Chapter 03 Sources of Comparative Advantage

Sources of Comparative
Advantage
PowerPoint slides prepared by:

Andreea Chiritescu
Eastern Illinois University
© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license
distributed with a certain product or service or otherwise on a password‐protected website for classroom use 1
Factor Endowments
• Factor-endowment theory
• Heckscher-Ohlin theory
• Immediate basis for trade: 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
• Production possibilities curves depend on
technology and resource endowments
© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
license distributed with a certain product or service or otherwise on a password‐protected website for classroom use 2
Factor Endowments
• Ultimate determinants of comparative
advantage
• Technology
• Resource endowments
• Demand
• Assumption: technology and demand are
approximately the same between countries
Factor Endowments
• Resource-endowment ratio
• Determines comparative advantage
• Export the product that uses a large amount of
its relatively abundant resource
• Import the product which in production uses
the relatively scarce resource
TABLE 3.1 Producing aircraft and textiles: factor endowments
in the United States and China
Factor Endowments
• Effect of resource endowments on
comparative advantage
TABLE 3.2 Capital stock per worker of selected countries, 1997*
FIGURE 3.1 The factor-endowment theory
A country exports the good whose production is intensive in its relatively abundant factor. It
imports the good whose production is intensive in its relatively scarce factor.
Factor Endowments
• Factor-endowment theory, U.S.-China trade
• United States
• Relatively abundant: human capital (skills),
scientific talent, and engineering talent are
relatively abundant
• Relatively scarce: unskilled labor is relatively scarce
• China
• Relatively rich: unskilled labor
• Relatively scarce: scientific and engineering talent
Factor Endowments
• Factor-endowment theory, U.S.-China trade
• United States exports to China
• Goods embodying relatively large amounts of
skilled labor and technology
• Aircraft, software, pharmaceuticals, and high-tech
components of electrical machinery and equipment
• China exports to the United States
• Goods for which a relatively large amount of
unskilled labor is used
• Apparel, footwear, toys, and the final assembly of
electronic machinery and equipment
TABLE 3.3 U.S.-China trade: top ten products, 2007
(thousands of dollars)
Factor Endowments
• Factor-Price Equalization
• Redirect demand away from the scarce
resource
• Toward 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
• Until price equalization occurs
FIGURE 3.2 The factor-price equalization theory (a)
By forcing product prices into equality, international trade also tends to force factor prices
into equality across countries.
FIGURE 3.2 The factor-price equalization theory (b)
By forcing product prices into equality, international trade also tends to force factor prices
into equality across countries.
Factor Endowments
• Factor-Price Equalization
• Real world – no full factor-price equalization
• Uneven ownership of human capital
• Education, training, skill, and the like
• Not all countries use the same technology
• New and better technology replaces older technologies
– faster in developed countries
• Transportation costs and trade barriers
• Reduce the volume of trade
TABLE 3.4 Indexes of hourly compensation, manufacturing
workers, 2006 (U.S.=100)
Factor Endowments
• Stolper-Samuelson Theorem
• Extension of the theory of factor-price
equalization
• An increase in the price of a product
• Increases the income earned by resources that are
used intensively in its production
• A decrease in the price of a product
• Reduces the income of the resources that it uses
intensively
• Some people will suffer losses from free trade
Factor Endowments
• Magnification effect of Stolper-Samuelson
theorem
• The change in the price of a resource
• Is greater than the change in the price of the
good
• That uses the resource relatively intensively in
its production process
Factor Endowments
• Policy implications of Stolper-Samuelson
theorem
• Even though free trade may provide overall
gains for a country
• There are winners and losers
• Owners of relatively abundant resources
• Favor free trade
• Owners of relatively scarce factors
• Favor trade restrictions
TRADE Globalization drives changes for
CONFLICTS
U.S. Automakers
• Big Three (GM, Ford, and Chrysler)
• Higher production costs
• Large pension obligations and health care costs
• Hundreds of thousands of retirees
• 2008, GM spent $4.8 billion on health care
• $1,500 higher cost per vehicle
• Higher hourly wages: $30 (and $30 in benefits)
• Toyota, Honda
• Health care costs - $200 per vehicle
• Hourly wages: $24 (and $24 in benefits)
TABLE 3.5 Labor-cost gap per vehicle hurts competitiveness of
big three automakers
Factor Endowments
• International trade - substitute for migration?
• Immigrants
• Help the economy grow
• Increasing the size of the labor force
• Take low skilled jobs few native-born Americans are
available to work
• Take jobs that contribute to the United States being
a leader in technological innovation
