Free Trade Passé

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Readings Required 1

Chapter 3 in International Economics 2

Krugman, P.R. (1987) Is free trade passé? The Journal of Economic Perspectives, 1(2), 131-144. Retrieved 3

from 4

http://dipeco.economia.unimib.it/Persone/Gilli/food%20for%20thinking/simple%20general%20readings5

%20on%20economics/Is%20Free%20Trade%20Passe.pdf 6

For Your Success 7

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Factor endowment theory, the main topic of Module 2, focuses on two factor endowments, labor and 9

capital, as the source of comparative advantage and main determinant of trade. Factor endowment 10

theory and several important extensions have been highly influential in the development of trade theory 11

for almost a century. However, issues arise when the factors of production driving trade are seen as 12

fixed and given (leaving no room for smaller and less-developed economies to develop and move to 13

higher-level production) or variable but subject to increasing returns (meaning that advantage can lead 14

to increasing advantage, again with problematic implications for developing nations). These issues have 15

led to challenges to the foundations of trade theory based on comparative advantage. 16

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Explain and critically evaluate factor endowment theory. 18

Critically evaluate the implications of factor endowment theory and its two most influential extensions 19

to the case of trade between countries with different endowments of labor and capital. 20

Critically evaluate theories and arguments that challenge the basic assumptions of trade theory based 21

on comparative advantage. 22

http://www.youtube.com/embed/BmNdu9ABYt4 23

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1. Factor Endowment Theory 25

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The Ricardian model of trade based on comparative advantage is the foundation of classical trade 27

theory, but is of limited application to the complexities and realities of modern trade because it provides 28

no insight into the sources of comparative advantage. 29

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One of the first extensions of Ricardian trade theory, which remains among the most influential, 31

attempts to address this question with reference to each country's endowments of factors of 32

production. Factors of production include land, labor, and capital. The factor endowment theory of 33

comparative advantage in trade—also called the Heckscher-Ohlin theory (HO theory) after the two 34

Swedish economists who developed the model in the 1920s—is based on two factors: labor and capital. 35

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Factor endowment theory models production and trade patterns based on relative endowments of 37

labor and capital in a two-country, two-product model. 38

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In short, factor endowment theory says countries will specialize in and export products that more 40

intensively utilize their abundant factor (labor or capital) and import products that more intensively 41

utilize their less abundant factor. 42

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Here are two graphs that illustrate factor endowment theory for a hypothetical case of trade between a 44

relatively capital-intensive country—the United States—and a relatively labor-intensive country—China. 45

Factor endowment theory graph 46

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A country exports the good whose production is intensive in its relatively abundant factor. It imports the 48

good whose production is intensive in its relatively scarce factor. 49

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Because capital is relatively cheap in the United States and labor relatively cheap in China, the United 51

States has a comparative advantage in the relatively capital-intensive good, aircraft, and China has a 52

comparative advantage in the relatively labor-intensive good, textiles. Accordingly, specialization 53

continues (with the U.S. specializing in and exporting aircraft and China specializing in and exporting 54

textiles) until the United States reaches point B and China reaches point B'. 55

2. Extensions to the Factor Endowment Theory 56

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The factor endowments theory has been extended and applied by economists since Heckscher's and 58

Ohlin's day to capture and explain various aspects of modern-day trade. 59

Factor Price equalization 60

Factor price equalization suggests that free and competitive trade between capital- and labor-intensive 61

countries will result in the convergence of factor prices (the prices of labor and capital) and also 62

convergence of the price of traded goods. This is especially relevant to the case of trade between more- 63

and less-advanced capitalist economies, which tend to be capital- and labor-intensive respectively. 64

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A classic example is trade between the United States and Mexico, for which factor price equalization 66

predicts that in Mexico the price of capital go down and the price of labor go up while in the United 67

States the price of capital goes up and the price of labor goes down. At the same time the cost of traded 68

goods will go down in the U.S. and up in Mexico. 69

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Note that as is generally the case for trade theory based on comparative advantage, overall benefits will 71

accrue to both trading partners. The U.S. will benefit from cheaper goods and increasing return to 72

capital, while Mexican workers will benefit from increasing returns to labor (wages). 73

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The downside and political implications are obvious: factor price equalization should see wages in U.S. 75

import-competing industries go down to the detriment of workers, while in Mexico returns on the 76

investment of capital in industries producing traded goods goes down. 77

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The notion of factor price equalization underlies the argument that free trade with Mexico lowers U.S. 79

wages and harms workers. However, empirical evidence provides only weak support for this claim, 80

suggesting that Mexico trade exerts a statistically significant but minimal effect on U.S. wages. 81

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Two factors explain this: 83

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Higher productivity (output per unit of labor) in the U.S. economy partially compensates for the 85

difference in wages. 86

The large difference in the relative size of the two economies minimizes the impact of low Mexican 87

wages on the wages of American workers. 88

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The Stolper-Samuelson Theorem 90

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The Stomper-Saumelson theorem is an extension of factor endowments theory that states relative 92

changes in the prices of traded goods will affect the relative prices of the factors used to produce them. 93

That is, increased demand for the abundant resource used to produce goods for export makes this 94

resource more scarce, and therefore drives up its price and its income. 95

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Conversely, decreased demand for the less-abundant resource used to produce goods that are imported 97

makes this resource less scarce therefore drives down its price and its income. 98

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Carbaugh explains, "Simply put, the Stomper-Samuelson theorem states that an increase in the price of 100

a product increases the income earned by resources that are used intensively in its production" (p. 76). 101

