International Trade and Trade Restrictions Research Paper

Economists disagree about many aspects of economic policy. However, few topics garner as much support in
the field as the potential for free trade to make individuals and societies better off. At the same time, protests of
World Trade Organization meetings and labor union opposition to free trade agreements continue to make
headlines. This research paper presents the theory underlying the conclusion that trade makes people better off
and discusses conditions under which certain individuals or groups may not share in these gains from trade.
Empirical tests of trade theory are also discussed.

This research paper is organized around the main theories, or models, of international trade. Each model seeks
to explain certain aspects of the complex interactions between trading countries. Some models are more useful
than others for answering certain questions. None tells the entire story, yet all capture important insights, and
together they provide a useful basis for understanding international trade.

Trade Theory and Evidence

Ricardian Model of Comparative Advantage
Absolute Advantage
One simplistic view of world trade would be to expect that whatever country is “better” at producing a good in
some absolute sense will end up specializing in the production of that good. Were this the case, it would spell
bad news for poor developing countries considering opening up their borders to free trade. Because
industrialized countries such as the United States have high levels of productivity across all sectors, a less
technologically advanced developing country would have no hope of competing in a free trade environment if
absolute productivity levels were all that mattered. For example, consider the United States and Mexico.
Suppose that one laborer using U.S. technology can produce a computer in 2 hours of work. That same person
working with U.S. agricultural technology can harvest a bushel of corn in 1 hour. Now suppose that in Mexico,
producing a computer takes a person 12 hours, and harvesting a bushel of corn takes 3 hours. In this example,
Mexico is slower at producing both computers and corn. We say that the United States has an absolute
advantage in producing both goods because it can produce each of them at a lower cost (measured in person-
hours) than Mexico.

Comparative Advantage
In 1817, a British economist named David Ricardo turned this idea of absolute advantage on its head. Using a
model with two countries and two goods, he demonstrated that even if one country has an absolute advantage
in the production of both goods, both countries can still gain from trade as long as their relative productivities
for each good differ. The implications of this insight were huge. A country does not have to be highly
developed or technologically advanced to reap the benefits of the global economy.

To see how this works, consider the example of the United States and Mexico described before. In this case,
the United States is absolutely better at producing each good. However, relative productivities differ across the
countries. In the United States, making one computer takes twice as long as harvesting a bushel of corn. So for
each computer produced, the United States must forgo production of two bushels of corn. This tradeoff
between the outputs of each good is known as the opportunity cost of production. The opportunity cost of
producing a computer in the United States is two bushels of corn, and the opportunity cost of producing a
bushel of corn in the United States is one half of a computer. However, in Mexico, the opportunity cost of
producing a computer is much higher. Mexico must give up four bushels of corn for every computer produced.
Yet the opportunity cost of producing a bushel of corn in Mexico is only one fourth of a computer. So while
the United States has the absolute advantage in producing both goods, Mexico is relatively better at making
corn (e.g., they do not have to give up as many computers for each unit of corn produced). We say that the
United States has the comparative advantage in computers, and Mexico has the comparative advantage in corn.

The Pattern of Trade

Both countries can benefit if they specialize based on comparative advantage. Sticking with this example,
suppose that each country has 120 person hours available for production. This means that the United States can
produce at most 60 computers or 120 bushels of corn. U.S. producers will most likely do something in
between, say, dividing their labor evenly between the two sectors and producing 30 computers and 60 bushels
of corn. If there is no possibility for international trade (a situation know as autarky), then they must consume
exactly what they produce. Note that under autarky, in the United States, each additional computer the
Americans want to consume requires them to give up 2 bushels of corn. Meanwhile, in Mexico, production is
at most 10 computers or 40 bushels of corn and most likely something in between, such as 5 computers and 20
bushels of corn. In Mexico, each additional computer costs 4 bushels of corn. Now imagine that instead of
making both goods, Mexico produces only corn and the United States produces only computers. When Mexico
wants to give up some corn for computers or when the United States wants to give up some computers for
corn, they can do so by trading on the world market. At what rate is the United States willing to give up its
computers for corn? As long as they can get at least 2 bushels of corn for 1 computer, the United States is
better off making only computers and then trading them for corn. And if Mexico can get at least one fourth of a
computer for each bushel of corn (or only have to give up 4 bushels of corn or less for each computer), then
they are better off producing only corn and trading for computers on the world market. The world relative price
of corn and computers will end up being somewhere in between the opportunity costs in the two countries. For
example, it could be 3 bushels of corn for 1 computer.

