Contents

1 Introduction

1.1 The Scope of International Economics 1.2 International Economics: Trade and Money1.3 Why is some knowledge of international economics

required?1.4 Historical Development of International Trade Theory

(Table 1)

2 The Law of Comparative Advantage

2.1 Introduction2.2 Mercantilism2.3 Trade Based on Absolute Advantage: Adam Smith2.4 Trade Based on Comparative Advantage: David

Ricardo2.5 Critics of Ricardo’s Comparative Advantages2.6 Exception to The Law of Comparative Advantage2.7 The Opportunity Cost and Comparative Advantages

(Gottfried Haberler)2.8 Empirical Tests of Ricardian Model

3 The Standard Theory of International Trade

3.1 Introduction3.2 The Production Frontier with Increasing Costs3.3 Equilibrium in Isolation with Increasing Costs (In a

Closed Economy)3.4 The Basis For and The Gains From Trade with

Increasing Costs3.5 The Gains From Exchange and From Specialization3.6 Trade Based on Differences in Tastes

4 Offer Curves, Demand and Supply, The Terms of Trade

4.1 Introduction4.2 Illustration of Offer Curves

2

5 Factor Endowments and The Heckscher-Ohlin Theory

5.1 Introduction5.2 Illustration of the H-O Theory5.3 Corollaries of the H-O Theory5.4 Empirical Tests of the Heckscher-Ohlin Model5.5 The New Trade Theories5.6 Synthesis of Trade Theories5.7 Transportation Costs and International Trade5.8 Environmental Standards and International Trade

6 Economic Growth and International Trade

6.1 Introduction6.2 Interaction Between Growth and Trade6.3 Comparative Advantages and Economic

Development

3

Chapter One

INTRODUCTION

1.1 The Scope of International Economics

This course deals with the main concepts and methods of International Economics

Examples for some concepts and subjects of International Economics:

Trade between independent nations

Tariffs and quotas

Exchange rates

Balance of payments

Economic Integrations

Capital inflows and outflows

And like…

International Economics uses the ‘same fundamental methods of analysis’ as other branches

of economics, because the ‘motives’ and ‘behavior’ of individuals and firms are the same in

international trade as they are in domestic transactions.

Yet, International Economics involves ‘new and different’ concerns, because international

trade and investment occur between independent nations.

For example,

Chine’s toys can become more expensive in Turkey if Turkey sets a quota that limits

imports.

If interest rates in Turkey fall, capital outflows may occur and the value of dollar in

terms of TL may rise.

4

Then, the subject matter of International Economics consists of issues raised by the special

problems of economic interaction between sovereign states.

Seven themes recur throughout the subject:

The Gains From Trade

The Pattern of Trade

Protectionism

The Balance of Payments

Exchange Rate Determination

International Policy Coordination

International Capital Market

5

i. The Gains From Trade

Probably the most important insight in all of International Economics is the idea that ‘there

are gains from trade.’

That is, that when countries sell goods and services to another, this is almost always ‘to their

mutual benefit.’

Many people are skeptical about the benefits of trade, but the range of circumstances under

which international trade is beneficial is much wider than most people appreciate.

(will be discussed in detail later.)

ii. The Pattern of Trade

‘Who sells what to whom?’ This summarizes the pattern of trade, which have been a major

preoccupation of international economists.

The reasons behind the trade might be:

Differences in climate and natural resources

Differences in labor productivity (D.Ricardo)

Relative supplies of national resources such as capital, labor, and land on one side and

relative use of these factors in the production of different goods on the other.

A random component such as economies of scale, and external economies.

(will be discussed in detail later.)

iii. Protectionism

If the idea of gains from trade is the most important theoretical concept in International

Economics, the seemingly eternal battle between free trade and protection is its most

important policy theme.

Limits on imports and subsidizing exports are devices of protectionist policies.

International Economics analyzes the effects of these protectionist policies. And usually,

though not always, it criticizes protectionism and shows the advantages of freer international

trade. (These devices will be analyzed)

6

iv. The Balance of Payments

Some countries run large ‘trade surpluses’ -that is, each sells more goods to the rest of the

world than it buys in return, like Japan.

On the other side, some countries run large ‘trade deficits’ -that is, each buy more goods from

the rest of the world than it sells, like Turkey.

What does it mean when a country runs a trade surplus or a trade deficit?

To make sense of numbers like the trade deficit, it is essential to place them in the broader

context of the whole of a nation’s international transactions.

The record of a country’s transactions with the rest of the world is called ‘the balance of

payments.’

Explaining the balance of payments and diagnosing its significance is a main theme of

international economics.

The balance of payments has become a central issue for Turkey because the nation has run

huge trade deficits for a long time.

v. Exchange Rate Determination

In February 2001, a dollar was worth about 1500 Turkish Liras. During the following years a

dollar fell up to TL 1200, and this year fluctuated between 1300 and 1700. These changes

have many effects far beyond financial markets.

Exports, imports, industrial efficiency, foreign direct investments, saving behavior, etc are

affected by the value of Turkish Lira in terms of other currencies.

One of the key differences between International Economics and other areas of Economics

is that countries have different currencies.

Exchange rate can be fixed by government action (fixed Exchange rate regime) or can be

determined in the market place (floating Exchange rate regime)

For the time being, however, some of the world’s most important exchange rates fluctuate

minute by minute and the role of changing exchange rates remains at the center of the

international economics story.

7

vi. International Policy Coordination

The international economy comprises of sovereign nations, each free to choose its own

economic policies.

Unfortunately, in an integrated world economy, one country’s economic policies usually

affect other countries as well.

For example:

When the United States imposed a tariff on imports of lumber during 1986, the

Canadian Lumber Industry experienced a crisis.

The FED’s interest rate policy is very important for the policy actions of other

governments.

Therefore, differences in goals between countries often lead to conflicts of interest. Even

when countries have similar goals, they may suffer losses if they fail to coordinate their

policies.

While cooperation on international trade policies is a well-established tradition, coordination

of international macroeconomic policies is a newer and more uncertain topic.

vii. International Capital Market

The debt problems of developing countries (especially Latin Americans) during 1970s, 1980s

and 1990s brought the public attention to the growing importance of the international capital

market.

The growing importance of international trade has been accompanied by the growth in the

‘International Capital Market’ which links the capital markets of individual countries.

‘Some special risks’ are also associated with international capital markets; currency

fluctuations, national default...

So, the growing importance of international capital markets and their new problems

demand greater attention than even before.

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1.2 International Economics: Trade and Money

The economics of international economy can be divided into two broad subfields.

The study of International Trade

The study of International Money

International trade analysis focuses primarily on the ‘real transactions’ in the international

economy (that is, physical movements of goods).

International monetary analysis focuses on the ‘monetary side’ of the international economy

(that is, on financial transactions such as foreign purchases of U.S. dollars on Turkish Lira)

In the real world, there is no simple dividing line between trade and monetary issues. Most

international trade involves monetary transactions, while many monetary events have

important consequences for trade.

Nonetheless, the distinction between international trade and international money is useful.

In accordance with this distinction we will,

at first, study international trade theories and policies;

secondly, we will study international monetary theory and policy issues.

Before starting the analysis of international trade theories, it might be useful to have a look at

the historical development of international trade theory as a whole (see Table 1).

1.3 Why is some knowledge of international economics required?

Because, first, it is necessary to understand what goes on in the world today and to be

informed consumers, citizens, and voters.

Second, on a more practical level, the study of international economics is required for

numerous jobs in multinational corporations, international banking, government agencies, and

international organizations.

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Table 1

1.4 Historical Development of International Trade Theory

Theory of Absolute Advantage

Theory of Comparative Advantage

Extension of Theory With New

Concepts

Factor Proportions

Theory (Hecksher-Ohlin

Model)

Some Theorems Depending on H-

O Model

Leontief Paradox New Theories

-Adam Smith, ‘The Wealth of Nations’ (1776)

-Classical Liberalism Homoeconomicus Laissez faire laissez passer Invisible Hand

-Advantages of specialization and division of labor are emphasized.

