Introduction

Part 1: Neoclassical Trade Theory

Analysis beginning from the equilibrium in a

single economy
Get familiar with the two basic international
trade models and the standard analysis

Session A

Preliminaries: Two-Sector
Models
Feenstra (Ch 1)
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Larry D. Qiu

Outline of the Ricardian model and

results.

1. The Ricardian Model

The environment: labor, technology difference,

Question: Whats the pattern of trade?
Result: Comparative advantage determines the

pattern of trade.

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Home

Foreign

Good 1

Good 1

Good 2

Good 2

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The 2x1 model

Analysis 1: Autarky equilibrium

Two goods: i

Social planners problem: utility maximization:

One factor: labor, L in Home and L* in Foreign

Technology:

ai unit of labor needed per unit of production

production possibility frontier (PPF):

1
1
and *
ai
ai

Prices:

(1)

Def: Production possibility set (PPS) and

ai*
Productivity:

max y1 , y2 u ( y1 , y2 ) s.t. a1 y1 + a2 y2 L

pi , pi* , relative price p =

y2

p1
and p *
p2

u1 a1
=
u 2 a2

L / a2
y2a

Labor is perfectly mobile b/w industries within each

country, but immobile b/w countries

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y1a

L / a1

y1

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Analysis 2: International trade

A1: Perfect competition

H has comparative advantage in producing

good 1
a1 a1*
<
a2 a2*

Zero profit condition

pi = wai ,

p1 p2
p
a
=
and 1 = 1
a1 a2
p2 a2

Then,

p a < p a*

Normalize p2 = 1
Assumption: free trade and no transport costs

Then,
w=

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Question: what is the equilibrium p at which

1
L
and I = wL =
a2
a2

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world demand equals world supply?

Let us first use graphic analysis

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Pattern of trade:

Complete specialization vs.

only one country specializes

Ricardian Theory:

A country exports the good which it has

comparative advantage in production. At least
one country completely specializes in its
comparative advantage good.

World relative supply

p a*

pa
y1 + y1*
y2 + y2*

L / a1
L* / a2*

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Various possibilities
Gains from trade: consumption outside PPF
y2

L
a2

p > pa

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a1 a1*
<
and a1 < a1* , a2 < a2*
a2 a2*

p < p a*
p a*
L*
a1*

y1

F benefits from trade even if it has no absolute

advantages in any product

C*
*

pa
L
a1

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a1 a1*
=
even if ai < ai*
a2 a2*

*
2

L*
a2*

No comparative advantages, no gains from trade

y1*

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2. The 2x2 Model

Model: 2x2, given goods prices.

Justification: small open economy, a firststep to the full analysis.

Questions

Home

Good 1

What determines this countrys pattern of trade?

How are factor prices determined?
How does output price affect factor price?
How does endowment affect output?

ROW

Good 2
Labor
Capital

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13

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The model
Assumptions:
Constant returns to scale
Perfect competition in both product and factor
market
Factors are fully mobile b/w the two sectors
Production:

Endowment constraint
L1 + L2 L
K1 + K 2 K

PPF

(1.1)

y2

Concavity

yi = f i ( Li , K i )

y2 = h( y1 ; L, K ),

yi = f i (Li , K i ) = f i ( Li , K i )

2h
<0
y12

y1
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Analysis: production point

Analysis: cost function

Maximize the GDP

Given factor price (w,r) and output, a firm chooses

input levels to minimize its (unit) cost.

