International

Economics
Woraphon Yamaka
Chapter 3:
Sources of Comparative Advantage

Modified form International Economics 9th Edition by

Robert J. Carbaugh
2 Review Chapter 2
 In Chapter 2, we learned how the principle of comparative
advantage applies to the trade patterns of countries.
 Sometimes comparative advantage is determined by natural
resources or climate, sometimes by the abundance of cheap labor,
sometimes by accumulated skills and capital, and sometimes by
government assistance granted to a particular industry
 Some sources of comparative advantage are long lasting, such as
huge oil deposits in Saudi Arabia; others can evolve over time,
such as worker skills, education, and technology.

In this chapter, we consider the major sources of comparative advantage:

differences in technology, resource endowments, and consumer demand;
and also, the existence of government policies, economies of scale in
production, and external economies
3 Heckscher-Ohlin Theory
 Ricardo formulated the principle of comparative advantage,
Problem of Ricardo theory.
1) He did not explain what ultimately determines comparative advantage.
2) He simply took that relative labor productivity, and thus relative labor costs
and relative product prices, differed in the two countries before trade.
3) His theory cannot explain the source of comparative advantage
4) Cannot explain the effect of international trade on the earnings of various
factors of production in trading nations.
 Heckscher-Ohlin Theory is introduced
They mentioned that actor (resource) endowments determine a nation’s
comparative advantage, their theory became known as the factor-
endowment theory. It is also known as the Heckscher-Ohlin theory.1
Why relative price differentials?

4
Factor endowment theory: assumptions

Carbaugh, Chap. 4
 What does it mean to be relatively
5
abundant/ scarce in a resource?

U.S. capital/labor ratio equals 0.5 (100 machines/200 workers)

China capital/labor ratio is 0.02 (20 machines/1,000 workers)
United States the
capital/labor ratio
> capital/labor ratio relatively capital-
abundant country
China the
relatively Labor-
abundant country
 How does the relative abundance of a resource
6 determine comparative advantage according to the
factor-endowment theory?

When a resource is relatively abundant, its relative cost is less than in

countries where it is relatively scarce.
For Example:
Before the US and China trade
Comparative advantages are that capital is relatively cheap in the
United States
Labor is relatively cheap in China.
So, the US has a lower relative price in aircraft, which use more
capital and less labor.
China’s relative price is lower in textiles, which use more labor and
less capital.

Carbaugh, Chap. 4
7 Quiz: Let analyze the comparative advantage of US
and Thai Economies, What can we conclude?

Carbaugh, Chap. 4
Factor endowment model

Visualizing the Factor-Endowment Theory

Autarky equilibrium

Suppose that in autarky, both countries have the same demand for textiles and aircraft
that results in both countries producing and consuming at point A
United States has a comparative advantage in aircraft while China has a comparative
advantage in textiles because MRT(US)= 0.33 < MRT(CHINA)= 0.40
8
Factor endowment model

Visualizing the Factor-Endowment Theory

Post-trade equilibrium

With trade, each country continues to specialize in the production of the product
of its comparative advantage until its product price equalizes with that of the
other country. (reach Point B)
- The points that production possibilities curve is tangent to the common relative price
slope of 1.0. ( Term of Trade 1:1) .
- This relative price line becomes the equilibrium terms of trade (Price import =Price
9
export)
Factor endowment model

10 Factor endowment theory: implications

 Factor price equalization (same resource prices)

 The shift within each nation to use of cheaper factors, and
away from expensive ones, leads to more equal factor prices
(if factors are mobile) This lead a factor-price equalization.

EX: Form previous graph, the Chinese demand for inexpensive American aircraft results
in an increased American demand for its abundant resource, capital; the price of
capital(R) thus rises in the United States. As China produces fewer aircraft, its demand
for capital decreases, and the price of capital falls. The effect of trade is thus to equalize
the price of capital in the two nations.
R(US)= R(CHN)
Similarly, the American demand for cheap Chinese textiles leads to an increased demand
for more labor in China, its abundant resource; the price of labor(w) thus rises in China.
With the United States producing fewer textiles, its demand for labor decreases, and the
price of labor falls.
Carbaugh, Chap. 4
W(US)= W(CHN)
11 Factor endowment theory:
implications
 Distribution of income (Stolper-Samuelson theorem)
Trade changes domestic distribution of income as demand
for different factors changes

• Free international trade benefits the abundant factor and harms the scarce
factor. (see, Factor price equalization)
• Some groups in society will oppose international trade.
• Scarce factors will lobby government for
trade protection.
• Even though some in society lose, the country overall benefits from
international trade relative to autarky.
• A system of taxation and transfers could
be developed to compensate the losers
while leaving the gainers better off relative
toCarbaugh,
autarky. Chap. 4
 Stoper – samuelson theory

L China and K US gain from trade

K China and L US loss from trade
Distribution of income

13 Before leaving the factor-endowment theory

Does trade worsen inequality?

 Trade theory suggests that countries with abundant
skilled labor will import goods which are made with
unskilled labor
 Equilibrium wage ratios for skilled/unskilled labor
are affected by trade and technology change,
immigration, and education & training
 Evidence suggests that trade contributes relatively
little to wage inequality, compared to technological
change and other factors; better education and
training are potential solutions

Indeed, Skilled and unskilled make lead an inequality wage

Bringing theory closer to reality

14 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

Carbaugh, Chap. 4
Economies of scale

Economies of scale as basis for trade

Although comparative-advantage theory has great appeal, it has little ability to
explain why similar productivity countries trade with each others.
This question can be explained by economies of scale

By adding to the size of the domestic market, international trade permits

longer production runs by domestic firms, which can lead to greater
efficiency and reductions in unit costs
EX. Companies such as Toyota and Honda reduce costs by specializing in machinery
15
and labor and obtaining quantity discounts in the purchase of inputs.
Bringing theory closer to reality

16 Other extensions of the theory

 Overlapping demands
 Intra-industry trade
 Product cycles
 Dynamic comparative advantage - industrial policy

Carbaugh, Chap. 4
Bringing theory closer to reality

17 Trade & the environment

 Environmental regulation can lead to a policy tradeoff
 Increased costs can reduce comparative advantage of
regulated industry
 Public receives health and environmental benefits
 Concern that polluting industries would move to poor
countries with less regulation
 But studies indicate that environmental rules have a small
role in investment location decisions
 Polluter-pays principle: incentive to find ways to
reduce pollution at least cost

Carbaugh, Chap. 4