-It is not adequate to explain the trade. But has importance for being the first attempt.

-Countries producing more efficiently should sell.

-Trade would be unilateral/one-sided

-David Ricardo‘On The Principals of Political Economy and Taxation’(1817)

-Even if a country has advantage on producing of the two goods, trade can be possible and two sides can gain from trade.

-The theory depends mainly on the differences of labor productivity.

-Has been developed with the contribution of new concepts.

- Opportunity Cost

-International relative prices (Reciprocal Demand Curves/Offer Curves)

-Economic growth and foreign trade

-Why does a country have comparative advantage?

-Resources / Factor Endowments are emphasized.

Eli Hecksher, Swedish, his article ‘The Effect of Foreign Trade on The Distribution of Income’(1919);

Bertil Ohlin’s book, ‘Inter-regional Trade and International Trade’(1933)

-Equalization of international factor prices

-Income Distribution Theorem of Stolper-Samuelson (Free trade policy is in favor of abundant factor, but protectionism is in favor of scarce factor.)

-Rybczynski Theorem (Under full employment conditions, if the supply of one factor increases, the production of the good which uses that factor increases, but the production of other good decreases.)

-The results of Wassily Leontief’s Studies (1951) and others stimulated new theories. (He devised input-output analysis and tested H-O Theory)

-Skilled Labor Hypothesis

-Technological Gap Hypothesis

-Product Cycle Model

-Similarity in Preferences Hypothesis

-The Theorem of Economies of Scale

-The Theorem of Monopolistic Competition

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Chapter Two

THE LAW OF COMPARATIVE ADVANTAGE

2.1 Introduction

We will start with the simplest model and develop it with extentions and additions.

The basic questions are:

1) What is the ‘basis for trade?’

A nation will voluntarily engage in trade if it benefits from trade.

2) What are the ‘gains from trade’?

But, how are gains from trade generated? And, how large are the gains and how

are they divided among the trading nations?

We will see, successively:

Mercantilism

Adam Smith’s theory of ‘Absolute Advantage’

David Ricardo’s theory of ‘Comparative Advantage’

Gottfried Haberler’s ‘Opportunity Cost’ Theory, as a contribution to comparative

advantages.

2.2 Mercantilism During 17th and 18th centuries mercantilism was the popular economic philosophy.

Briefly, the mercantilists maintained that the way for a nation to become ‘rich’ and

‘powerful’ was to export more than it imported.

According to Mercantilists, the source of power and richness was to accumulate

precious metals, primarily gold and silver.

For that reason, the government had to stimulate the nation’s exports and restrict

imports.

Thus, the mercantilists preached ‘economic nationalism’.

But, since all nations could not simultaneously have an export surplus and the amount

of gold and silver was fixed at any particular point in time, one nation could gain only at

the expense of other nations.

Consequently, trade was a ‘zero-sum game’: one part gains, but the other loses!

11

2.3 Trade Based on Absolute Advantage: Adam Smith

Economics as an organized science can be said to have originated with the publication in 1776

of ‘The Wealth of Nations’ by Adam Smith.

Smith started with the simple truth that for two nations to trade with each other ‘voluntarily’,

both nations ‘must gain’.

And the questions:

How does this ‘mutually beneficial trade’ take place? and

From where do these ‘gains from trade’ come?

2.3a Absolute Advantage:

According to Smith, trade between two nations is based on ‘absolute advantage’.

According to the theory of absolute advantage, when one nation is more efficient than

the other in the production of one commodity, it should specialize in producing this

commodity and export the surplus over its need.

In return, this nation can buy (import) the commodity which is the surplus of the other

nation’s production that is generated by the specialization of this nation.

Thus,

Two nations allocate their resources so as to produce most efficiently.

And free trade would cause world resources to be utilized most efficiently and would

maximize world welfare.

This is the policy of ‘Laissez-faire’ (There were to be only a few exceptions to this

policy of Laissez-faire and free trade; e.g. the protection of industries important for

national defense.)

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2.3b Illustration of Absolute Advantage

Table 2.1 one hour of labor time

U.S. U.K.

Wheat (bushels*/man-hour) 6 1Cloth (yards**/man-hour) 4 5

*bushel: a unit of measure, approximately 8 gallons (36lt); Kile **yard: 3 feets/36 inch; or 0.91 m (1 feet: 30.5cm, 1 inch: 2.54 cm)

From the table, we can see that;

One hour of labor time produces 6 units of wheat in the U.S., but only 1 unit of wheat

in the U.K.

On the other hand, one hour of labor time produces 5 units of cloth in the U.K., but

only 4 units of cloth in the U.S.

Thus, the U.S. has an absolute advantage over the U.K. in the production of wheat (or

is more efficient than the U.K.)

And, the U.K. has an absolute advantage over the U.S. in the production of cloth (or is

more efficient than the U.S.)

With trade,

the U.S. would specialize in the production of wheat, and exchange part of it for

British cloth. The opposite is true for the U.K.

Now, let’s assume that the U.S. gives up to produce cloth (C) and specializes in the

production of wheat (W); producing for example 12 units of wheat.

If the U.S. exchanges 6 units of W for 6 units of British C, then the U.S. gains 2 C.

6 C (imported)- 4 C (domestically produced) = 2 C

Similarly,

6 W ( the U.K. receives from the U.S.) = 6 man-hours for the U.K.

With 6 man-hours, the U.K. can produce 30 C (=6 man-hours x 5 C).

So, the U.K. gains 24 C (30 C- 6C=24 C)

In this example, no matter how much more one nation (the U.K.) gained

than the other nation (the U.S.).

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What is important is that ‘both’ nations can gain from specialization in production and trade.

However, in the example above, if the U.S. was efficient in the production of both wheat and cloth, the trade could not be possible because the U.K. could not gain from trade.

Absolute advantage can explain only a very small part of world trade today, such as some of the trade between developed and developing countries.

It remained for David Ricardo to explain the basis for and the gains from trade: The Law of

Comparative Advantage.

2.4 Trade Based on Comparative Advantage: David Ricardo

Definition: According to the law of comparative advantage, even if one nation is less efficient

than the other nation in the production of ‘both’ commodities, there is still a basis for

mutually beneficial trade.

In other words, one nation may have an absolute disadvantage with respect to the other

nation, but they can gain from trade.

Let’s look at the example given by Ricardo:

Table 2.2 Commodities produced with one labor-day

Cloth (meter) Wine (liter)

U.K. 80 40Portugal 10 20

But, in cloth, U.K. Labor is 8 times productive; and in wine, U.K. labor is 2 times

productive.

It is said that Portugal has a comparative advantage in wine and the U.K. has a

comparative advantage in cloth.

In other words, the U.K.’s absolute advantage is greater in cloth, so the U.K. has a

comparative advantage in cloth.

14

The U.K. has an absolute advantage for C&W

The Gains from Trade:

Now look at the domestic prices. (Note that prices are relative in terms of other commodity:

terms of trade domestically)

Domestic Prices in the U.K.: 1 unit of cloth= 1/2 units of wine (1C=1/2W)

Domestic Prices in Portugal: 1 unit of cloth= 2 units of wine (1C=2W)

Domestic Prices are different. The difference in domestic prices is a base for trade.

(Assuming no transportation costs)

For example, say, current world price is as follows:

1 unit of cloth= 1 unit of wine (1C=1W)

Then, how much do the trading nations gain? = world price- domestic cost

The U.K. gains ½ W.

Because 1C (Export) is exchanged for 1W (Import), then 1W- ½ W (domestic cost) = 1/2 W

Portugal gains 1/2 C.

Because 1W (exports) is exchanged for 1C (imports); then 1C-1/2 C (domestic cost) = 1/2C

2.5 Critics of Ricardo’s Comparative Advantages

Of course, although Ricardo’s theory of comparative advantage is a very challenging one with

practical applications, it is not perfect.