G ( p1 , p2 , L, K ) = max( p1 y1 + p1 y2 ) st y2 = h( y1 ; L, K )
y1 , y 2

Ci ( w, r ) = min {waiL + raiK | f i (aiL , aiK ) 1}

(1.2)

= max( p1 y1 + p1h( y1 ))

aiL , aiK

y1

y2

FOC:
p=

p1
y
= 2
p2
y1

(1.4)

= waiL + raiK
By envelope theorem:

(1.3)

Ci
Ci
= aiL ,
= aiK
w
r

Duality: output maximization and cost minimization

By envelope theorem
G
= yi
pi

y1
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Analysis: equilibrium conditions

a1L y1 + a2 L y2 = L
a1K y1 + a2 K y2 = K

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( p1 , p2 , L, K )
Given
( y1 , y2 , w, r )
Four unknowns
Four equilibrium conditions
(1.5) and (1.6)
where other variables/functions in (1.5)-(1.6) are derived
before

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solution, but focus on the properties of the

equilibrium. In this case, we ask

(1.6)

Equilibrium:

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Often time, we dont need to solve for explicit

(1.5)

Full employment (factor market)

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Analysis: determination of factor prices

Zero profit condition (goods market)

pi = Ci ( w, r )

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How is (w,r) determined

How does a change in goods prices affect the factor
prices
How does a change in endowment affect the
production

Try to use (1.5) to determine the factor prices.

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Case 1: factor intensity reversals

Two iso-cost curves from (1.5)

Question: which

Total differentiation

(w,r) (factor prices)

for Home?
Answer: endowment
matters. Therefore,
we need to analyze
(1.6) (full
employment) as
well.

a
dr i
= iL
i
dw
aiK

p1 = C1 ( w, r )

rA

At point A

dr 1
dr 2
a
a
|>| 2 | or 1L > 2 L
1
dw
dw
a1K a2 K

rB

p2 = C2 ( w, r )

Def: industry 1 (2) is labor

(capital) intensive

p1 = C1 ( w, r )

rA

rB

p2 = C2 ( w, r )

wB

wA

At point B: reverse

wB

wA

FIR: factor intensities change at different factor prices

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Graphic analysis of (1.6)

Suppose A is the solution to (1.5). Then we have

What is the total endowment required to produce

y1 and y2

aiL = aiL ( w A , r A ), aiK = aiK ( w A , r A )

Producing y1 , y2
K

Producing
one unit of
each good

a2 K

a2 K

a1K

a1K
a2 L

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a1L

y 2 ( a2 L , a2 K )

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K
A

KA

y1 (a1L , a1K )

a2 L

a1L

L
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LA

24

 If y1 and y2 are produced, A is the total factors

needed. In reverse, if the country has endowment A,

there is a unique y1 and y2 which will be produced.
This is how (1.6) is solved.
What if the countrys endowment is outside the cone
(next slide)?
Answer: only one good will be produced (with factor
prices being adjusted to satisfy (1.6)).

K
D

A
Cone of diversification

Def: Cone of diversification

L
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Result: If H is a labor (capital) abundant country, A (B) is

Graphic analysis of (1.6)

the solution, with low (high) wage and high (low) rental
LA
LB
> B
A
K
K

Suppose B is the solution to (1.5). Then we have

aiL = aiL ( w B , r B ), aiK = aiK ( w B , r B )

A: labor abundant
Diversification
cone B

B: capital abundant
K

Note: there is no
overlapping

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K
Diversification
cone A

1 in B
2 in B
2 in A
1 in A
L
L
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L
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Factor Price Equalization Theorem: Suppose 2 countries

have free trade, identical technologies, but different
endowments. If both countries are diversified and FIR does not
occur, then the factor prices (w,r) are equalized across these
countries.

Case 2: No FIR (Factor Price Equalization)

