Global economic environment- 8&9

Dr. Anil K Kanungo

 Limitations of Comparative Advantage

• ???
 Limitations of Ricardian Concept of Comparative Advantage

• Drawbacks
-- Non-homogenous labour
-- Example(Textiles vs Software)
-- (Opposition to FT)
-- No CRS
-- Higher probability in DRS(Cocoa vs Rice)
 Analysis
• Verdict
-- DRS suggests gains from specialization are
exhausted before economy attains specialization.
-- Until specialization outweighed by diminishing returns
 Discarding of Ricardian argument
• Not labour productivity/difference in labour productivity
• CA lies in difference in national factor endowments
• Emergence of H O theory
 Hecksher-Ohlin (H-O) theory
• To examine:
- Basis of comparative advantage
- How different from Smith and Ricardo’s theories
- Effect of international trade on return to labour
• In the real world, while trade is partly explained
by differences in labor productivity, it also reflects
differences in countries’ resources.
• The Heckscher-Ohlin theory:
• Emphasizes resource differences as the only source of
trade
• Shows that comparative advantage is influenced by:
- Relative factor abundance (refers to countries)
- Relative factor intensity (refers to goods)
• Is also referred to as the factor-proportions
theory
 H-O Theory
• CA of Ricardo-difference in labour productivity
• Eli Hecksher & Bertil Ohlin-difference in Factor endowments
• More abundant a factor; lower is the cost
• Intensify exports in products where factor endowments are locally abundant
• Import goods where factor endowments scarce
• Pattern of int. trade determined by difference in factor endowments
- - Canada (wheat); China (toys)
 H-O Theory
• Significance of drawback of Smith & Ricardo
 H-O theory-Assumptions
• 1. Two nations, two goods, two factors of
production- 2X2X2 model
• 2. Technology same in both nations
• 3. Commodity X is labour intensive, commodity Y
is capital intensive in both nations.
• 4. Constant returns to scale for X and Y in both
nations
• 5. Incomplete specialization in production in both
nations
 Assumptions
• 6. Tastes are equal in both nations
• 7. Both commodities and factors are traded in perfectly
competitive markets
• 8. Perfect factor mobility within each nation, but not
between nations
• 9. No transportation costs, tariffs or other barriers to
free trade.
• 10. All resources are fully employed in both nations
• 11. International trade between the nations is
balanced.
 Factor Intensity, Factor Abundance, and the Shape of the
Production Frontier

• Factor Intensity
- In a two-commodity, two factor world, commodity Y is
capital intensive if the capital-labor ratio (K/L) used in the
production of Y is greater than K/L used in the production
of X.
- It is not the absolute amount of capital and labor used in
production of X and Y, but the amount of capital per unit of
labour that determines capital intensity.
Factor intensities in commodities X and Y in Nations 1&2
 Questions(K&O)
• How do you determine int. trade according to H-O theory?
• How do you measure the K/L?
 Analysis of factor intensities

• Even though commodity Y is more K intensive in both nations, Nation 2 uses a higher K/L in
producing both Y & X than Nation 1
• For Y, K/L=4 in Nation 2 whereas K/L=1 in Nation 1
• For X, K/L=1 in nation 2 whereas K/L= ¼ in nation 1
• Then the question………………
• Why does nation 2 use more K-intensive production techniques than K-1 in both the commodities?
 Analysis

• Answer may be………

• K could be cheaper in Nation 2 than Nation 1
• So that producers in Nation 2 use relatively more capital in production of
both commodities to minimize their costs of production
• Why K is cheaper in Nation 2?
 Analysis based on assumptions

• Assumption-
- Relative price of capital falls
- Then, Y is unequivocally K intensive
 Factor abundance
• Factor Abundance
• In terms of physical units:(availability of L and K)
- Nation 2 is capital abundant if the ratio of the
total amount of capital to the total amount of
labour (TK/TL) available in Nation 2 is greater than
that in Nation 1.
- It is not the absolute amount of capital and labour
available in each nation, but the ratio of the total
amount of capital to the total amount of labour.
 Factor abundance
• Factor Abundance
• In terms of relative factor prices:
- Nation 2 is capital abundant if the ratio of the rental
price of capital to the price of labour time (PK/PL) is lower
in Nation 2 than in Nation 1.
- Rental price of capital is usually considered to be the
interest rate (r), while the price of labour time is the wage
rate (w), so PK/PL = r/w.
- It is not the absolute level of r that determines whether a
nation is K-abundant, but r/w.
The Shape of the Production possibility Frontiers of
Nation 1 and Nation 2.
 Factor Endowments and the H-O Theory