It has been criticized in some aspects:

The theory considers only the labor productivity. Whereas, there are other resources

used in production process such as capital, land, etc.

The theory does not explain the difference in labor productivities.

It assumes that labor is domestically mobile, but immobile between countries.

It is a supply theory. Whereas, the demand side should be considered.

15

It depends on constant costs and complete specialization. Whereas, increasing costs

and incomplete specialization are more realistic in the world of today.

It is a static model. It does not consider the changes over time. This criticism is

especially important to developing countries.

It does not take the production processes into consideration in the world of today.

Trade between industrialized countries is mostly of intra-industry character (not only

inter-industry). Intra-industry trade means the trade among similar industries.

2.6 Exception to the Law of Comparative Advantage

There is one exception to the law of comparative advantage but not very common.

This occurs when the absolute disadvantage that one nation has with respect to another nation

is the ‘same’ in both commodities.

For example, let us reorganize Table 2.2 as below:

Table 2.3 Commodities produced with one labor-day

Cloth (meter) Wine (liter)

U.K. 80 40Portugal 10 5

If, with one labor day, Portugal produced 5 units of wine, Portugal could be exactly one-eight

as productive as the U.K. in both cloth and wine.

The U.K. and Portugal would then have a comparative advantage in either commodity, and

no mutually beneficial trade could take place.

This requires slightly modifying the statement of the law of comparative advantage to

read as follows:

16

Even if one nation has an absolute disadvantage with respect to the other nation in the

production of both commodities, there is still a basis for mutually beneficial trade, ‘unless the

absolute disadvantage (that one nation has with respect to the other nation) is in the same

proportion for the two commodities.’

While it is important to note this exception in theory, its occurrence is rare and a matter of

coincidence, so that the applicability of the law of comparative advantage is not much

affected.

Furthermore, natural ‘trade barriers’ such as transportation costs can preclude trade even

when some comparative advantage exists.

2.7 The Opportunity Cost and Comparative Advantages (Gottfried Haberler)

Ricardo based his law of comparative advantage on a number of assumptions:

1. Only two nations and two commodities,2. Free trade,3. Perfect mobility of labor within each nation but immobility between the two nations,4. Constant costs of production,5. No transportation costs,6. No technical change,

7. The labor theory of value. (But this assumption is not ‘valid’ and should not be used for explaining comparative advantage)

According to the Labor Theory of Value, the value or price of a commodity depends

exclusively on the amount of labor going into the production of the commodity.

This implies:

1. that either labor is the only factor of production or labor is used in the ‘same’ fixed

proportion in the production of all commodities.

2. that labor is homogenous (i.e., of only one type)

17

These assumptions can easily be relaxed!

Since neither of these assumptions is true, we cannot base the explanation of comparative

advantage on the labor theory of value.

It was left for Gottfried Haberler in 1936 to explain or base the theory of comparative

advantage on the ‘opportunity cost theory’. In this form, the law of comparative advantage is

sometimes referred to as ‘the law of comparative cost’.

According to the opportunity cost theory, the cost of a commodity is the amount of a

second commodity that must be given up to release ‘just enough resources’ to produce one

additional unit of the first commodity. ‘Just enough resources’, here, imply some cost!

In this case, we can write the costs of commodities in terms of national currencies, and

later convert them into relative commodity prices (Table 2.4)

Table 2.4 Domestic Prices (in terms of national currencies)For 1 unit ofSteel* Wheat*

In Turkey 10 TL 1 TLIn the U.S. 1 $ 1 $*: It requires some resources of

These costs can be stated as relative commodity prices as follows:

In Turkey: 1 unit of steel = 10 units of wheat

In the U.S.: 1 unit of steel =1 unit of wheat

In Turkey, WHEAT is cheap Turkey specializes in WHEAT

In U.S., STEEL is cheap The U.S. specializes in STEEL

In this case they trade and gain from trade!

How do this trade and gains from trade occur? To understand the case, we first should recall

the production possibility frontier.

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Opportunity cost domestically

2.7a the Production Possibility Frontier under Constant Returns

(The following explanation is just that of Salvatore, page 44-48)

Definition: ‘The production possibility frontier’ is a curve that shows the alternative

combinations of the two commodities that a nation can produce by fully utilizing all of its

resources with the best technology available to it.

Table 2.5 Production Possibility Schedules for Wheat and Cloth in The U.S. and U.K.

United States United KingdomWheat Cloth Wheat Cloth180 0 60 0150 20 50 20120 40 40 4090* 60* 30** 60**

60 80 20 8030 100 10 1000 120 0 120*: (90, 60) represents Point A in the figure below.**: (30, 60) represents Point A’ in the figure below.

From figure 2.1 and Table 2.5, we see that the United States should give up 30 units of wheat

if it wants to increase 20 units of cloth (from 180 W to 150 W, from 0 C to 20 C, from 150 W

to 120 W, from 20 C to 40 C, etc.)

For the U.S., note that for every 20 C it requires 30 W to give up for the U.S. In other

words, for each 1 W, it requires 2/3 C to give up.

This means that “the cost of 1 unit of Wheat is 2/3 units of Cloth in the United States.”

On the other hand, for the U.K., note that for every 40 C it requires 20 W to give up.

In the other words, for each 1 W it requires 2 C to give up.

This means that “the cost of 1 unit of wheat is 2 units of cloth in The United Kingdom .” (1 W = 2 C)

This case is called constant opportunity cost, because the cost of 1 W does not

change “no matter from which point on its production possibility frontier the Nation

starts.”

19

Figure 2.1 Production Frontiers under Constant Returns

30 60 90 120 150 180

Wheat Production

U.S.

1W = 2/3C

A

Clo

th P

rodu

ctio

n

120

100

80

60

40

20

0

A’

20 40 60

120

100

80

60

40

20

0

U.K.

1W = 2C

Clo

th

Wheat

Why do constant opportunity costs arise?

They arise when;

(1) resources or factors of production are either

- ‘perfect substitutes for each other’ or

- ‘used in fixed proportion in the production of both

commodities’.

(2) all units of the same factor are homogeneous or of exactly the same

quality.

20

Figure 2.2 Graphical illustrations of the gains from trade under constant returns

In the absence of trade,Production and consumption point is ;

Production 90W = 0W1 Production & ConsumptionAnd of the nation depend on the

consumption 60C = 0C1 people’s tastes ,or demand considerations (The Nation chooses point A)

In the absence of trade,Production and consumption point is ;

Production 40W’ = 0W’1 Production & ConsumptionAnd of the nation depend on the

consumption 60C’1 = 0C’1 people’s tastes ,or demand considerations (The Nation chooses point A’)

If trade possible for 1 W = 1 C internationally

The U.S. might choose point E

( might want to exchange 70 W for 70 C ;

chooses E )

Production ; 180 W = 0B ; 0C

(no cloth production )

Consumption ; 110 W = 0W2 >0W1

(110 – 90 = 20 W )

Export ; 70 W (180 – 110 )

Import = consumption of cloth;

70C = 0C2>0C1 (70-60 =10C)

“With trade, The U.S. gained 20 W and 10 C”.

Similarly, if trade possible for 1W=1C internationally

The U.K. might choose point E`

(might want to exchange 70 W for 70 C );

Then,

Production ; 120 C =0B`; 0W

(no wheat production)

Consumption; 50C=0C2`>0C1` (50-40 = 10C)

Export ; 120-50 =70C

Import = consumption wheat;

70W= 0W2`>0W1

` (70-40=30W)

“With trade The U.K. gained 10C and 30W.”

21

B’

C’2 50C’1 40

120

A’E’

X

0 40 60 70 120 W’1 W’2 Wheat

Cloth U.K.

MA E

B

M

180

120

C2 70 C1 60

0 90 110 180W1 W2 Wheat

Cloth

U.S.