Two iso-cost curves

from (1.5)
No FIR: Factor
intensities do not
change
E
E
( w , r ) determine
aiL and aiK , using
which in (1.6) to
determine

p1 = C1 ( w, r )

rE

p2 = C2 ( w, r )

wE

y1 and y2

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KE

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LE

30

Effects of goods price changes on factor

price
Suppose industry 1 is labor intensive

Comparative statics on the zero profit condition (1.5)

dpi =
Denote

Ci
C
dw + i dr = aiL dw + aiK dr
w
r

Also suppose the relative price of good 1 increases

x =

dx
waiL
waiK
, iL =
, iK =
x
Ci
Ci

Percentage change

iL + iK = 1

Then

cost share

p 1 1L 1K w
w 1 2K

=
=

r
r | | 2L
2K
2 2L

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| |> 0

Then

1K p 1

1L p 2

p1
>0
p2

p = p 1 p 2 > 0

2 K p 1 1K p 2 ( 2 K 1K ) p 1 + 1K ( p 1 p 2 )
=
> p 1
2 K 1K
| |
p p ( ) p + ( p p 2 )
r = 1L 2 2 L 1 = 1L 2 L 2 2 L 1
< p 2
1L 2 L
| |
w =

(1.7)

| |= 1L 2L = 2K 1K
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Then, from (1.7), we have

Then

where

a1L
a
> 2L
a1K
a2 K

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Stopler-Samuelson Theorem

Graphic analysis of SST

r

An increase in the relative price of a good will

p '1 = C1 ( w, r )

increase the real return to the factor used

intensively in that good, and reduce the real return
to the other factor.

Suppose p 1 > 0 but p 2 = 0

r0

Intuition:
Definition: magnification effect

w > p 1 > p 2 > r

r'

p2 = C2 ( w, r )

Implications: income redistribution

p1 = C1 ( w, r )

w0
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w'

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Effects of endowment changes on output

Comparative statics on the full employment condition

Suppose industry 1 is labor intensive

(1.6)
iL =

Denote

Then

yi aiL
ya
, iK = i iK , 1L + 2L = 1, 1K + 2K = 1
L
K

a1L
a
> 2L
a1K
a2 K

| |> 0

Also suppose

L > 0 and K = 0

Then
L 1L
=
K
1K

where

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2L y1
y 1 2K
1 =

2K y 2
y 2 | | 1K

2L L

1L K

Then, from (1.8), we have

(1.8)
y1 =

2 K L
L
> L > 0 and y 2 = 1K < 0
| |
| |

| |= 1L 1K = 2K 2L

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Graphic analysis of the

Rybczynski Theorem

Rybczynski Theorem
K

An increase in a factor endowment will increase

output of industry using it intensively, and

decrease the output of the other industry.

(L,K)

(L,K)

y 2 ( a2 L , a 2 K )
y '2 ( a2 L , a2 K )

Intuition (see next slide):

Implications: Dutch disease

y '1 (a1L , a1K )

( a 2 L , a2 K )
y1 (a1L , a1K )
(a1L , a1K )

L
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Conclusion

Part 1: Neoclassical Trade Theory

Ricardian model
2x2 model (the preliminary H-O model), with fixed

Session B

output prices: derive a set of results

Provide tools to prove the theorems and intuitions,
for further study.

The Heckscher-Ohlin Model

Feenstra (Ch 2)

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38

Introduction

The Heckscher-Ohlin Theory

The HOS model

Keep the same assumptions as in the 2x2 model
in Ch 1 (two countries with identical technology,
identical demand (homothetic taste), free trade in
goods, no FIR, etc), but prices are determined
endogenously in international trade between two
countries: 2x2x2 model.

The environment: endowment difference.

Questions:

Pattern of trade?
Gains from trade?
Do data support the theory (next part)?

The Theorem

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Each country will export the good that uses its

abundant factor intensively.
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Analysis/Proof
Analysis

Strategy:
Focusing on the case in which good 1 is labor
intensive, home is labor abundant, moreover
a1L a 2 L
>
,
a1K a 2 K

L L*
>
,
K K*

L = L * K* > K

Procedure: autarky
Methodology: graphic analysis

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Indifference curve

pa
p = 1a
p2
a

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y2

Autarky equilibrium
at home (slope):

43

What is p ?
We prove p a > p a
by contradiction
(next slide).

