Traditional international trade theory

(Ricardo and Heckscher-Ohlin models)

• Comparative advantage provides the foundation

upon which the classical (or traditional) theory of
international trade is based
• International trade arises due to differences
across countries (productivity or factor
endowments)

1
 Model by Ricardo
• Productivity differences between countries
determine international division of labour and
trade pattern
• If two countries have the same level of
productivity, no trade would occur

Model by Heckscher-Ohlin
• Concerned with factors of production
• If two countries have identical factor endowment
ratios, they would not trade each other

2
• Differences in technology or factor endowments
determine differences in opportunity cost of
production and therefore in relative autarky
prices
⇒ The only rationale for trade

• The theory of comparative advantage suggests

that trade should happen between economies
with large differences in opportunity costs of
production

3
 Implications:
• Countries who are “different” should trade more
• Countries who are “different” should specialise in
“different” goods
Example: “North” specialising in manufacturing and
“South” in agriculture (inter-industry trade)
In reality, we observe also that:
• A large amount of trade flows is between “similar”
countries
• These countries trade several goods which are
“similar” (intra-industry trade)
Example: automobiles exchange (intra-industry
trade) between “similar” countries
4
 US trade data (2015)

Country U.S. exports to U.S. imports from

European Union 19.0% 21.0%
Canada 22.0% 14.0%
Japan 4.0% 6.0%

Source: U.S. Census Bureau, 2015

5
 US sectoral trade data (2014)
U.S. Exports Exports, quantity, $ bn Imports, quantity, $ bn
Autos $146 $327
Food and beverages $144 $126
Capital goods $550 $551
Consumer goods $199 $558
Industrial supplies $507 $665

Source: U.S. Census Bureau 2014

6
Evolution of Intra-Industry Trade at the 5- and 3-Digit SITC (Standard
International Trade Classification) Levels (percent of total trade)
Source: Kenneth A. Reinert, “An Introduction to International Economics”, 2012

7
 Heckscher-Ohlin theory
Factor advantages
• A location (country, region) has a factor advantage
for a product if the unit factor costs are lower than
alternative locations
• A location is more likely to offer factor advantages
for producing a certain good if the factors used
intensively to produce that good are relatively
abundant there

8
 Heckscher-Ohlin (factor abundance) model:
• Two countries (Home H and Foreign F)
• Two factors (Capital K and Labour L)
• H is relatively K-abundant
• F is relatively L-abundant
• Two homogeneous goods (Cloth and Food)
• Cloth is relatively K-intensive
• Food is relatively L-intensive
⇒ Factor advantages:
• In producing Cloth for country H
• In producing Food for country F

9
 Factor abundance model (Heckscher-Ohlin)
Trade based on factor advantages
Simple exchange of Cloth for Food:
Country H exports Cloth and country F exports Food
Cloth (K-intensive) Food (L-intensive)

Home (K-abundant)

Foreign (L-abundant)
10
 New Trade Theory

o Departs from the traditional trade theory

o Goes beyond comparative advantage and the
traditional international trade theory

New frameworks characterised by:

 Different varieties of goods
 Economies of scale in production
 Heterogeneous consumers’ preferences
 Consumers’ love of variety

11
 Exports and product differentiation

• Market access is a key reason to export

• Reaching different pools of consumers enables the
firm to expand its market shares
• Larger market shares result in a better
exploitation of scale economies
• A successful exporting strategy may depend on
the right balance between
o Product differentiation/adaptation – to supply for
(and exploit) different tastes
o Standardisation – to exploit scale economies
12
 Love of variety (Krugman)

• Consumers are heterogeneous (more so across

countries) and have a love of variety
• This explains the high degree of product
differentiation we observe
• Horizontal differentiation – for a given level of
quality, products differ in “perceivable”
characteristics (subjective features, e.g. style)
• Vertical differentiation – different quality levels

13
• Two products are differentiated horizontally if,
when the two prices are equal, some consumers
prefer one product and other consumers prefer the
other product (same car with different colours, e.g.
FIAT 500 red and blue)

• Two products are differentiated vertically if, when

the two prices are equal, all consumers prefer the
same product (different types of car, e.g. BMW and
FIAT)

14
 Love of variety (LoV)

• At the aggregate level:

LoV ⇒ Tastes differ across consumers

• At the individual level:

LoV ⇒ Each consumer likes variety

• LoV generates an incentive to produce more

varieties

15
 Horizontal product differentiation

Gap: product characteristics are not the same

Varieties
1 3 5
Characteristics space

• Consumers buy goods closer to their ideal variety

• Positioning between two existing varieties may
increase market share by “capturing” otherwise
indifferent consumers
16
 LoV and economies of scale: a trade-off

• Many industries are characterised by economies of

scale
• Production is more efficient the larger the scale at
which it takes place
• With internal economies of scale: large firms have a
cost advantage over small firms ⇒ only a few firms
in the market
• Firms have an incentive to specialise in few
varieties

17
 Internal economies of scale

• Perfect competition – no internal scale economies

⇒ Firms are very small and their output is a tiny
fraction of the industry’s output
⇒ Firms are price-takers

• Imperfect competition, with a few firms in the

industry – internal scale economies are important
⇒ Firms are aware they can influence price and that
they can sell more only by reducing the price
⇒ Firms are price-setters

18
F: fixed cost MC = c: marginal cost (constant)
AC: average cost TC: total cost Q: output

TC = F + cQ AC = TC/Q = F/Q + c > MC

8
Unit cost • F gives rise to scale
7 economies ⇒ the
higher Q, the lower
6

4
AC
3

2
Average cost
• AC curve slopes
1

0
Marginal cost downward
• AC > MC (due to F)
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
Output

19
 Monopolistic competition
• Consumers love to have a choice between different
varieties of a good
• Once a new variety becomes available, there is
always a market for it ⇒ “Love-of-variety”
• Firms can differentiate their products from their
rivals and consumers perceive these differences
• Each firm is the only one producing one particular
good
• Differentiation gives firms some monopoly power
• Monopoly power is not complete: competition with
firms offering similar goods
20
 Countries: A and B, both producing n varieties

Gap: product characteristics are not the same

Varieties in country A
1 3 5

2 4 Varieties in country B
Consumers buy goods close to their ideal variety

21
 Trade in a world without economies of scale
Back to the factor abundance model
Simple exchange of Cloth for Food
Cloth (K-intensive) Food (L-intensive)

Home (K-abundant)

Foreign (L-abundant)

22
 Adding economies of scale & love of variety

• Cloth industry: a number of firms produces a

differentiated good, with internal scale economies
• Neither country is able to produce the full range of
cloth products by itself
• Both countries will produce some cloth, but they
will produce different things
• Trade will take place between countries in varieties
of clothes

23
 Trade pattern

• Home has a comparative advantage in cloth: it will

be a net exporter of cloth (trade surplus in Cloth)
• Consumers in Home love variety and they will
import different varieties of cloth from Foreign
• Foreign has a comparative advantage in food: it will
be a net exporter of food (trade surplus in Food)
• Consumers in Foreign love variety and they will
import different varieties of cloth from Home

24
 Trade with economies of scale & love of variety
• Two-way trade within the cloth sector: intra-industry trade
• Remainder is trade of cloth for food: inter-industry trade
Cloth (K-intensive) Food (L-intensive)

Home (K-abundant) Inter-

industry
trade

Intra-
industry
trade
Foreign (L-abundant)

25
Trade with economies of scale & love of variety

• Inter-industry (cloth for food) trade reflects

comparative advantage:
Home (K-abundant) is net exporter of cloth

• Intra-industry (cloth for cloth) trade does not

reflects comparative advantage:
Even if countries were identical, they would still
trade in cloth – economies of scale drive this trade

26
 Trade pattern
• Relative importance of inter- and intra-industry
trade depends on how similar countries are
• Similar countries (similar relative factor
endowments or technology) ⇒ little inter-industry
trade, dominant intra-industry trade
• Very dissimilar countries (very different relative
factor endowments or technology) ⇒ most trade
will be inter-industry trade driven by comparative
advantage

27
Positive relationship between intra-industry trade and
country similarity index, Germany, 2004

Source: “World Trade Report 2008” (WTO)

28
Positive relationship between intra-industry trade and country
similarity index (more than 2,000 countries)

Source: Hummels & Levinsohn, Quarterly Journal of Economics, 1995

29
Readings:

Krugman Obstfeld and Melitz, 9th edition, chapter 8

Krugman and Obstfeld, 6th edition, chapter 6

30