X

EW2B is called ‘foreign trade triangle.’

Vertical axis shows import,

Horizontal axis shows export,

Hypotenuse shows “rate of exchange.” /

‘relative prices’ /

‘terms of trade’

E`C2`B` is the foreign trade triangle of The U.K.

Now, to be noted is that by each nation specializing in the production of the commodity it

has comparative advantage the total production of world increases and also the two nations

end up consuming more than before trade (as shown in Table 2.5).

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Table 2.5 Increases in the World Production and Consumption after TradeWorld Production Before Trade After Trade

U.S U.K Total U.S U.K TotalWheat 90 40 130 180 0 180Cloth 60 40 100 0 120 120

World Consumption Before Trade After TradeU.S U.K Total U.S U.K Total

Wheat 90 40 130 110 70 180Cloth 60 40 100 70 50 120

2.8 Empirical Tests of the Ricardian Model

Various tests were conducted for the validity of Ricardian simple model.

G.D.A. Mac Dougall (in1951, 1952), Bela Balassa (in 1963), R.M. Stern (in 1962), S.S.

Golub (in1995), S.S. Golub and C.T. Hsieh (in 2000) studied the theory empirically.

The Ricardian trade model has to a large extent been empirically verified.

Despite this, it has a serious shortcoming in that it “assumes” rather than “explains”

comparative advantage.

The model explains NEITHER the reason for the differences in labor productivity across

nations NOR the effect of international trade on the earnings of factors.

By providing answers to both of these important questions, The Hecksher-Ohlin model

theoretically improves upon Ricardian Model.

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Chapter Three

THE STANDARD THEORY of INTERNATIONAL TRADE

3.1 Introduction

By ‘The Standard Theory’ we mean the extension of the model with the more realistic

case of ‘increasing opportunity costs.’

We consider ‘tastes or demand preferences’, represented by ‘community

indifference curves’

So, together with production possibility curve (supply force) and community

preferences (demand force), we will drive the equilibrium relative price in each nation

in the absence of trade under increasing costs. (This will also indicate the commodity of

comparative advantage for each nation)

Subsequently, we examine how, with trade, each nation gains by specializing in the

production of the commodity of its comparative advantage.

Also, we’ll see a special case; how mutually beneficial trade is possible even when two

nations are exactly alike except for tastes under increasing costs.

3.2 The Production Frontier with Increasing CostsIt is more realistic for a nation to face increasing rather than constant opportunity costs.

Increasing opportunity costs mean that the nation must give up more and more of one commodity to release just enough resources to produce each additional unit of another commodity.

Increasing opportunity costs result in a production frontier (production possibility curve) that is concave from the origin (Figure 3.1a).

Nation 1 incurs increasing opportunity costs in the production of both commodities.

For each additional unit of X commodity, Nation 1 must give up more and more Y. ( Y1< Y2< Y3 )

This is also valid when each additional unit of Y is increased.

25

X

Y2

Y

Y3

Y1

A

D

B

C

0 1 2 3 4

Figure 3.1 a Nation 1

Nation 2 incurs increasing costs in the production of Y.

For each additional unit of Y commodity, Nation 2 must give up more and more X. ( X1< X2< X3 )

3.2a The Marginal Rate of Transformation (MRT)

The marginal rate of transformation of X for Y refers to the amount of Y that a nation

must give up to produce each additional unit of X.

Thus, MRT is another name for the opportunity cost of X, and is given by the

(absolute) slope of the production frontier at the point of production.

In Figure 3.1a, if the slope of the production frontier (MRT) of Nation 1 at point A is 1/4, this

means that Nation 1 must give up 1/4 of a unit of Y to release just enough resources to

produce one additional unit of X at this point.

Similarly, if the slope, or MRT, equals 1 at point B, this means that Nation 1 must give up one

unit of Y to produce one additional unit of X at this point.

Thus, a movement from point A down to point B along the production frontier of

Nation1 involves an increase in the slope and reflects the increasing opportunity costs

in producing more X.

In contrast, in the case of constant opportunity costs the MRT is constant, as seen in Figure 2.1.

3.2b Reasons for Increasing Opportunity Costs and Different Production Frontiers

How do increasing costs arise?

26

X1

X2

X

Y

X3

5

4

3

2

1

0

Figure 3.1 bNation 2

Why are they more realistic than constant opportunity costs?

Because;1) Resources or factors of production are not homogenous. That is, all units of the

same factor are not identical or of the same equality (no perfect substitution)

2) Resources or factors of production are not used in the same fixed proportion or

intensity in the production of all commodities.

This means that as the nation produces more of a commodity, it must utilize

resources that become progressively ‘less efficient’ or ‘less suited’ for the production of that

commodity.

For instance, suppose some of a nation’s land is flat and suited for growing wheat, and

some is hilly and better suited for grazing and milk production. The nation originally

specialized in wheat but now wants to concentrate on producing milk. By transferring its hilly

areas from wheat growing to grazing, the nation gives up very little wheat and obtains a great

deal of milk. Thus, the opportunity cost of milk in terms of the amount of wheat given up is

initially small. But if this transfer process continues, eventually flat land, which is better

suited for wheat growing, will have to be used for grazing. As a result, the opportunity cost of

milk will rise and the production frontier will be concave from the origin.

Note that the production frontiers of Nation 1 and Nation 2 in figure 3.1 have different

factor endowments and / or use different technologies in production.

In the real world, the production frontiers of different nations will usually differ,

since practically no two nations have identical factor endowments (even if they could

have access to the same technology).

3.2c Community Indifference Curves

So far, we have discussed production, or supply, considerations in a nation.

Now, we introduce the demand considerations (or tastes) in a nation. These are given by community indifference curves (or social indifference curves).

27

Definition: ‘A community indifference curve shows the various combinations of two

commodities that yield equal satisfaction to the community or nation.’

Higher curves refer to greater satisfaction, lower curves refer to less satisfaction.

Community indifference curves are negatively sloped and convex from the origin.

To be useful, they must not cross.

Illustration of Indifference Curves Figure 3.2a Figure 3.2b

Here, tastes (or demand preferences) are different in the two nations.

Points N and A give equal satisfaction to Nation 1, since they are both on the same indifference curve (I).

Points T and H refer to a higher level of satisfaction, since they are on a higher indifference curve (II).

Even though T involves more of Y but less of X than A, satisfaction is greater at T because it is on Indifference Curve II.

Point E refers to still greater satisfaction, since it is on indifference curve III.

Then, N=A<T=H<E; and for Nation 2, A`=R`<H`<E`

The community indifference curves are negatively sloped. It implies that if the nation wants to consume more of X, it must consume less of Y, remaining on the same level of satisfaction.

The Marginal Rate of Substitution (MRS)

28

X

IIIN

T

E

H

A

Nation 1

I

II

0 0

R’

E’H’

A’

X

Y

Nation 2

I’II’

III’

Y

The marginal rate of substitution (MRS) of X for Y in consumption refers to the

amount of Y that a nation could give up for one extra unit of X and still remains on the

same indifference curve.

This is given by the (absolute) slope of the community indifference curve at the point

of consumption and declines as the nation moves down the curve. Because, the

marginal utility of commodity X decreses more and more as the commodity is used

more and more.

Figure 3.2 c

tan A> tan B means that the slope at point N is higher than the slope at point A.

opposite rise(Tangent is measured as ˗˗˗˗˗˗˗˗˗˗˗˗ = ˗˗˗˗˗˗˗˗˗˗ ) adjacent run

(The position of an indifference curve represents for what commodity the society demands more.

The slope represents the degree of substitution.)

Declining MRS means that community indifference curves are convex from the origin.

Thus, while increasing opportunity cost in production is reflected in concave

production frontiers; a declining marginal rate of substitution in consumption is

reflected in convex indifference curves.