Conversely, a decrease in the price of a produce reduces the income of the resources that it uses 102

intensively. 103

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Here's an example: an economy exports goods that are relatively capital intensive and produces import-105

competing goods that are relatively labor intensive. As trade opens up and increases, the labor-intensive 106

import-competing sector will shrink and the export sector will increase, increasing the demand for labor 107

relative to capital. This will cause wages to decrease, which implies an increase in the return to capital. 108

As a result, capital owners win and wage earners lose. 109

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If trade is constrained (for example, by the imposition of a tariff that raises the relative price of the 111

import-competing sector’s product) this will cause the labor-intensive import-competing sector to 112

expand at the expense of the export sector and raise the demand for labor relative to capital. This will 113

cause wages to rise, which in turn implies a fall in the return to capital. Furthermore, the wage must rise 114

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by more than the price of imports, which is called the magnification effect. As a result, wage-earners 115

gain and capital owners lose. 116

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The Stolper-Saumelson theorem has been invoked to argue that owners of capital with above-average 118

incomes disproportionately are the winners from free trade while less-skilled, lower-income wage 119

earners are the losers. Empirically, this conclusion remains controversial. 120

3. Challenges to Comparative Advantage 121

Beginning in the late 1970s, the longstanding dominance of comparative advantage as the basis of 122

classical trade theory began to face challenges, in particular with respect to the assumptions of constant 123

returns to scale and perfect competition (or some reasonable approximation thereof). 124

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Fundamental to traditional trade theory has been assumptions that, in the first place, comparative 126

advantage is derived from factor endowments that are in some sense given, and in the second place, 127

that increased investment in productive resources will display constant or diminishing returns (each 128

additional investment earning an equal or smaller return than its predecessor). 129

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However, it did not escape the attention of trade theorists that much trade takes place among countries 131

with similar factor endowments. 132

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The third fundamental assumption of traditional trade theory is that the reality of a capitalist economy 134

approaches, or at least approximates, a state of perfect competition. The latter assumption has been 135

held up even in an economic environment that has obviously come to be dominated by oligopolistic 136

competition. 137

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Innovations in trade theory beginning at the end of the 1970s eroded all three of these assumptions. 139

Increasing Returns to Scale and the Home Market Effect 140

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It became increasingly obvious to economists not only that most manufacturing industries are 142

characterized by some degree of increasing returns which occur as firms gain advantage from size as 143

well as the accumulation of knowledge (Krugman, 2001, p. 343), but that "increasing returns can be an 144

independent cause of international specialization and trade” (Krugman, 1987, p. 132). 145

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146

In a seminal article, Romer (1986) argued that the primary source of growth during the current epoch is 147

derived from knowledge and human capital, which, it can be argued, exhibit increasing returns. 148

Krugman (1987) notes that increasing returns (to scale, or to knowledge as a factor of production) must 149

by necessity lead to imperfect competition (because advantage will lead to even greater advantage), 150

and the possibility that “trade might arise for reasons other than exogenous differences in tastes, 151

technology and factor endowments” (p. 133). 152

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An important implication of increasing returns trade theory is that specialization in goods for export may 154

be enhanced by a large domestic market for traded goods. This is because under increasing returns to 155

scale, the large scale of production to meet the demands of the home market creates an advantage over 156

producers in smaller markets . This is called the home market effect. 157

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Increasing returns raises the following possibilities: 159

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Some countries or firms can gain persistent advantage in trading relations based on their size or 161

accumulation of knowledge, while others—typically less-developed countries and their firms—may be 162

unable to move up the "value chain" to trade in knowledge- or scale-intensive industries. 163

Strategic government policy may be beneficial to overcome such persistent disadvantages. 164

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Intraindustry Trade 166

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The theory of intraindustry trade provides a response to the question of why countries import and 168

export products of the same type and with similar factor endowments when classical trade theory 169

predicts specialization between and among industries. 170

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Intraindustry trade theory suggests that trade within industries may be based on comparative advantage 172

or on increasing returns to scale, so that while countries as a whole will be net exporters of goods in 173

which they enjoy comparative advantage, each country will import some products even in industries in 174

which it is a net exporter, and vice versa, because of intraindustry specialization. 175

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Intraindustry trade has been increasingly prevalent in the age of increasingly large, multinational firms, 177

which raises the issue of increasing returns and the possibility that markets will be insufficiently 178

competitive to reap the full benefits of comparative advantage. 179

Product Life Cycle Theory 180

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A major criticism of factor endowment theory is that sources of comparative advantage are given and 182

unchanging, which does not seem to be the case in the real world. The product life cycle theory 183

represents a response to the static character of factor endowment theory, which is based on 184

endogenously given factors and assumes given and unchanging technology. The theory argues instead 185

that real world production of a product over time leads to technological innovation that is dynamic, 186

occurring at increasing rates of speed over time. Accordingly, manufactured goods go through a 187

predictable trade cycle or progression: 188

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Manufactured good is introduced to home market. 190

Domestic industry shows export strength. 191

Foreign production begins. 192

Domestic industry loses competitive advantage. 193

Import competition begins. 194

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Carbaugh points that one implication of product life cycle theory is that comparative advantage in 196

innovating industries in an economy such as the United States’ may be lost if the country does not 197

continue to innovate at a more rapid rate than competitors. 198

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Product cycle theory has also been influential in supporting various "stages" theories of development. 200

Beginning with Rostow's (1960) Stages of Economic Growth, classical economists have argued an 201

optimistic scenario for liberalizing markets in developing countries by arguing that under free market 202

conditions, developing states will naturally move in stages to progressively higher levels of production. 203

However, for less-developed countries, this notion is undermined by the advantages enjoyed by more 204

advanced countries and their industries based on increasing returns to scale and knowledge 205

(technology). 206