NS3040 Winter Term 2015

Trade Theories

Comparative Advantage

• The main theory of trade is comparative advantage• The idea that with different shaped production

possibility curves, each country can transform resources into particular products at lower cost than other countries

• Example:• wheat cloth• United States 6 10• England 2 5• or• United States 36 60• England 24 60

• The US must give up 36 units of wheat to produce 60 of cloth while UK only gives up 24 HOWEVER

• England must give up 60 of cloth to produce 24 of wheat while US produces 36 of wheat with the same 60 of cloth

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Heckscher-Ohlin Theory I

• Basically the same idea as comparative advantage but easier to generalize:

• Countries have comparative advantage in those products that use in their production relatively large amounts of the resources the country has in abundance

• Example – Because of abundance of land, U.S. has a comparative advantage in wheat while Japan does not

• Countries have a comparative disadvantage in those products that use relatively large amounts of the resources that country has shortages of.

• Example the U.S. has a comparative disadvantage in textiles that use a lot of semi-skilled workers, while Indonesia has an advantage in textiles.

• Free Trade will lead to factor price equalization

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Heckscher-Ohlin Theory II

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Leontief Paradox• When Heckscher-Ohlin first tested in 1947 by Harvard

economist W. Leontief he discovered:• The U.S. exported labor intensive products and imported

capital intensive• Explanations –

• Measurement problems – capital inputs hard to measure precisely

• Goods might be produced by different factor combinations in different countries. A U.S. capital intensive good, might be produced with much more labor in India

• Data to aggregative – just man-hours and amounts of capital used. If introduce idea of human capital then paradox solved – US invests relatively large amounts in humans and this is a form of capital – an area the U.S. has traditionally had relatively large amounts.

• Shortcomings of H-O Theory led to development of a variant approach -- comparative labor costs

• Labor costs function of productivity of worker and the wage5

Comparative Labor Costs

• U.S. /UK Productivity Differential

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Other Variants of Comparative Advantage

• Theory of Overlapping Demand• H-O emphasized supply side. Need demand

considerations• Countries of similar levels of income will trade more with

each other because of similar tastes and purchashing power

• Explains why U.S. trades more with Canada than Mexico• Product Cycle Theory• Products go through various stages in their lives

• New product – science, engineering important inputs

• Mature product – management, finance important inputs

• Standardized product – low wage semi-skilled assembly workers important input

• Idea comparative advantage will shift from country to country depending on their factory endowments

• Flying- Geese Patterns in East Asia• Transport Costs U.S retains some industries due to

high-transport costs from foreign markets.7

Linder Theory of Overlapping Demands

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Product Life-Cycle Theory

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