This convexity property of indifference curves is necessary to reach a unique

equilibrium consumption point for the nation

3.3 Equilibrium in Isolation with Increasing Costs (In a Closed Economy)

Figure 3.3 a Figure 3.3 b

29

tan Btan A

AN

Y

X

Nation 1 is in equilibrium, or maximizes its welfare, in isolation by producing

and consuming at point A, where its production frontier reaches, or is tangent

to, indifference curve I (the highest possible).

Similarly, Nation 2 is in equilibrium at point A’, where its production frontier

is tangent to indifference curve I’.

The equilibrium relative price of X in Nation 1 is given by the slope of the

common tangent to its production frontier and indifference curve I at point A.

This is PA=1/4 for Nation 1, PA’= 4 for Nation 2

Since the relative price of X is lower in Nation 1 than in Nation 2, Nation 1 has a

comparative advantage in commodity X, and Nation 2 has a comparative advantage

in commodity Y.

3.4 The Basis For and the Gains from Trade with Increasing Costs

Now, suppose that the world (equilibrium) relative price is 1Y=1X

We know that, in Nation 1, 1/4 Y=1X

If Nation 1 can exchange 1X for more than 1/4 Y, it wants to specialize in X production.

30

A

Nation 1

50 130

PA=1/4

X

I

Nation 2PA’=4

I’

Y

X

A’40

80

Nation 1

60

50 130

PA=1/4

X

Y

I

But as long as Nation 1 specialize in X production, the opportunity cost of X will rise.

Nation 1 will specialize in X production up to the point where 1X is exchanged for

1Y. This point is B in figure 3.4 a.

Figure 3.4 a

1) Point A represents the equilibrium in isolation. In this case, Nation 1 consumes the amount of X and Y that it produces (that is, X1 and Y1).

2) With trade, Nation 1 moves from point A to point B in production. By then exchanging 60X for 60Y with Nation 2, Nation 1 ends up consuming at point E (on indifference curve III). It represents a higher welfare level.

(After trade, Nation 1 changed its production and consumption combinations.)

3) The trade triangle is ECB.

4) The key point here is that the specialization is incomplete. Nation 1 still produces the

two goods, but it produces more commodity X (X2) than commodity Y (Y2). It

consumes some X (X3), and sell the amount not used (X3- X2=CB); in return, it buys

commodity Y (Y2-Y3=EC).

Similarly, we can analyze the case of Nation 2, as illustrated in Figure 3.4 b.

Figure 3.4 b Nation 2

1) A’ is the point where production and consumption of Nation 2 are in isolation.

31

(80) Y3

Y1

(20) Y2

0 X1 X3 X2

(70) (130)

AI

E

III

C B

PB=1

YNation 1

C'

A'

I'

X2 X1 X3

(40) (80) (100)

B'

E'III'

PB=1

Y

X

X

2) With trade, production moves from point A’ to point B’.

3) Consumption moves from point A’ to point E’, which represents a higher welfare level.

4) The trade triangle is C’E’B’.

5) B’C’ is the export of Nation 2.

6) C’E’ is the import of Nation 2,

7) The hypotenuse of the trade triangle (B’E’) represents the world relative

commodity price.

8) PB is the ‘equilibrium-relative commodity price with trade’.

9) Also note that specialization is ‘incomplete’.

As the result of these analyses, these two nations want to trade at an equilibrium-relative commodity world price that is higher than domestic relative commodity prices of these two nations.

3.5 The Gains from Exchange and From Specialization

Figure 3.5 A nation’s gains from trade can be broken into two components:

1) The gains from ‘exchange’, and

2) The gains from ‘specialization’.

This breakdown is illustrated in Figure 3.5.

From A to T (Gains from exchange)From A to E (Gains from specialization)

Suppose that, for whatever reason, Nation 1 could not specialize in the production of X with the opening of trade but continued to produce at point A.

- Point A shows both producing and consuming combinations (in isolation)- Pd (=1/4) is the relative domestic price.

Let us assume that Pw (=1) represents the world relative price. Accordingly, Pw

* also represents the world relative price.

32

120

60 Y1

0

PD=1/4

P*W=1PW=1

A

E

U10

FB

T

U7

U5C

X2 X1 X3 X4

Y3

Y2

Y1

Y4

0

Nation 1

Because Pw (=Pw*=1) is higher than PD (=1/4), Nation 1 can produce at PD and

sell at Pw.

That is, Nation 1 can exchange X2X1 (CA) amount of X for Y1Y2 (CT) amount of Y. (Note that preferences do not change, therefore T is the new consuming point)

TCA is the trade triangle in the case of without specialization.

Now, after trade, Nation 1 reduced consumption of X, but increased consumption of Y.

Even though Nation 1 consumes less of X and more of Y at point T in relation to point A, ‘it is better off than it was autarchy because T is on higher indifference curve U7’.

The movement from point A to point T in consumption measures the gains from exchange.

If subsequently Nation 1 also specialized in production of X and produced at Point B (at the prevailing relative world price Pw (=1)), then it could exchange X3X4 amount of X for Y4Y3 amount of Y and ends up in consuming at point E on indifference curve U 10

which represents a higher consumption combination (a higher welfare level).

Production and consumption points in the case of specialization:

B: equilibrium production point.E: equilibrium consumption point.

Nation 1 produces X4 units of X, consumes X3 units of X, (X3>X1)

exports X3X4 amount of X, imports Y4Y3 amount of Y in exchange of X3X4.

Total consumption of Y is OY3, which is the sum of OY4 (its own production) and Y3Y4 (its import).

Recall that EFB is the trade triangle in the case of specialization.The movement from T to E in consumption measures ‘the gains from specialization in production.’

3.6 Trade Based on Differences in Tastes

Figure 3.6

33

Nation 1 and Nation 2 have identical production frontiers (shown by a single curve)

In the analysis before (in

Figure 3.4 a and Figure 3.4

b), we supposed that the ‘difference in pretrade relative commodity prices’

was based on the ‘differences in the production frontiers and indifference

curves’ in two nations.

Whereas, even if two nations have identical production possibility frontiers,

there will still be a basis for mutually beneficial trade if tastes (i.e. demand

preferences) in two nations differ.

The nation with the relatively smaller demand (or preference for a commodity)

will have a lower relative price for that commodity.

The process of specialization in production and trade would then follow, as

described in previous cases (for previous cases see pages 28/ Figure 3.4a and

29/ Figure 3.4b).

In figure 3.6, the two nations have the same production possibility curve (DD).

A is the point where Nation 1 is in equilibrium in autarky.

PA represents the autarky price of Nation 1.

In this case, Nation 1 has a comparative advantage in commodity X.

On the other hand,

A’ is the point where Nation 2 is in equilibrium in autarky.34

B

IMA

IMA’

EXA

EXA’

E’

U’5

U’8

A’

PA’= 4C

C’

B’

PA = 1/4U5U8

A

E

0 X'2 X'1

Y'2

Y'1

X

Y

PW = 1

PA’ represents the autarky price of Nation 2.

In this case, Nation 2 has a comparative advantage in commodity Y.

Note that the two nations have different relative domestic (autarky) prices

because of different tastes (demand preferences) even though they have the

same production possibility frontier.

PW is the world relative commodity price, which is higher than PA (when the

price of X is measured in terms of Y) and higher than PA’ (when the price of

Y is measured in terms of X).

Now, there is a basis for mutually beneficial trade between the two nations at world price PW.

With trade, Nation 1 will move from A to B in production and it will move from A to E for consumption.

Nation 1 will consume more X and more Y than the pretrade case (it will export EXA’ amount of X commodity, and import IMA’ amount of Y commodity).

Also with trade, Nation 2 will move from A’ to B’ in production and it will move from A’ to E’ for consumption.

Nation 2 will consume more Y and more X than the pretrade (it will export EXA amount of Y commodity, import IMA amount of X commodity).

Consequently, mutually beneficial trade became possible though the same production

frontiers, depending on the difference in tastes.

