International EconomicsBy Robert J. Carbaugh8th Edition

Chapter 4:Trade Model Extensions and Applications

Factor endowment theory (Heckscher-Ohlin)

Comparative advantage is explained entirely by different national supply conditions, especially resource endowmentsNations export products that use inputs which are relatively abundant (cheap) at home, and import products which need inputs which are relatively scarce (expensive) at home

Why relative price differentials?

Factor endowment theory: assumptions

Nations all have the same tastes and preferences (same indifference curves)They use factor inputs which are of uniform qualityThey all use the same technology

Why relative price differentials?

Comparative advantage according to factor endowment theory

Factor endowment model

Autarky equilibrium

Comparative advantage according to factor endowment theory

Factor endowment model

Post-trade equilibrium

Factor endowment theory: implications

Factor price equalization The shift within each nation towards use of

cheaper factors, and away from expensive ones, leads to more equal factor prices

Distribution of income Trade changes domestic distribution of

income as demand for different factors changes

Factor endowment model

Economies of scale & specialization

Economies of scale provide incentives for specialization, since per unit costs go down as production increases Trade provides a larger potential market for products, making higher production levels possible

Bringing theory closer to reality

Economies of scale as basis for trade

Economies of scale

Trade & specialization under decreasing costs

Economies of scale

Other extensions of the theory

Overlapping demands Factor endowment theory has considerable explanatory power

for trade in primary products and agricultural goods. The main force influencing manufactured-good trade is domestic

demand conditions. Firms’ incentive is large market foreign buyers have similar

taste firms begin to export. Taste = f(Y) High income country will demand high quality manufactured goods, nation with low per capita incomes demand lower-quality goods Rich country will likely trade with other rich countries, poor countries will trade with other poor countries. overlapping demand

Could not rule out all trade in manufactured goods between rich and poor countries.

Bringing theory closer to reality

Other extensions of the theory (cont.)

Intra-industry trade Involves two ways trade in a similar commodity Could be intensively found in advanced nations with similar

resource endowments. Ex: Us exports IBM computers and imports Hitachi computers from Japan

Involves flows of goods with similar factor requirements. Firms that produce these goods tend to be oligopolies

Includes trade in homogenous as well as differentiated products Reason for intra-industry trade in homogenous goods:

Transportation costs Seasonal factor & differentiation in time

Reason for intra-industry trade in differentiated products: Taste. Domestic firms supply majority taste and nation imports

to fulfill minority taste Overlapping demand similar taste Economies of scale focusing on a few variety and style of a

product

Other extensions of the theory (cont.)

Product cycles So far, the basis of trade was attributed to such factors as differing

labor productivities, factor endowments and national demand structures. Now, technological change plays an important role in determining trade.

Technological innovations result in: New methods of producing existing commodities Production of new commodities Commodity improvements

Stages that many manufactured goods follow in terms of product cycle: Manufactured good is introduced to home market Domestic industry shows export strength Foreign production begins Domestic industry loses competitive advantage Import competition begins

Trade cycle is complete when the production process becomes so standardized that it can be easily used by other nations.

Other extensions of the theory (cont.)

Dynamic comparative advantage - industrial policy Comparative advantage theory implies that nations are better

off by promoting free trade and allowing competitive markets to determine what should be produced and how. specialization and reallocation of existing resource found domestically

Criticism: Static theory Overlook the fact that additional resources can be made available to

the trading nation because they can be created or imported Increasing cost. short run not in the long run (decreasing cost).

Possible partly because firms learn to be more efficient and partly because of economies of large-scale production

Dynamic comparative adv. Thorugh government policies (industrial policy). Ex: Japan with picking winners policy

Antitrust immunity, tax incentives, R&D subsidies. Loan guarantees, low-interest-rate loans, and trade protection

Free trade under increasing costs

Transportation costs

No transportation costs

Free trade under increasing costs

Transportation costs

Transportation costs of $2000 per auto

Specific factor theory

Looks at the income distribution effects of trade in the short run, when some factor inputs are not mobile among sectorsIndicates that workers may be better or worse off, depending on preferencesPredicts that owners of factors used in export industries gain from trade, while owners of factors used in import-competing industries will lose from trade

Bringing theory closer to reality

Relative prices and the specific factor model

Bringing theory closer to reality