The Role of Wages

In the Ricardian model, the pattern of trade is determined by relative labor productivity, not by wages. Even if
wages were much lower in one country than in the other, the relative cost of producing each good within each
country would still determine the gains from trade. It does not matter if the absolute cost of producing
computers and corn is lower in a given country because they are more productive or because they pay lower
wages. As long as there is some difference in the relative costs of producing each good across countries, then
both countries can gain from trade.

Extensions to the Ricardian Model

The standard formulation of the Ricardian model involves only two countries and two goods. However, the
basic results still hold even with many countries or many goods. To incorporate many goods, simply line these
goods up in order from the one in which the home country has the strongest comparative advantage (lowest
opportunity cost) to the one in which the home country has the weakest comparative advantage (highest
opportunity cost). There will be some cutoff point above which the home country will produce (and export)
and below which the home country will import from its trading partner. So instead of completely specializing
in one good, each country specializes in a subset of goods.

Incorporation of more than two countries can be handled in a similar way. When countries are lined up
according to their labor productivity ratios in a given good, the country with the highest ratio will export that
good and the country with the lowest ratio will import the good. Countries in the intermediate range may end
up either exporting or importing the good, though all countries that export will have higher productivity ratios
for that good than the countries that import.
Empirical Evidence
The Ricardian model’s simplicity, as well as its stark predictions, makes it difficult to test empirically. In the
real world, production requires more inputs than just labor and we generally observe partial rather than
complete specialization. However, the basic prediction of the model—that countries tend to export goods for
which their productivity is relatively high—has strong empirical support. A classic 1963 study by Bela Balassa
compared British and American labor productivity and trade. In the period studied, the United States had
higher absolute labor productivity than the United Kingdom in almost all industries. Yet British exports were
equally as large as those of the United States. Balassa found that the goods being exported by Britain were
those in which the country had a relative productivity advantage, even though absolute U.S. labor productivity
was higher. More recent evidence shows that, while the United States had higher overall labor productivity
than Japan in the 1990s, Japan’s relative labor productivity in the automobile industry was about 20% higher
than that of United States, potentially explaining the large volume of automobile exports from Japan to the
United States (Krugman & Obstfeld, 2005)

Specific Factors (Ricardo-Viner) Model

One key assumption in the Ricardian model is that people working in, say, an automobile manufacturing plant
can immediately switch to a job programming software or giving management consulting advice should they
lose their old job to the forces of free trade. Another way to say this is that the Ricardian model assumes that
labor may move freely between sectors. The Ricardo-Viner model relaxes this assumption by allowing certain
factors of production to be specific to (or used exclusively in) certain industries. In the classic version of the
Ricardo-Viner model, land is specific to agricultural production, capital is specific to manufacturing, and labor
can move freely between the two sectors. However, the implications would be the same if we assumed that,
say, certain types of labor were specific to each sector and capital could move freely between them. Capital,
land, and labor are all known as factors of production. What matters in this model is that three factors exist,
one of them is mobile across sectors, and the other two can be used in only one specific sector.