Chapter Four

OFFER CURVES, DEMAND and SUPPLY (Reciprocal Demands), and the TERMS OF TRADE

4.1 Introduction

So far, while analyzing trade between two countries we have assumed a hypothetical relative equilibrium (world) price which is higher than domestic relative commodity prices.

35

Then, the question is that how this equilibrium-relative commodity price (PW) is determined.

We will make use of ‘offer curves’ (sometimes referred to as ‘reciprocal demand curves’).

Offer curves (or reciprocal demand curves) were devised and introduced into international economics by Alfred Marshall and Ysidro Edgeword, two British economists. Offer curves have been used extensively in international economics, especially for pedagogical purposes.

The offer curve of a nation shows how much of its import commodity the nation demands for it to be willing to supply various amounts of its export commodity.

(In other words, how much of its export commodity Nation 1 offers for 1 unit of import commodity of Nation 2).

As the definitions indicate, offer curves incorporate elements of both demand and supply.

Alternatively, we can say that the offer curve of a nation shows the nation’s willingness to import and export at various relative commodity prices.

4.2 Illustration of Offer Curves

Suppose that U.S. and Turkey will trade. U.S. has a comparative advantage in machine

(M), Turkey has a comparative advantage in wheat (W)

In Turkey; 1W=1/2M

In U.S. ; 1W=2M (or 1/2W=1M)

Figure 4.1

Considering Figure 4.1, Turkey would be neutral if the world price was equal to Turkey’s domestic price.

But, if Turkey can exchange 1W for more than 1/2M, it wants to

36

B

A

PUS

PT

Turkey’s relative commodity price (Domestic price )

U.S’s relative commodity price

5

4

3

2

11/2

Mac

hine

0 1 2 3 4 5 6 Wheat

Area for mutually benefical trade

trade.

Similarly, the U.S. would be neutral if the world price was equal to its domestic price.

But if U.S. can Exchange 1M for more than 1/2W, it wants to trade.

Then, the area between lines showing domestic relative prices of Turkey and U.S. takes place for mutually beneficial trade.

Depending on figure 4.2, we derive the offer curve of Turkey.

Figure 4.2

(The offer curve of Turkey bulges toward X axis).

According to figure 4.2, Turkey is neutral to trade up to point A, because point A is on its domestic (relative) price.

But, for example, at point B, which is on the world relative commodity price of B, Turkey wants to exchange 3W for 2M.

That is, Turkey offers (or exports/supplies) 3 units of wheat and demands (or imports) 2 units of machine in return.At point C, which is on the world relative-commodity price of C, Turkey wants to Exchange 4W for 4M

That is, for Turkey to import 2 more units of machine it offers less amount of wheat.

As Turkey consumes more and more units of machine, for one additional unit of machine it offers less amount of wheat (because of diminishing marginal utility law).

37

Machine

0,5 1 1.5 2 3 4 5

4

2

11/2

Wheat

D (10M=5W)

C

B

A

C (10M=10W)

B (10M=15W)

A (10M=20W) (1/2M=1W)

If we joint the points A, B, C, D from the origin, we obtain the offer curve of Turkey.

Following the same method, the U.S.’s offer curve can be derived (This is left for the students).

Let us suppose that the offer curve of U.S. is as follows.

Figure 4.3

The offer curve of U.S. bulges toward Y axis.

The world equilibrium relative commodity price is determined at the point where the offer curves of the two nations intersect.

Figure 4.4

Keep in mind that prices are relative-commodity prices

38

B(10M=15W)

C(10M=10W)

D (10M=5W)

4

3

2

1

0

Machine

1 2 3 4 Wheat

(M) 4

1

0 1 4 (L)

PwTurkey

USE

Wheat

Machine

At price PW, Turkey exports 4 units of wheat (OL)At price PW, Turkey imports 4 units of machine (EL)

At the same price, U.S. exports 4 units of machine (OM=EL)At the same price, U.S. imports 4 units of wheat (EM=OL)

OLE is the Turkey’s trade triangle OME is the U.S.’s trade triangle

How does the equilibrium relative commodity price change?

For various reasons, when the offer curves of the nations shift, the equilibrium price changes.

The variables which cause supply and demand curves to shift cause the offer curves to shift as well.

(Recall that consumer’s income, the price of related goods, tastes, expectations, technology, and input prices cause the forces of demand and supply to shift).

Figure 4.5 Illustration of a change in equilibrium world price)

Let Turkey demands more of U.S. import good.

The offer curve of Turkey shifts to the right.

39

US

T’

P’

P

T

The hypotenuse represents the world price

(Equilibrium relative commodity price)

Machine

Wheat

The world price rises from OP to OP’ (If the United States does not change its demand preference).

The world price changes; it moves toward the relative price of Turkey.

How does the welfare effect of this change take place?

The welfare effect takes place with the comparison of two opposite changes: The first is the change in the terms of trade ( P) The second is the change in trade volume ( TV)

Figure 4.6

4.3 A Special Case: The Importance of Being Unimportant

Let’s take two nations. The first is large (U.S.), and the second is small (Luxembourg).

The U.S.’s offer curve bulges more toward Y axis because its demand for the good (say, butter) of Luxembourg is high.

On the other hand, Luxembourg’s offer curve bulges less toward X axis because its demand for the good (say, engine) of U.S. is small.

Figure 4.7

40

0 L

T

AP’

P

0 L L’ Wheat

Machine

If TV> P , the welfare effect is (+)If TV< P, the welfare effect is (-)

OPL is the trade voşume in the first case.OP’L’ is the trade volume in the second case.

O

L

P

APus

Butter

Engine

Luxembourg’s gains from trade

U.S.’s gains from trade

OPUS = The U.S.’s domestic price OP = World relative price OA = the U.S.’s offer curve OL = Luxembourg’s offer curve

The area between OA and OP represents the U.S.’s gains from trade.

The area between OL and OP represents the Luxembourg’s gains from trade.

Because the world price is very high from Luxembourg’s domestic price, Luxembourg gains more from trade than U.S.

This case is called the importance of being unimportant (Marshall’s contribution to the theory of trade).

Chapter Four

FACTOR ENDOWMENTS and the HECKSCHER-OHLIN THEORY

5.1 Introduction

We have seen in previous chapters that the difference in relative commodity prices between two nations is evidence of their comparative advantage and forms the basis for mutually beneficial trade.

We now go one step further and explain the reason, or cause for the difference in relative commodity prices and comparative advantage between the two nations.

41

According to classical economists (Smith, Ricardo, Mill), comparative advantage was based on the difference in the productivity of labor among nations,

but they provided no explanation for such a difference in productivity.

The Heckscher-Ohlin theory extends the trade theory and examines the basis for comparative advantage.

The H-O theory is based on the following assumptions (see Salvatore, pp.123-124):

1. There are two nations, two commodities, and two factors of production (labor and capital). Considering more than two nations, more than two commodities, and more than two factors will leave the conclusions of the theory basically unchanged.

2. Both nations use the same technology in production.3. Commodity X is labor intensive and commodity Y is capital intensive in both nations.4. Both commodities are produced under constant returns to scale in both nations.5. There is incomplete specialization in production in both countries.6. Tastes are equal in both nations.7. There is perfect competition in both commodities and factor markets in both nations.8. There is perfect factor mobility within each nation but no international factor

mobility.9. There are no transportation costs, tariffs, or other obstructions to the free flow of

international trade.10. All recourses are fully employed in both nations.11. International trade between the two nations is balanced.

The main idea of the H-O is that; “Each nation has comparative advantage in the commodity that it can produce in

accordance with its factor intensity.”

5.2 Illustration of the H-O Theory

According to the Figure 5.1., the U.S. has a comparative advantage in machine

because machine is a capital intensive good and the U.S. has more capital than labor.

So, capital is the cheap factor with respect to labor in the U.S.