• H-O theory is based on two theorems:

• 1. The H-O theorem
- A nation will export the commodity whose production requires
the intensive use of the nation’s relatively abundant and cheap
factor and import the commodity whose production requires the
intensive use of the nation’s relatively scarce and expensive
factor.
 Example
H-O Theory-Analysis
• Home(Country A) Foreign(Country B)
Capital, Labour Labour, Capital

Cars, textiles Textiles, Cars

H-O theory says: A country will export that

commodity which uses intensively its
abundant factor and import that commodity
which uses intensively its scare factor
 Conti…….
• Home(Country A)
Textiles(importables)

Competition from imports (lower

Cars (exportables demand for textiles) and
decline in relative prices of textiles

Increased demand for Reduced demand for both capital and

cars+ increase in labour in the textiles
relative prices industry, capital and labour released
from this industry
Increased demand for
both capital and labour in
the car industry

In the car industry, there is increased demand for capital and labour. But from
the textiles sector, relatively more labour is released than capital
 Conti…….
• Home(Country A)

Capital, Labour

• The Car industry becomes more labour intensive

• Marginal product of capital increases, return to capital increases
• Owners of this factor of production benefit
• With the assumption that labour is freely mobile b/w sectors, this model
shows why trade can lead to distributive issues.
 Useful takeaways from H-O theory
• It is a country’s relative factor endowment that determines its
comparative advantage. This is why the H-O model is also
called the factor proportions theory.
• Once trade opens up, owners of abundant factors gain, while
owners of scarce factors lose with trade.
• A country as a whole is predicted to be better off with trade,
so winners could, in theory, compensate the losers within each
country.(How???-Indian economy, world economy---New
mercantilism)
 Gains from Trade and Distribution

• In a model with two goods and two factors of

production, with full inter sectoral mobility of the
factors, owners of one of the two factors are made
necessarily worse off with the opening to trade.
• The factor which is used intensively in the importable
good must experience a decline in its real earnings.
• While as a whole countries participating in
international trade gains, trade also creates winners
and losers within the countries.
• Unless gains from trade are properly redistributed, it
will not lead to a Pareto Improvement.
 Theorems
• H-O theory is based on two theorems:
• The H-O theorem
- In short, the relatively labour-rich nation exports the
relatively labor-intensive commodity and imports the relatively
capital-intensive commodity
- Explains comparative advantage rather than assuming it.
 Findings
• According to Ohlin “International trade is a special
case of inter-regional trade". Difference in factor
endowments is the main cause of international trade
along with inter-regional trade.
• Heckscher cites the following causes for
difference in comparative costs:
-- (i) Difference in factor Endowments, and
-- (ii) Difference in factor Intensities
 Findings
• According to Heckscher-Ohlin theory of
international trade, the immediate cause of
international trade is the difference in relative
commodities prices.
- 1. The cause of difference in the relative prices of the goods is the
difference in the amount of factor endowments, like capital and
labour, between the two countries.
- 2. As a result, there is difference in the relative demand and supply
of factors, these difference cause difference in the prices of the
factors.
- 3. It is due to difference in factor prices that difference in the
relative prices of the commodities takes place and it is this difference
that constitutes the main cause of international trade.
• How do we empirically prove it?
Tap factor endowments of various countries as a %age of the world
1. Arable land
2. Physical capital
3. R&D Scientists
4. Highly skilled labour (tertiary education and above)
5. Medium skilled labour (secondary education))
6. Unskilled labour (primary and not above)
7. GDP
Need to establish the H-O theory
Data: World Bank, OECD, UN Data Bank, UNCTAD, Individual Govt. sites
 Assignments