The existence of these specific factors leads to more subtle outcomes than the stark predictions of complete
specialization in the Ricardian model. Instead of trading off production of two goods at a constant rate (e.g.,
two bushels of corn for one computer), production in each sector exhibits diminishing returns. Consider the
agricultural sector. The country is endowed with a fixed amount of land, and this land can be used only for
agricultural production. The land on its own cannot produce output, how-ever. Labor is also needed for
agricultural production. In this example, labor is the factor that can move freely between the agricultural and
manufacturing sectors. With no labor, production per acre of land is zero. When the first unit of labor moves to
the agricultural sector, the marginal product of that one unit of labor is very large as production goes from zero
to some positive amount. Each additional unit of labor also increases production, but not by nearly as much as
that first unit. As more and more workers move from manufacturing to agriculture, these workers add less and
less additional output (or marginal product) because they have only a fixed amount of land to work with. The
same is true in the manufacturing sector. The first worker who shows up and turns on the machinery (or
capital) has made an enormous contribution to output, yet the individual (or marginal) contribution of each
additional worker is less and less given the fixed amount of capital. It follows that the optimal allocation of
labor between the two sectors will involve at least some agricultural and some manufacturing production rather
than complete specialization in one sector. It would not make sense for an economy to allow its last worker to
have a very small impact working in a crowded factory when that worker could have an enormous productivity
impact by moving to an empty field and producing agricultural goods. Wages are the adjustment mechanism
that ensures this balance. Employers will hire an additional unit of labor up to the point at which the additional
value produced by that unit of labor exactly equals the cost, or wage rate, of that labor. As described
previously, the marginal product added by each additional worker in a sector is declining, so wages in a sector
must also be declining as more and more workers move to that sector. Because labor can move freely across
sectors, if workers could earn higher wages working in a factory than on a farm, they would quit their jobs in
the farming sector and move into manufacturing instead (and vice versa). Equilibrium requires that the wage
rates, and thus marginal products of labor, must be equal across sectors. Due to the diminishing product of
labor, this is not likely to occur under complete specialization.

The relative price of the two goods in a country reflects the relative cost of producing those goods. If a factor
of production is relatively scarce, then it will be relatively costly, translating into a relatively higher price for
the good that uses the scarce factor in its production. On the other hand, the industry with the relatively
abundant specific factor will have a relatively lower price. When two countries move from autarky to free
trade, they are no longer constrained by their own factor endowments. For example, if one country is relatively
well endowed with land versus capital when compared to another country, then agricultural goods will be
relatively cheaper and manufactured goods will be relative more expensive in the first country. When the two
countries open up to trade, Country 1 now has the option of importing some cheaper manufactured goods from
abroad rather than making them itself. This reduces that demand for the scarce capital in Country 1, reducing
both the cost of capital and the price of manufactured goods in that country. A similar process occurs with the
relatively scarce land in Country 2. Trade allows this country to import some agricultural goods from Country
1, freeing up land and reducing the price of domestically produced food. At the same time, the demand for
Country 1’s abundant land and cheap agricultural products goes up, raising their price, while the relative price
of Country 2’s abundant capital and manufacturing products also goes up. This happens until relative prices are
equalized across the two countries. The end result is that the country that is relatively abundant in land sees the
relative price of goods that use land go up and the relative price of goods that use capital go down. The
opposite occurs in the country that is relatively abundant in capital.

As in the Ricardian model, the country as a whole is better off under free trade than under autarky. Each
country sees the relative price of its exported good go up, which increases income from exports. At the same
time, the price of the imported good goes down, meaning that they can buy more of the imported good for a
given amount of export production.

However, the existence of specific factors leads some individuals to be hurt by trade. Owners of the factor
specific to the export industry gain from trade as the demand for their factor of production increases. Owners
of the factor specific to the import-competing sector are worse off because the demand for (and thus the returns
to) their factor have gone down. In the example just described, owners of the abundant land in Country 1 see
the demand for their land go up and thus receive higher rental income for that land. However, the owners of
the scarce capital see the demand for their factor go down and thus receive a lower return to that capital. The
impact on the mobile factor (in this case, labor) is ambiguous, because workers will have to pay more for the
exported good but can now consume the imported good more cheaply. This theoretical result can explain why
certain individuals or interest groups may be opposed to free trade even if the world as a whole gains from
trade.