Figure 5.1 a Figure 5.1 b

42

On the other hand, Turkey has a comparative advantage in wheat because wheat is a labor

intensive good and Turkey has more labor than capital.

So, labor is the cheap factor with respect to capital in Turkey.

In this case, according to the H-O theory, the U.S. will specialize in the machine

production and export machine but import wheat. On the other hand, Turkey will

specialize in wheat production and export wheat but import capital.

The analysis is very similar as we did for the cases in this chapter. It is left for you!

(Proceed the analysis)

In sum, according to H-O theory, “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.”

5.3 Corollaries of the H-O Theory

Depending on the H-O Theory, various theorems have been developed. We will examine them briefly in the following.

1. The factor-price equalization theorem

43

PW

EXT

IMT

EXUS

IMUS

U10

E

T’

A’

PA

PT

U5

T

A

Machine (Y)

A

T

Before Trade After Trade

0 A T Wheat (X)

Wheat (X)(

Machine (Y)

Paul Samuelson (1976 Nobel Prize in economics) rigorously proved the factor-price

equalization theorem, which is really a corollary since it follows directly from the H-O

theory.

For this reason, it is sometimes referred to as the Hecksher-Ohlin-Samouelson theorem

(H-O-S theorem, for short)

According to the H-O-S theorem, “International trade will bring about equalization in

the relative and absolute returns to homogenous factors across nations.”

What this means is that international trade will cause the wages of

homogenous labor to be same in all trading nations.

Similarly, international trade will cause the return to homogenous capital

(i.e. capital of the same productivity and risk) to be the same in all trading nations.

In this respect, it brings about the same results of international factor mobility.

How this process works?

Turkey has abundant labor; therefore, the price of labor is relatively cheap. With

the opening of trade, as it specializes in wheat production, the demand for labor will

increase.

The price of labor (wage) will tend to rise.

The U.S.A. has abundant capital factor. For this reason, the price of capital (i.e., interest

rate) is relatively cheap.

With the opening of trade, as it specializes in machine production, the demand for

capital will increase in the U.S.

The price of capital (interests) will tend to rise.

As a result of the movements of factors, the wages in Turkey will tend to be equal to

the wages in the U.S. and the interest rates in the U.S. will tend to be equal to the

rates in Turkey.

44

The best example of this theorem is the real hourly wages in manufacturing in leading

Industrial Countries as a percentage of the U.S. wage (see p. 144 of your textbook,

Salvatore, Table 5.6 in the 9th edition).

Depending on H-O-S theorem, it is expected that, with the increasing of factor mobility

and trade in European Union, the wages will rise and the interest rates will fall in the

developing nations who will be integrated with the European Union.

2. Stolper- Samuelson Theorem of Income Distribution

This theorem is the corollary of the H-O-S theorem.

According to this theorem, free trade will raise the real income of the factor that is

abundant in the nation, and reduce the real income of the factor that is scarce in the

nation.

The protectionist policies of the European Union for the agricultural sector can be

explained by this theorem.

3. The Rybczynski Theorem

This theorem postulates that at constant commodity prices, an increase in the

endowment of one factor will increase by a greater proportion the output of the commodity

which is intensive in that factor and will reduce the output of the other commodity.

Figure 5.2

45

The nation experienced economic growth with the increase in the endowment of labor.

The world relative price remained the same.

The output of the commodity (wheat) which is labor-intensive increased by a greater proportion.

The Output of the other good decreased.

5.4 Empirical Tests of the Heckscher-Ohlin Model

The first empirical test of the H-O model was conducted by Wassily Leontief in 1951 using U.S. data for the year 1947.

Since the U.S was the most capital-abundant nation in the world, Leontief expected to find that it exported capital-intensive commodities and imported labor-intensive commodities.

According to the results, the United States seemed to export labor intensive commodities and import capital intensive commodities.

This was the opposite of what the H-O Model predicted and became known as the “Leontief Paradox”.

Hereupon, some explanations were made for this paradox.

Many empirical studies were conducted with data from other countries.

But, the empirical studies give conflicting results.

46

Machine

W1 W2

A

A’M2

Pw=1 Pw=1

M1

Wheat0

In consequent, such an explanation has been made:

The H-O Model is adequate for the explanation of the trade

between the developed and developing nations but not enough to

explain the trade between industrial nations.

New theories have been developed...

5.5 The New Trade Theories

Heckscher and Ohlin based comparative advantage on the difference in factor

endowments (labor & capital) among nations. This theory, however, leaves a great

deal of today’s international trade unexplained. Because trade among 200 nations

and trade of thousands of goods are difficult to explain with one model.

To fill this gap, after 1960s, new international trade theories have been developed.

In fact, some of these new theories try to explain the source of comparative advantage

and the difference between factor endowments.

The new theories are explained briefly in the following.

1. Skilled Labor Hypothesis:

The skilled labor-intensive goods are almost the same as capital-intensive

goods. In general, these two kinds of goods are treated together as “man-

made”.

This revision of H-O Model is called “New-factor Endowment Theory”.

Empirical studies show that the developed nations having skilled labor export

industrial goods and the developing nations having unskilled labor and

abundant land export primary agricultural goods.

2. Technological Gap Model

47

According to this model, a great deal of the trade among industrialized countries is based on the introduction of new products and new production processes.

These give the innovating firm or nation a “temporary” monopoly in the world

market. Protected by laws such as patents and copyrights.

In time, the new technology becomes widespread. The exporting nation

becomes importing one and vice-versa.

The industries of textile, electronic equipment, chemistry, steel and iron and

cement are typical examples.

The model is tested for various countries. According to the empirical results,

there is a high correlation between the net exports of industries and their

research and development investments.

For instance, more than 50 percent of R& D personnel in the world work in the

United States. This fact can be interpreted that the United States has

comparative advantages especially in high-tech products.

3. Product Cycle Model

This model is a generalization and extension of the technological gap model.

The process is from the innovating to imitating nation:

Step 1: Innovation and to meet the domestic consumption.

Step 2: The product matures. The amount of production becomes greater than

the domestic consumption. The nation exports.

Step 3: * Gradually, the technology and the product become standardized. The

innovative firm starts to give licenses to the firms of other nations.

* The production becomes more advantageous in previously importing

countries with the contribution of other factors.

* The production in the innovating nation starts to decrease.

Step 4: * Anyway, the technology and production methods are fully

48

standardized and the legal limitations such as patents and copyrights

are removed.

* The innovating nation is eventually in the position of an importing

nation.

* The product cycle is completed.

And the innovating nation, in the meantime, is up to new products.

In the world of today, the time period of product cycles becomes

considerably shorten. This fact implies that the innovating nations such

as U.S. and Japan have to provide technological improvements to keep

their competitiveness. As a matter fact, they do so!

4) Preference Similarity Hypothesis

This hypothesis, different from others, views the demand side of the

international trade.

Therefore, it is also named “overlapping demands” hypothesis.

According to this model, a nation exports those manufactured products for

which a large domestic market exists.

These are products that appeal to the majority of the population.

In the process of satisfying such a market, the nation acquires the necessary

experience and efficiency to be able subsequently to export these commodities

to other nations with similar tastes and income levels.

On the other hand, the nation will import those products that appeal to its low-

and high-income minorities.

According to this hypothesis, trade in manufactures is likely to be largest

among countries with similar tastes and income levels.

While confirmed for Sweden, this hypothesis has not been confirmed for other

nations. It cannot explain the goods that a nation produces only for exports.

49

For example, why such non-Christian nations as Japan and Korea export

artificial christmas trees and christmas cards in the absence of a domestic

market for these products?

5) Economies of Scale and Monopolistic Competition

These two theories are related to one another.

The factor endowment theory (H-O Model) makes explanations under “constant returns to scale”.

“Constant returns to scale” refers to the production situation where output

grows at the same rate with the increase in inputs or factors of production.

That is, if all inputs are doubled, output is doubled.