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A
Home
PPF

Budget line
GDP line

y1

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44

Where is the free trade equilibrium price p? Prove p ( p a , p a )

a
a
Suppose p = p

Z(p)D(p)S(p) excess demand for good 1 at home

Homothetic taste

y2

fixed share of income

spent on each good

Z*(p)D*(p)S*(p) excess demand for good 1 abroad

Z(p)+Z*(p) excess demand for good 1 in the world
B

F in point C

Since

Z(pa) = 0,
Z*(pa) > 0

Z(pa)+Z*( pa) > 0

also Z(pa*) < 0,
Z*(pa*) > 0
a

Z(p *) +Z*(pa*) > 0

Then by continuity of the excess demand functions, there must
be a price p, with p ( p a , p a ) such that Z(p)+Z*(p) = 0

C
Rybcynzski Theorem
A

F should produce at
at point like B, not
C.
Contradiction!
But should it be

p a p a

y1

p a < p a or p a > p a ? It must be

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p a > p a

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45

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Welfare and gains from trade?

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46

Gains from trade for

each country

Whats the welfare implication of the HO

theorem?

The abundant factor in each country gains from

trade, and the scarce factor loses.

a
a
Proof: p ( p , p ) and the SST.

Gains from trade?

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48

Introduction

Part 1: Neoclassical Trade Theory

Continuum of goods vs. many discrete

commodities: simplification
The distinguishing feature: a cut-off point
which determines imported and exported
goods
Tariffs and transport costs: a range of
commodities not traded
Useful framework for other applications

Session C

Ricardian Model with a

Continuum of Goods
Dornbusch, Fisher and Samuelson (AER, 1977)

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The model and issues

The model: Supply side

What is the pattern of trade?

Discrete commodity case

Is every product traded?

Constant unit labor requirement

Arrangement

Comparative advantages?

50

How is pattern of trade affected by a change

in country size, technology progress, demand

shift, and unilateral transfer?
Home

Foreign
Technology
a*(z)

Technology
a(z)

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52

 A continuum of goods

Define
for z [0, 1].

Then, H and F efficiently produce

Relative unit labor requirement (decreasing in

Relative price of z, produced at H, to z, also

z)

produced at H
Comparative advantages? Competitiveness:

H produces z iff

Relative price of z, produced at H, to z,

Relative wage

produced at F

Relative costs

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The model: Demand side

In summary of the supply side: we use the

Cobb-Douglas demand

relative wage

To determine the borderline commodity,

which gives indication of pattern of production
To determine the relative price structure,
because the we have known which countries
produce which goods.

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Constant expenditure share (prove for 2 good

case)

Identical tastes between two countries

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Equilibrium relative wages and

specialization
What are the equilibrium conditions?
Hs labor market: income equals expenditure

The fraction of income spent on the goods

produced by H

The fraction of income spent on the goods

produced by H

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The schedule starts at zero and approaches infinity as

approaches unity. It is a representation of the demand
side: arise in results in a rise in relative wage

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The previous condition is also a trade balance

condition

Another condition (supply side): the

specialization condition

= A( z ) at ~z

Equilibrium relative
prices?
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Comparative statics

Relative size:

The importance of comparative statics in

economic analysis
Based on Fig 1, we can see that the unique
equilibrium is determined jointly by tastes,
technology, and relative size. Hence we can
do comparative statics analysis with regard to
these changes.

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Intuition?

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Technical progress:

Demand shifts:

How?
A uniform
proportional
reduction in Fs unit
labor requirement
Intuition: loss in
comparative
advantages

How?
A shift from high z
commodities
toward low z
commodities
Intuition

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Transport costs and nontraded goods

Supply side
Therefore H exports z iff

Samuelsons iceberg transport cost: a

fraction of the good arrives: g=g(z)

F exports z iff

Then, for any given

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Demand side

Other applications

Let

Tariffs

be the fraction of H income spent on Hs goods.