Factor Endowments
• International trade
• Substitute for the movement of resources from
one country to another
• International movements in resources are not
essential
• International trade in products can achieve the
same result
• Complement labor migration, short and near-
long terms
• Expanding trade – some unemployed workers
• Forced to seek employment abroad
Factor Endowments
• Specific-factors theory
• Income distribution effects of trade
• In the short term
• When resources are immobile among industries
• Resources specific to import-competing
industries
• Lose as a result of trade
• Resources specific to export industries
• Gain as a result of trade
Does Trade Make the Poor Even Poorer?
• Wage gap: skilled and unskilled workers
• Some combination of trade, technology,
education, immigration, and union weakness
• Income inequality - pervasive
• Wages of skilled workers “relative” to those of
unskilled workers
• Outcome of the interaction between supply and
demand in the labor market
• Wage ratio
• Wage of skilled workers divided by the wage of
unskilled workers
• Labor ratio
• Quantity of skilled workers available divided by
the quantity of unskilled workers
FIGURE 3.3 Inequality of wages between skilled and unskilled
workers
By increasing the demand for skilled relative to unskilled workers, expanding trade or technological improvements
result in greater inequality of wages between skilled and unskilled workers. Also, immigration of unskilled workers
intensifies wage inequality by decreasing the supply of skilled workers relative to unskilled workers. However,
expanding opportunities for college education results in an increase in the supply of skilled relative to unskilled
workers, thus reducing wage inequality. In the figure, the wage ratio equals wage of skilled workers/wage of
unskilled workers. The labor ratio equals the quantity of skilled workers/quantity of unskilled workers.
• International trade and technological change
• Increase in the demand curve of skilled workers
relative to unskilled workers
• Higher degrees of wage inequality
• Immigration
• Decrease in the supply of skilled workers
• Higher wage inequality
• Education and training
• Increase in the supply curve of skilled workers
• Reduce the wage inequality
• Sources of wage inequality
• Trade and immigration
• Small effects
• Domestic sources, especially technology
TRADE Does a “flat world” make Ricardo
CONFLICTS
wrong?
• Critiques of globalization
• The world has become “flat”
• Comparative advantages dwindled / or dried up
• China and India – economic development; more
similar to U.S.
• A level playing field
• Internet, wireless technology, search engines, other
innovations.
• United States could become worse off with trade
TRADE Does a “flat world” make Ricardo
CONFLICTS
wrong?
• Problems with this critique
• Globalization - increased international
economic interdependence
• Ignores the ways in which modern trade differs
from Ricardo’s simple model
• The world is not flat at all
Skill as Source of Comparative Advantage
• U.S.
• Relatively capital abundant
• Relatively labor scarce
• Export capital-intensive goods
• Import-competing goods will be labor intensive
• Leontief paradox
• Capital/labor ratios, 200 export industries and
import-competing industries, 1947
• Capital/labor ratio for U.S. export industries
• Lower than that of its import-competing industries
• Exports - less capital intensive than import-
competing goods
• Import-competing goods - more capital
intensive than U.S. exports
TABLE 3.6 Factor content of U.S. Trade: capital and labor
requirements per million dollars of U.S. Exports and
import substitutes
• Exports of the U.S.
• Not intensive in physical capital
• Intensive in human capital
• Skill intensive
• Countries with highly educated workers
• Exports concentrated in skill-intensive goods
• Countries with less educated workers
• Export goods that require little skilled labor
FIGURE 3.4 Education, skill intensity, and U.S. import
shares, 1998
The figure suggests that countries that are abundant in skilled labor capture larger shares of
U.S. imports in industries that intensively use those factors. Conversely, countries that are
abundant in unskilled labor capture larger shares of U.S. imports in industries that intensively
use those factors.
Increasing Returns to Scale
• Increasing-returns trade theory
• Nations with similar factor endowments
• Negligible comparative-advantage differences
• May find it beneficial to trade
• Because they can take advantage of massive
economies of scale
• Produce that good in great quantity at low average
unit costs
• Trade those low-cost goods to other nations
FIGURE 3.5 Economies of scale as a basis for trade
By adding to the size of the domestic market, international trade permits longer production
runs by domestic firms, which can lead to greater efficiency and reductions in unit costs.
External Economies of Scale
• External economies of scale
• The average cost of the typical firm decreases
• As the output of the industry within this area
increases
• Concentration of an industry’s firms in a
particular geographic
• Larger pools of a specialized type of worker