On the other hand, “increasing returns to scale” refers to the situation where

output grows proportionately more than the increase in intputs or factors of

production. That is, if all inputs are doubled, output is more than doubled.

Increasing returns to scale may occur because at a larger scale of operation a

greater division of labor and specialization becomes possible.

Therefore, even if two nations are identical in every respect, there is still a

basis for mutually beneficial trade based on economies of scale.

Because of “external” and “internal” economies, nations specialize in

different goods in the same industry. Thus, trade in the same industry becomes

possible. This is called “intra-industry trade”.

In addition, the economies of scale stimulate the “differentiated products”

under the situation of monopolistic competition. The consumers are presented

a wide range of differentiated products of the same good.

The automobile industry is the best example of economies of scale,

differentiated products and intra-industry trade.

The importance of intra-industry trade became apparent when tariffs and other

obstructions to the flow of trade among members of the European Union were

removed in 1958.50

The study made by B. Balassa (in 1967) showed that “The trade volume

increased very speed among member nations of the E.U., but most of this

trade was different goods within the same industries.

5.6 Synthesis of Trade Theories

The overall conclusions that we can reach regarding the empirical relevance of the trade

theories examined thus far are:

(1) Most of the trade between developed and developing countries are “inter-

industry trade” based on differences in factor endowments, as postulated by Heckscher-

Ohlin.

(2) An increasing proportion of the trade among industrialized countries is

“intra-industry trade” based on economies of scale in differentiated products, as

postulated by the new trade theories.

5.7 Transportation Costs and International Trade

So far we have assumed that costs of transportation are zero. We can relax this

assumption.

Costs of transportation affect international trade directly by affecting the price of the

traded commodity in the exporting and importing countries.

Furthermore, costs of transportation affect international trade indirectly by affecting

the international location of production and industry.

Costs of transportation include

Freight charges Warehouse costs Costs of loading and unloading Insurance premiums Interest charges while goods are in transit

In sum, the term transport or logistics costs include all the costs of transferring

goods from one location (country) to another.

51

Logistic costs are affected by the country’s geography, the quality of its

infrastructures, and the management techniques of the firms.

Transport or logistics costs as a percentage of the price of the goods

transported vary very much among countries. These costs are 4.24 percent for

developed countries and more than double for other countries.

The reason for much higher transport costs for developing countries is

higher freight rates, longer waiting time for goods to clear ports, and

higher inventory holding of raw materials by firms.

Higher transport costs in getting goods to market and in terms of importing

necessary inputs represent a significant barrier to international trade for

firms in developing countries.

Transport costs can impede the trade if they outweighs the the difference

between domestic prices of the goods in trading nations. For example, you

do not go to Greece for haircut even if the cost of haircut in Greece is much

cheaper than in Turkey!

On the other hand, in some cases, high transport costs may cause

international trade. For example, the U.S exports lumber to Canada in the

west of the country and imports lumber in the east!

5.8 Environmental Standards and International Trade

Environmental standards also affect the location of industry and international trade.

Environmental standards refer to the levels of air pollution, water pollution, thermal

pollution, and pollution resulting from garbage disposal that a nation allows.

Environmental pollution can lead to serious trade problems because the price of traded

goods and services often does not fully reflect social environmental costs.

A nation with lower environmental standards can in effect use the environment as a

resource endowment or as a factor of production in attracting polluting firms

abroad and achieving a comparative advantage in polluting goods and servises.

52

Chapter Six

ECONOMIC GROWTH AND INTERNATIONAL TRADE

6.1 Introduction

Growth, in technical terms, is the shift out of the nation’s production frontier.

Growth can result from the “increases in production factors” and a “technical

progress”.

The nation’s production frontier shifts depending on the source of growth.

Growth can be balanced (neutral / unbiased) or unbalanced (biased).

* Fig. 6.1 shows a balanced growth.

The nation’s production frontier

shifts out evenly in all directions

at the rate of factor growth.

* This type of growth could result from a

progress in the production technology

(holding the amount of production factors

unchanged).

Fig. 6.2 shows examples of unbalanced

growth.

AB’ can take place either because of an

increase in factors that commodity X uses

intensively, or because of a technical progress

realized in the production of commodity X.

53

B B’

A

A’

Commodity X

Figure 6.1

Com

mod

ity

Y

0

Y

X

B’B

A

A’

Figure 6.2

6.2 Interaction between Growth and Trade

Growth and trade interact each other. The results depend on various factors. These

factors are :

The direction of growth,

The terms of trade,

The tastes (demand preferences).

Example 1 :

In this case,

The nation’s production frontier

shifted out parallel to previous

one (from AB to A’B’). This

means that a balanced growth

occurred.

The tastes (that is, the demand

preferences) did not change (I5 is

parallel to I10).

The terms of trade (world relative commodity price) did not change (PW is parallel to

P’W).

But, the trade triangle of the nation changed. The new trade triangle (C’E’D’) is bigger

than the previous one (CED); the export of X increased (E’D’>ED), and the import of Y

increased (C’E’>CE).

The nation ended up consuming more of X and Y, and reached a higher welfare level

(presented by C’).

54

A

A’

0

E’

C’

P’W

PW

B B’

C

DE

I5

I10

D’

X

Y

Figure 6.3

Example 2: (A Special Case: Immiserizing Growth)

Figure 6.4

Suppose that the nation experienced an unbalanced growth. Growth occurred

in favor of commodity X, say, because of a technical progress in the

production of X.

Tastes (or the demand preferences) did not change.

But the terms of trade fell drastically from PW to P’W, so that the nation

produced at point D’ and consumed at point C’ which shows a lower welfare

level.

(If growth is heavily export biased it might lead to a fall in the terms of trade of the exporting nation. In rare circumstances this fall in the terms of trade may be so large as to outweigh the gains from growth. There is a strong correlation between immiserizing growth and the export of primary goods in developing countries.)

Consequently; even though an economic growth took place, the effect of a

fall in the terms of trade resulted in the nation being worse off than before

the growth. This case was termed ‘immiserising growth’ by Jagdish

Bhagwati (in 1958).

55

I5

I10

Y

PW

P’W

C’

D

D’

C

B’B

A

X

6.3 Comparative Advantages and Economic Development

The comparative advantages of the

nations can change over time. Economic development can significantly affect the

factor endowments of the nations.

Depending on this fact, the trade

patterns change over time. A developing nation can

change the composition of its exports from labor-intensive to capital-intensive goods.

Table 7.2 in your textbook

( Salvatore, p.218 ) shows the changes in capital-labor ratio

of selected countries from 1979 to 1997.

Increases in capital stock per worker

(capital-labor ratio) for a nation show that its comparative advantage increases in

“capital-intensive goods.”

Let’s look at some figures from the table (Table 7.2).

Country % Change in Capital Stock Per Worker (1979-1997 )

Canada 35.3United States 24.4JapanTurkeyKenya

20.620.143.9 (-)

According to these figures, the U.S comparative disadvantage in capital-intensive

commodities increased from 1979 to 1997 with respect to Canada and decreased with respect

to Japan.

Changes in comparative advantages can be illustrated by using the production frontier,

indifference and terms of trade curves ( see figure 6.5 ).56

Figure 6.5

In 1970, the nation has

comparative advantage in X,

labor-intensive commodity.

In 1990, with the

development process, the

factor endowment of the

nation became capital-

intensive.

Let’s suppose that the tastes

and the terms of trade

remained the same.

The production point moved from D to D’, showing that the nation specialized in Y

(capital-intensive good).

The consumption point moved from C to C’, showing that the nation reached a

higher welfare level.

On the other hand, while the nation in 1970 was exporting commodity X ( =ED ) and

importing commodity Y ( =EC ), it started to export commodity Y and import

commodity X in 1990.

57

I5

I20

P’W

PW

x’

x

m’

m

E’

E

C

C’

D

D’

Y1990

1980

1970

1970 1980 1990 X

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