• Based on H-O theory with criteria

• Groups 1 to 11 -Italy, Greece, Denmanrk, Sweden, Luxembourg, Hollnd, England, Romania, hungary,
Germany, France, Austria, -Finland, -Bulgaria, Croatia, Latvia, Finland, Estonia, Spain, Finland, Mexico,
Argentina, Canada, Chile, Peru, Columbia, Brazil, Russia, Bangladesh, Pakistan, Sri Lanka, Singapore,
Philippines, Vietnam, New Zealand
 Books
• Robert Feenstra & Alan M Taylor: International Trade
 Nation 2 is K-abundant, and
commodity Y is K-intensive

Nation 1 is L-abundant, and

commodity X is L-intensive

The Shape of the Production Frontiers of

Nation 1 and Nation 2.
Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
H-O model
 Lessons
• The Heckscher-Ohlin model, in which two
goods are produced using two factors of
production, emphasizes the role of resources
in trade.
• A rise in the relative price of the labour-
intensive good will shift the distribution of
income in favor of labour:
- The real wage of labour will rise in terms of both goods,
while the real income of landowners will fall in terms of
both goods.
 Lessons
• For any given commodity prices, an increase in
a factor of production increases the supply of
the good that uses this factor intensively and
reduces the supply of the other good.
• The Heckscher-Ohlin theorem predicts the
following pattern of trade:
- A country will export that commodity which uses
intensively its abundant factor and import that commodity
which uses intensively its scarce factor.
 Lessons
• The owners of a country’s abundant factors gain
from trade, but the owners of scarce factors lose.
• In reality, complete factor price equalization is
not observed because of wide differences in
resources, barriers to trade, and international
differences in technology.
• Empirical evidence is mixed on the Heckscher-
Ohlin model.
- Most researchers do not believe that differences in resources alone can
explain the pattern of world trade or world factor prices.
 Relevant questions
• What are the continuity and change in evolution of trade theories?
• How trade can lead to distributive gains/issues?
• What are the takeaways of H-O theory?
• How do you prove empirically the H-O theory?
 Leontief paradox
• Objectives:
• To prove that the H-O Model was correct; and
• To show that the U.S. exports were capital intensive
• Empirically proves H-O theory wrong
- Wassily Leontief, in 1953, found that US is
exporting labor-intensive products, while US is
claiming that it is a capital-intensive economy.
 Leontief premise I
• A widely shared view on the nature of trade
between US and the rest of the world is
derived from what appears to be a common
sense assumption that this country has a
comparative advantage in the production of
commodities which require large quantities of
capital and relatively small amounts of labour
for manufacture of goods.
 Leontief premise II
• USA possesses a relatively large amount of
capital(K) and less of labour(L).
• So oft-repeated argument is, if more of labour
is involved in USA production, then “labour
intensive” products would be uneconomical;
USA can obtain them from abroad in exchange
of capital intensive products.
 Leontief Analysis
• Leontief’s method: how to determine the relative
amounts of labor and capital in a good?
- Input-output analysis:
-- A method for estimating market activities and
potential that measures the factor inflows into
production and the resultant outflow of products.
--Input-output analysis, is a technique of
decomposing a good into the values and quantities
of the labour, capital, and other potential factors
employed in the good’s manufacture.
 Leontief Analysis
• Leontief developed a 1947 input-output table for the USA to
determine the capital-labor ratios used in the production of
USA exports and imports. Leontief found that the U.S.
exports used a capital-labor ratio of $13,991 per man year,
whereas import substitutes used a ratio of $18,184 per man
year.
 Leontief Analysis
• The key ratio of [( KX / LX ) / ( KM / LM )]

• (13,991 / 1) / (18,184 / 1) = 0.76

• was calculated. Given the presumption

that the U.S. was relatively capital abundant,
that ratio was just the reverse of what the H-O
Model predicted. Thus, it is called the
Leontief Paradox.
 Leontief Analysis
• Hypothesis: US exports should be relatively
capital intensive than US imports.
• Results: The products that US firms exported
were relatively more labor intensive than the
products the US imported.
• Questions:
• A.Is the factor proportions theory true?
• B.Is the United States a relatively labour-
abundant country?