• New knowledge about production technology
spreads among firms in the area
Overlapping Demands as a Basis for Trade
• Theory of overlapping demands, Linder, 1960s
• Factor-endowment theory - explains trade in
primary products and agricultural goods
• Not trade in manufactured goods
• Force influencing manufactured-good trade
• Domestic demand conditions
• Firms within a country – manufacture goods for
which there is a large domestic market
• A nation’s exports - extension of the production for
the domestic market
• 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)
• Nations with similar per capita incomes
• Overlapping demand structures
• Consume similar types of manufactured goods
• Wealthy (industrial) nations
• More likely to trade with other wealthy nations
• Poor (developing) nations
• More likely to trade with other poor nations
Intra-industry Trade
• Intra-industry specialization, trade
• Production of particular products or groups of
products within a given industry
• The opening up of trade does not generally
result in the elimination or wholesale
contraction of entire industries within a nation
• The range of products produced and sold by
each nation changes
• Emphasized by advanced industrial nations
• Involves flows of goods with similar factor
requirements
• Conducted mostly among industrial countries
• Similar resource endowments
• Firms – oligopolies
• Trade in homogeneous goods
• Transportation costs
• Seasonal
• Trade in differentiated products
• Unmet need
• Overlapping demand segments in trading nations
• Economies of scale
• Fewer adjustment problems
TABLE 3.7 Intra-industry trade examples: selected U.S. exports
and imports, 2007 (in millions of dollars)
Technology: The Product Cycle Theory
• Technological innovations
• Different nations, at different rates of speed
• Result in:
• New methods of producing existing commodities
• Production of new commodities
• Commodity improvements
• Often transitory
• Product life cycle theory
• Predictable trade cycle:
1. Manufactured good is introduced to home
market
2. Domestic industry shows export strength.
3. Foreign production begins
4. Domestic industry loses competitive
advantage
5. Import competition begins
• International product cycle
• U.S. and Japanese radio manufacturers
• U.S. and Japanese pocket calculators
manufacturers
Dynamic Comparative Advantage:
Industrial Policy
• Dynamic comparative advantage
• Comparative advantage in a particular industry
• Can be created
• Mobilization of skilled labor, technology, and capital
• Industrial policy
• Government is actively involved in creating
comparative advantage
• Strategy to revitalize, improve, and develop an
industry
Dynamic Comparative Advantage:
Industrial Policy
• Antitrust immunity, tax incentives, R&D
subsidies, loan guarantees, low-interest-rate
loans, trade protection
• Requires government to identify the “winners”
• And encourage resources to move into industries
with the highest growth prospects
Government Subsidies Support
Boeing and Airbus
• Government subsidies – commercial jetliner
industry
• World’s manufacturers of commercial jetliners
• Oligopolistic market
• Dominated by
• Boeing of the United States
• Airbus Company of Europe
Boeing and Airbus
• Boeing, United States
• “Airbus receives unfair subsidies from
European governments”
• Allegedly:
• Loans for the development of new aircraft
• Below-market interest rates
• 70-90% of an aircraft’s development cost
• Repay the loans after it delivers an aircraft
• Can avoid repaying the loans in full if sales of its
aircraft fall short
Boeing and Airbus
• Airbus
• Defended its subsidies
• Prevent U.S. from holding a worldwide monopoly in
commercial jetliners
• “Boeing benefits from government assistance”
• Indirect subsidies
• Support aeronautics and propulsion research –
government organizations
Boeing and Airbus
• Airbus
• Indirect subsidies
• Support for commercial jetliner innovation
-military-sponsored research and military
procurement
• Subcontracts part of the production of its jetliners
to Japan and China
• Receive substantial governmental subsidies
• Tax breaks
Government Regulatory Policies
• Government regulations
• Workplace safety
• Occupational Safety and Health Administration
• Product safety
• Consumer Product Safety Commission
• Clean environment
• Environmental Protection Agency
• May improve the wellbeing of the public
• Can result in higher costs for domestic firms
TABLE 3.8 U.S. Steelmakers complain about regulatory burdens
Below are some examples of U.S. regulations affecting domestic steel producers:
•Health Care. U.S. steel companies spent more than $1.5 billion for health care in 2003 for
workers, retirees, and dependents. This adversely affects the competitiveness of U.S. steel
companies vis-à-vis foreign competitors, many of whose health care costs are borne by
government through general tax revenues.
•OSHA. The complexity and cost of compliance with Occupational Safety and Health
Administration (OSHA) regulations continue to increase. Many OSHA rules do not have a
sound scientific or medical basis and thus are impractical and cost ineffective.
•Electricity Policy. Electricity is a major component of steel-manufacturing costs, but it cannot