Similarly, . Then,

And so the unique solution for relative wage as a

function of exogenous variables: relative size and

transport costs

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Exchange rates
Etc, e.g.,
Copeland and Taylor, Trade and transboundary
pollution, AER 1995
Eaton and Kortum, Technology, Geography, and
Trade, Econometrica, 70, 2002.
Matsuyama, Beyond Icebergs: Toward A Theory
of Biased Globalization (forthcoming), Review of
Economic Studies

The trade balance condition

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68

Introduction

Part 1: Neoclassical Trade Theory

An application of the continuum of goods

Session C

model to technology transfer via FDI

Explore the implications on

Technology transfer, FDI and

international trade: A Ricardian
approach

Cheng, Qiu and Tan (JDE, 2004)

Division of labor between local firms and MNEs;

NorthSouth wage gaps;
Regional and aggregate welfare;
Government incentives to promote or discourage
technology transfer via MNEs;
Pattern of product cycles.

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A continuum Ricardian trade model with

technology transfer
Features and contributions

Goods and technology

FDI arise due to technological differences

between two regions (as opposed to market
entry, etc)
Perfect competition (as opposed to
oligopolistic competition)
FDI and technology transfer requires specific
resources consisting of expatriate managers
and technicians

South L, North L*
South a(z), North a*(z), z in [0, 1]
For simplification: a*(z)=1
Assumption: a(z)>1 and is increasing in z
Normalization: Southern wage rate =1
Notation: Northern wage rate w*>1.

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Equilibrium without technology transfer

Technology transfer:
Efficiency loss, expatriates wage
Unit cost of producing z by MNEs in the South

We have the standard DFS model, in which

the equilibrium consists of

determined by

and is

Hence,
Preferences: a continuum version of Cobb-

Douglas utility function

Welfare
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Equilibrium with technology transfer

How to determine w*?

Good z is produced by

World income
Goods market equilibrium condition
For given w*

Demand for expatriates

Substituting T to get Y

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 The equilibrium

is determined by

Then, we can conduct comparative statics

analysis to get some results/propositions

below
And more results
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80

Introduction

Part 2: Empirical Tests of Trade

Patterns and Flows
(A)
Leontief Paradox
Feenstra (Ch 2)

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HOV Model and Leamers Test

Leontief Paradox

It is a presumption that the US is capital-abundant but

yet it exports labor intensive goods.
Leontief rejects the null hypothesis (H-O theory): Is the
theory wrong?

Three possibilities to explain the paradox:

Assumptions are not realistic
Data problem
Methodology is wrong
Note
(1) capital stock vs. capital flow
(2) Use US technology for both import and export
An half-century debate
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Vanek (1968): Extension to include many

countries, many goods and many factors, the

MxN model. And consumption difference.
Essence of the HOV model

The HOV theorem:

A country exports factor k services if its
endowment of factor k relative to the world
endowment exceeds its share of world GDP.
81

a2 L
a
A = 1L

a1K a2 K
yi
y i = 1i
y2
Di
D i = 1i
D2

Then T = y D
i

F = AT
i

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The HOV theorem

F i = AT i = V i s iV w

Technology matrix
where

Output vector for country i

V i
V i = Li ,
VK
Di
si = w
D

Demand/consumption vector for country i

V w = V 1 +V 2

Endowment vectors

Share of world consumption

is the net export (of goods) vector for country i

is the factor content of trade

If

FLi > 0

then, country i exports labor services

If

FKi > 0

then, country i exports capital services

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The HOV model

Let

State the relationship between endowment

and pattern of trade in factor services.

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Leamers test (1980)

Explanations: Leamer vs Leontief

There is no paradox!: US K/L ratio in production exceeds

What is source of the paradox?

It must be the methodology problem, because Leamer
used the same data and assumptions.

that in consumption

Where did Leontief go wrong?

Leontief had performed the wrong test! (Leamer): we
should not compare the K/L ratios in the export and
import. Why?
There are more than 2 factors
Trade is not balanced: US is a net exporter of both
capital and labor services
Leontief calculated only production, Leamer calculated
both production and consumption

Why?