Empirical Evidence
In addition to partial specialization along the lines of comparative advantage, this model also predicts that (a)
each country will have both winners and losers from trade and (b) these winners and losers can be
distinguished based on the industries that they are connected with. Precisely quantifying the gains and losses
from trade that accrue to specific groups is not something that can be easily done with existing data. However,
if we assume that individuals will either be for or against more open trade policies based on the perceived
impact on their own welfare, then we can use the organization of interest groups and their voting patterns on
trade policy proposals to test these predictions. If this model is correct, then we should observe support for and
opposition to trade-related legislation to be divided by industry. Stephen Magee (1980) finds that this is indeed
the case.

Heckscher-Ohlin Model
 In the Heckscher-Ohlin model, comparative advantage comes from an interaction between the characteristics
of countries and industries. It is a model with two countries, two goods, and two factors of production. Each
country is endowed with a certain amount of each factor (e.g., high-skilled and low-skilled labor). By
comparing the ratio of high-skilled to low-skilled labor in each country, we can say that the country with the
larger ratio is relatively well endowed with (or abundant in) high-skilled labor and the country with the smaller
ratio is relatively well endowed with (or abundant in) low-skilled labor. A similar comparison can be made
between goods by looking at the ratio of high- to low-skilled labor used in the production of each good. The
good with the higher ratio is said to be intensive in the use of high-skilled labor, and the good with the lower
ratio is intensive in the use of low-skilled labor. The Heckscher-Ohlin model can be summarized by its four
main theorems.

1. The Heckscher-Ohlin Theorem. The country that is relatively more abundant in a factor of production will
export the good that uses that factor relatively intensively. In other words, countries trade based on
comparative advantage, and the source of that comparative advantage is relative factor endowments
interacted with relative factor intensities.
2. The Rybczynski Theorem. When the endowment of a factor increases, output of the good that uses that
factor intensively increases more than proportionally and output of the other good falls.
This theorem links relative factor endowments to production. Even under autarky, this relationship holds. It is
not surprising that an increase in one factor should increase production of the good that uses that factor
intensively. However, the coinciding reduction in output of the other good is a unique result of this model.

3. The Factor Price Equalization Theorem. If goods prices are equalized by trade, then so are factor prices.
This result relies on several key assumptions. The first is that of perfect competition. Under perfect
competition, goods are priced at their marginal cost of production. If this were not the case, another producer
would be able to enter the market and sell the identical good at a lower price. Marginal cost pricing results in a
direct relationship between goods prices and factor prices. Another crucial assumption is that production
technology is identical across countries, such that one unit of capital or labor will have the same marginal
product in each country. Otherwise, we could observe marginal cost pricing and goods prices that are
equalized across countries, even if wages are much lower in one country, if the low wage country is less
productive. For example, if one country requires 10 person hours to produce a good and the wage is $1.00 per
hour, then the cost per unit of good is the same as in a country where production requires only 1 person hour
but the wage is $10.00 per hour. This result also assumes that wages are set by market forces rather than trade
unions or government policies.

4. The Stolper-Samuelson Theorem. When relative prices change, the factor used intensively by the good
whose price has increased receives a greater reward in terms of both goods.
Trade creates clear winners and losers within each country. The winners are those who control the relatively
abundant factor, and the losers are those who control the relatively scarce factor. Suppose a country is
relatively well endowed with high-skilled labor. When that country opens up to trade with a relatively low-
skilled country, they will specialize in high-skill intensive goods. This increases the demand for high-skilled
labor and raises the wages of high-skilled workers. At the same time, there is less demand for low-skilled
workers, because the goods they produce can be purchased more cheaply elsewhere. Low-skilled workers in
the high-skill abundant country will see their wages fall. Focusing on high- and low-skilled workers as the two
factors of production also has implications for the impact of trade on the income distribution within countries.
Because more developed countries are more well endowed with high-skilled labor, trade should cause them to
specialize in high-skill intensive goods, increasing the wages of high-skilled workers and decreasing the wages
of low-skilled workers. Because high-skilled jobs generally pay more, this results in a wider wage gap between
high-income and low-income workers. However, the opposite prediction holds for developing countries. When
these countries, which are relatively more well endowed with low-skilled labor, open to trade the wages of
low-skilled workers should increase, leading to a reduction in income inequality.