be purchased on a competitive basis as are other commodities.
•Global Climate Change. Efforts by the United States to achieve a seven percent decrease in
greenhouse gas emissions from 1990 levels by the year 2012, as dictated by the Kyoto
Protocol, could result in $5 billion in extra annual energy costs for U.S. steel companies.
•Clean Air. Proposed tighter standards for pollutants could place much of the United States—
including many steel industry sites—in nonattainment areas. The result would be enormous
new costs for steel, with no comparable requirements for U.S. trading partners.
FIGURE 3.6 Trade effects of governmental regulations
The imposition of government regulations (clean environment, workplace safety, product

safety) on U.S. steel companies leads to higher costs and a decrease in market supply. This
imposition detracts from the competitiveness of U.S. steel companies and reduces their share
of the U.S. steel market.
Transportation Costs
• Costs of moving goods
• Freight charges
• Packing and handling expenses
• Insurance premiums
• An obstacle to trade
• Impede the realization of gains from trade
liberalization
• Differences across countries in transport costs
• Source of comparative advantage
• Affect the volume and composition of trade
• Trade effects of transportation costs
• The high-cost importing country
• Produce more, consume less, and import less
• The low- cost exporting country
• Produce less, consume more, and export less
FIGURE 3.7 Free trade under increasing-cost conditions
In the absence of transportation costs, free trade results in the equalization of prices of traded
goods, as well as resource prices, in the trading nations. With the introduction of transportation
costs, the low cost exporting nation produces less, consumes more, and exports less; the high
cost importing nation produces more, consumes less, and imports less. The degree of
specialization in production between the two nations decreases as do the gains from trade.
• Reduce the volume of trade
• Reduce the degree of specialization in
production
• Reduce the gains from trade
• One possible reason for international wage
differential
• Falling transportation costs since 1965
• Imports - more competitive in U.S. markets
• Higher volume of trade for U.S.
• Due to technological improvements
• Large dry-bulk containers
• Large scale tankers
• Containerization
• Wide-bodied jets
• Telecommunications
Size of transportation costs, selected countries,
TABLE 3.9 2007
• Growing international trade
• Falling transportation costs
• Worldwide decrease in trade barriers
• Economic opening of nations that have
traditionally been minor players
TRADE
CONFLICTS Rising energy costs hinder trade flows
• Rising sensitivity to increased energy costs

• Shift toward containerization
• Speed
• Transport costs
TRADE
CONFLICTS Rising energy costs hinder trade flows
• Rising shipping costs

• Trade should be both dampened and diverted
• Substitute goods - from closer locations
• Sizable surcharges on domestic shipments by
train and truck
• Congested domestic transportation systems
• May slow the outsourcing of goods in the
future
• Terrorist attack
• Added costs
• Slowdowns for U.S. freight system
• Security can become a new kind of trade
barrier

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Chapter 03 Sources of Comparative Advantage

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Sources of Comparative

PowerPoint slides prepared by:

•Electricity Policy. Electricity is a major component of steel-manufacturing costs, but it cannot

The imposition of government regulations (clean environment, workplace safety, product

• Rising sensitivity to increased energy costs

• Rising shipping costs

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