTAGE

ECONOMIES OF SCALE AND COMPARATIVE ADVANTAGE

▸ Intra-industry trade

▸ Why in homogeneous goods?

▸ transportation costs?

▸ Differentiated goods?

▸ specialize in type of car or plane or computer

▸ economies of scale in a type of product

CHAPTER 3: SOURCES OF COMPARATIVE ADVANTAGE

TECHNOLOGICAL INNOVATION AND COMPARATIVE ADVANTAGE

▸ The product life cycle theory

▸ Manufactured goods undergo a predictable trade cycle:

▸ 1. Manufactured good introduced to home market

▸ 2. Domestic industry shows export strength

▸ 3. Foreign production begins

▸ 4. Domestic industry loses competitive advantage

▸ 5. Import competition begins

CHAPTER 3: SOURCES OF COMPARATIVE ADVANTAGE

TECHNOLOGICAL INNOVATION AND COMPARATIVE ADVANTAGE

▸ The product life cycle theory

▸ Much of this move can be explained in terms of a move

from capital intensive to labor intensive production if we
think of capital as including human capital

▸ Think of products that this has occurred.

CHAPTER 3: SOURCES OF COMPARATIVE ADVANTAGE

GOVERNMENT POLICY AND COMPARATIVE ADVANTAGE

▸ Industrial Policy

▸ Government try to create a comparative advantage.

▸ Basically give them room and time to develop economies

of scale.

▸ Is this a good idea?

▸ Government regulations

▸ Can give domestic companies an advantage or

disadvantage.

▸ Examples?
CHAPTER 3: SOURCES OF COMPARATIVE ADVANTAGE

TRANSPORTATION COSTS
CHAPTER 3: SOURCES OF COMPARATIVE ADVANTAGE

REVIEW
▸ What are sources of C.A. we discussed? and give an example.

▸ Factor Endowments

▸ Speci c Skill (variation on factor endowment)

▸ Economies of scale

▸ internal and external

▸ Overlapping Demand

▸ Intra-Industry Trade (variation of economies of scale)

▸ Technology (variation on factor endowments)

▸ Industrial Policy (variation on economies of scale)

▸ Role of Transportation costs and regulations

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