Questions to consider:

• Does free trade promote economic growth?

• Will high wage economies lose revenue and jobs in trade with low
wage economies like China?
• What determines in which industries a country will possess a
comparative advantage?
• Will all people of a country enjoy the gains from trade equally?
• If countries benefit most from specialising in those industries in which
they have a comparative advantage, why do many countries both
import and export the same products (eg the UK both imports cars and
export cars).
• What is dynamic comparative advantage?
Trade and growth?
We know that trade and growth are correlated – which causes
which?
Ricardo’s principle of comparative advantage demonstrates
that trade can lead countries to enjoy consumption positions
outside their PPFs: that is aggregate real incomes can grow as
a result of trade.
Also: the more countries’ incomes grow, the more their
populations want to consume goods and services from other
countries.
There is thus a virtuous circle at work here: trade promotes
growth, which promotes trade, and growth, and trade, and…
SOUTH KOREA: Total exports, top four partners (2011): US$ 206,000 million
NORTH KOREA: Total exports, top four partners (2013): US$ 3.8 million
South Korea is very highly integrated into the world economy; North Korea is an isolated
autarky. So - does free trade promote growth?
YES!
High wage versus low wage economies
• Will high wage economies lose revenue and jobs in trade with low wage
economies like China?
This is a question that tests your understanding of Ricardo’s theory of comparative
advantage. High-wage economies will specialise in industries that require
expensive, highly skilled workers. Low-wage countries (not China so much now…
more like Bangladesh and Vietnam) will specialise in low tech., low-wage products.
Low-wage jobs in the UK may migrate to East Asia, but export revenues will not
fall. Incomes in both high- and low-wage countries will rise.
• A similar complaint often heard in developed nations like the UK and US is that
‘we cannot compete against cheap labour in Asia’. Wrong!
• Imagine what they complain about in less-developed countries: that they cannot
compete against low-cost capital in the West. (Equally wrong!)
To conclude – trade theory demonstrates that both partners may benefit when trade
is freed-up between them, so long as each increases their specialisation in those
products in which they enjoy a comparative (not absolute) advantage
What determines in which industries a country will possess a
comparative advantage?
• In the 1930s, inter-war
period, two Swedish
economists, Eli Heckscher
and Bertil Ohlin argued that
countries have a
comparative advantage in
those commodities that use
more intensively those
factors of production
which they have in
abundance.
Will all people of a country enjoy the gains from trade equally?
The Heckscher-Ohlin model elaborates on the law of comparative advantage by predicting
not only that both trading partners will gain but also by predicting how the gains from
trade will be distributed within each country.
For example in 19th century trade between the UK and USA, increased rewards occurred
for US farm-workers and land owners, and for textile workers and mill owners in the UK.
North American prairies opened up as wheat farming expanded and the cotton towns of
Lancashire grew as more mills were built and employment increased.
Anecdotal evidence of the distribution of incomes from 19th
century history certainly seems to support the H-O model:
British industrialists grew in wealth whilst the landed
aristocracy lost incomes and status as American and
Commonwealth imports of primary produce seized market
share.

In the 19th century exchanges between primary producers and

manufacturers - between the New World and the Old World -
the theory of comparative advantage still seems a good
explanation for the pattern of world trade that evolved, and the
incomes it generated for both parties.
How does the (pre-war) H-O model, which predicts that trade
specialisation is based on the proportions of factors of production a nation
possesses, stand up to more rigorous and extensive (post-war) empirical
testing?
The USA in 1953 was by some margin the most capital-intensive producer
in the world. In a famous study published at the time by Wassily Leontief,
however, he found that the US imports were more capital intensive than
US exports! This result was quickly dubbed the Leontief paradox:

Factor content of US imports and exports IMPORTS EXPORTS

Capital (per million dollars) 2,132,000 1,876,000

Labour (person-years) 119 131

Ave. years of education per worker 9.9 10.1

Ratio of engineers and scientists in workforce 0.0189 0.0255
Source: Krugman and Obstfeld, (2009)
What explains this paradox?
Krugman notes firstly that 1953 US exports were more skilled labour- intensive,
and more engineer/science-intensive, than imports (a finding more in line with
expectations) and, secondly - from the 1950s right up to today - the higher tech
products that the USA specialises-in employ more sophisticated, innovative,
lightweight technologies than the heavy, metal-bashing, low-skill capital
equipment than its imports embody.
(The measurement of capital/technology inputs is extraordinarily difficult – and
thus most likely undervalues this component in Leontief’s calculations of US
exports)
Certainly, as just shown, comparing the Americas with Europe in the 19 th century,
the land abundant New World exported primary produce in exchange for capital
intensive manufactures from the Old World….and this pattern still fits trade
today between land-abundant South America and Australasia, exporting mineral
and agricultural commodities in exchange for manufactures from China, Japan,
the USA and the EU.)
The Stolper–Samuelson theorem
An important implication of the H-O model (derived by Wolfgang Stolper and Paul
Samuelson in the 1940s) is that returns to factors of production will be in line with
their employment in trade. Wages will rise for workers in labour-intensive export
industries; returns will increase to investors engaged in capital-intensive exports.
This theorem leads to the principle of factor-price equalisation:
As the price of trade-goods move to an equilibrium international price, so the prices
of their respective factors of production will tend to equalise. Thus, for example, if
Britons buy more and more land and labour-intensively produced farm products from
abroad then that US labour will begin to enjoy higher and higher wages; the land will
enjoy higher rents. British capitalists will equally earn higher returns, as will British
factory workers.
Following the changing pattern of international demand, and subject to the
occupational mobility of the resources involved, land and labour increasingly move
into agricultural employments in the Americas; labour and capital will increasingly
move into industrial employments in the UK. This reallocation of resources within
each trading country will continue, in theory, until factor prices equalise and there is
then no further incentive for land, labour and capital to redeploy.
Great theory; shame about the evidence…
The problem most recently is that, although such factor price equalisation might seem to have
converged in the 19th century, the incomes of skilled labour (doctors, engineers, computer
programmers, etc.) have not equalised across the trading world – e.g. between the US and the
UK, let alone with India and China.
If the logic of economic theory is correct but the predictions do not accord with reality then we
need to look at the assumptions…
The most relevant assumptions to examine are :
• Same production function for same commodity in different countries
• Factors internally mobile but internationally immobile
But skilled labour is produced and employed in different ways between the US and the UK (for
example, the NHS compared to private medicine);
and skilled labour markets are split into many non-competing groups (there is very restricted
internal mobility of skilled labour - especially in the short run).
The best we can predict is that, with increased international trade, there may be some narrowing
of differences between factor incomes in partner countries but they may not equalise…
So, will all people equally enjoy the benefits of increased international trade?
Theory predicts that incomes will rise for those factors most intensively employed in export industries. The
corollary to this is that factors employed more intensively in those industries where there is no comparative
advantage, and which now are subject to competition from imports, (eg landowners in British agriculture) –
their incomes will fall.
Insofar as they are occupationally mobile, land, labour, capital and enterprise in farms on the margin in the
UK will reallocate to alternative employments - ideally in export industries which enjoy a comparative
advantage in trade. Note that specialisation in trade is not complete: that is, the more efficient British farms
will continue to thrive. Production moves A to B; and C to D (not to E)

Agriculture

B
A
USA
C
D
UK Industry
E
The final position for trading countries however lies outside their respective PPFs (exactly
where depends on consumers’ tastes and preferences, say F and G); that is, real national
incomes rise. Thus, even if some resources are unable to redeploy and experience a net fall
in incomes, then the country concerned will still be able to tax winners and compensate
losers, and all can potentially gain from trade.
Agriculture

B
G
F
D
Industry

Note: although theoretically there is a sufficient rise in a country’s real income to allow
winners to compensate losers and for all to gain, this does not mean that that will actually
happen! Redistribution of the gains from trade depends on the efficiency of society
(government) to organise income transfers. We know, for example, that since the supply-
side/free market revolution in the UK and the USA that income inequalities have widened...
The rate of change of US real incomes, 1948-2012
(source: www.forbes.com)
UK Gini coefficient
Conclusion:
• There will be a redistribution of a nation’s incomes, subsequent to
trade.
• Not all benefit – there are losers as well as winners.
• It requires government intervention to ensure that resources are as
occupationally mobile as possible and, where that fails, that some
fraction of the gains from trade are diverted to the unemployed.
• There is a sufficient rise in a country’s real income to allow winners
to compensate losers and for all to gain…
How a change in the demand for cloth (or wheat)
changes the prices of each product and thus the incomes
and employment of the factors of production employed
in each:
• Cloth production is labour-intensive
• Wheat production is land-intensive
• An increase in demand for cloth will increase the relative price of
cloth to wheat (Pc/Pw)
• There will be an increase in demand for labour – greater than the
increase in demand for land
• Increasing the relative price of cloth will thus increase the relative
price of labour (wages of labour to rent on land: w/r)
The relationship between the relative price of cloth/wheat to wages/rent
is illustrated below
 The greater the demand for
wage/rent ratio cloth the more it will drive up
w/r its price and, along with it, the
SS derived demand and thus price
of that factor used most
intensively in its production –
labour
The SS curve illustrates this
relationship

Relative price of cloth: Pc/Pw (The opposite is also true: if

wages exogenously rise, it will
push up the price of cloth
What determines the steepness of this SS curve? compared to wheat.)
• Cloth has a higher labour concentration in its production
• Wheat has higher land concentration
As the price of wages/rent increases, both sectors will attempt to
reduce their labour/land mix (or increase their land/labour mix)…
though this will be more possible in wheat production than cloth
production
wage/rent (w/r) cloth wheat

land/labour ratio
Putting the last two diagrams together we can derive
the final model:
w/r
SS cloth wheat

Pc/Pw land/labour ratio

An increase in demand for cloth (from overseas markets) will increase the
relative price of cloth, increase relative wages of labour and lead to substitution
of other factors (land) in both sectors – agriculture as well as industry.