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No paradox for the US, but what about

other countries?

Treflers diagnostic test

Bowen, Leamer, and Sveikauskas (AER, 1987):

The assumption of equal technology across

Many countries
Sign test

sign ( Fki ) = sign (Vki s iVkw ), i = 1,...C ; k = 1,...M .

Rank test

Fki > Fl i (V ki s iV kw ) > (Vl i s iVl w ), i = 1,...C ; k = 1,...M ; l = 1,... M .

86

countries is especially bad!

Trefler (JPE, 1993) estimates technology
difference across countries and makes
adjustment:
There is no reason to requires the data to
match the HO model
US is abundant in adjusted labor => Leontief
was right!

Result?

50% success. FAIL again! No better than flipping a coin.

Implications: HOV model fails to meet the data. Some assumptions of the
model are wrong. Which one?
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Conclusions

Tests directly on HO model as Leontief did give

unsatisfactory results.
Empirical studies after Leontief try to improve it

Leamer (and others) uses HOV model: factor content

Trefler introduces technology differences

Both technology and endowment differences are

major determinants of trade patterns
Further research in empirical studies: explaining
tech differences

The Case of Missing Trade

Increasing returns to scale

Geography and climate
Colonial institutions
Social capital

Trade & Investment

Larry D. Qiu

Part 2: Empirical Tests of Trade

Patterns and Flows
(B)

Trefler (AER, 1995)

89

Motivation of the study

Contribution of the paper

The H-O theorem and the HOV theorem have been

First, it demonstrates that the HOV theorem is

widely accepted in international trade theory.

BUT, the HOV theorem has been repeatedly
rejected, empirically.
In other fields of economics, the poor performance of
a major theory leads to

rejected because factor service trade departs

from its endowments-based prediction in
systematic and informative way.
Second, it shows that the HOV is rejected
empirically in favor of a modification that
allows for home bias in consumption and
international technology difference.

More careful consideration of the data, and

New theories that can accommodate the anomalies.
But, not for the HOV theorem.

This paper attempts to do both.

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Larry D. Qiu

Literature Review (omitted)

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Testing the HOV theorem against

statistical alternative

A view through the HOV window

Fig. 1: define fc = F fc (V fc scV fw )
Plot it against V fc scV fw

Sample: 33 countries and 9 factors

Notation: F fc = the factor content of country cs net exports.

V fc = the endowment of factor f in country c.
V fw = the endowment of factor f in the world.
sc = the consumption share of country c in the world.
F fc = V fc scV fw
HOV equation:
If country c is abundant in factor f (i.e., V fc / V fw > sc
),
then it exports the services of factor f (i.e., F fc >0 ).

Result (there are 297 observations): the correlation between F fc

and V fc scV fw

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By HOV equation, fc = 0 (not shown).

At least F fc and V fc scV fw should have the same
sign (but only 50%).
F fc = 0 (the diagonal), called
The main feature:
the case of the missing trade

is 0.28, very poor.

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94

Fig. 2: the endowment paradox

The left panel of Fig 2: Poor countries tend to have

negative deviations, and rich countries tend to have

positive deviations. (The correlation of the number of
negative deviations per country with per capita GDP
is 0.87).
The right panel of Fig 2: Rich countries tend to be
scarce in most factors, and poor countries tend to be
abundant in all factors. (The correlation with per
capita GDP is 0.89).

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Larry D. Qiu

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 Suggestion/indication
The pattern of Fig 2 would occur if rich countries ran
trade deficits and poor countries ran trade surpluses.
But if anything, the opposite is true.
Thus, the HOV theorem must have omitted some
factors in the endowment set and for those factors the
rich countries are abundant.
What are they? It suggests alternative theories

(hypotheses).
Alternative hypotheses: technology and

consumption.
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Larry D. Qiu

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