2000 word report (international trade)

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3001IBA Lecture Notes Week 3 2.0 Economies of Scale, Geography & Trade Text: Carbaugh R J (2013), International Economics, 14th Edition Sources of Comparative Advantage

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Learning Objectives

Discuss the Heckscher-Ohlin (H-O) theory of international trade, based on factor endowments

Briefly discuss applications & criticisms of H-O

Explain the Increasing Returns to Scale theory

Discuss the theory of Overlapping Demands

Explain the basis for Intra-industry Trade

Discuss the Product Life Cycle Theory of international trade

Factor Endowments

Factor-endowment theory

Economists Heckscher and Ohlin formulated this theory in the 1920s and 1930s.

Immediate basis for trade: difference between pre-trade relative product prices of trading nations

Prices depend on the production possibilities curves and tastes and preferences (demand conditions) in the trading countries

Production possibilities curves depend on technology and resource endowments

Factor Endowments

Factor-endowment theory

Ultimate determinants of comparative advantage

Technology

Resource endowments

Demand

Assumption: technology and demand are approximately the same between countries

Factor Endowments

Factor-endowment theory

Resource-endowment ratio

Determines comparative advantage

Export the product that uses a large amount of its relatively abundant resource

Import the product which in production uses the relatively scarce resource

H-O Factor Endowments – Example TABLE 3.1 p. 67 of Carbaugh

U.S.: capital/labor (K/L) ratio = 0.5 (100/200)

China: capital/labor (K/L) ratio = 0.02 (20/1,000)

Since the U.S. has relatively more abundant capital (i.e. higher K/L ratio), the U.S. will produce capital-intensive goods, with China producing goods that are more labor-intensive. 6

Factor Endowments

Effect of resource endowments on comparative advantage

Capital stock per worker of selected countries, 1997*

TABLE 3.2

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

U.S. MRT = 0.33, China’s MRT = 4.0 - implication is that U.S. has a lower relative price of aircraft

so U.S. has comparative advantage in aircraft & China has comparative advantage in textiles

The factor-endowment theory

FIGURE 3.1

Factor Endowments

Factor-endowment theory, U.S.-China trade

United States

Relatively abundant: human capital (skills), scientific talent, and engineering talent are relatively abundant

Relatively scarce: unskilled labor is relatively scarce

China

Relatively rich: unskilled labor

Relatively scarce: scientific and engineering talent

Factor Endowments

Factor-endowment theory, U.S.-China trade

United States exports to China

Goods embodying relatively large amounts of skilled labor and technology

Aircraft, software, pharmaceuticals, and high-tech components of electrical machinery and equipment

China exports to the United States

Goods for which a relatively large amount of unskilled labor is used

Apparel, footwear, toys, and the final assembly of electronic machinery and equipment

U.S.-China trade: top ten products, 2007 (thousand of dollars)

TABLE 3.3

Skill as Source of Comparative Advantage

Leontief paradox

Capital/labor ratios, 200 export industries and import-competing industries, 1947

Capital/labor ratio for U.S. export industries

Lower than that of its import-competing industries

Exports - less capital intensive than import-competing goods

Import-competing goods - more capital intensive than U.S. exports

Factor content of U.S. Trade: capital and labor requirements per million dollars of U.S. Exports and import substitutes

TABLE 3.5

Economies of Scale Increasing Returns to Scale

Internal economies of scale

Largely based on Krugman’s work in the 1970s and 1980s

Nations with similar factor endowments

Negligible comparative-advantage differences

May find it beneficial to trade

Because they can take advantage of massive economies of scale

Produce that good in great quantity at low average unit costs

Trade those low-cost goods to other nations

By adding to the size of the domestic market, international trade permits longer production runs by domestic firms, which can lead to greater efficiency and reductions in unit costs.

Economies of scale as a basis for trade

FIGURE 3.5

External Economies of Scale

External economies of scale

The average cost of the typical firm decreases

As the output of the industry within this area increases

Concentration of an industry’s firms in a particular geographic area

Larger pools of a specialized type of worker

New knowledge about production technology spreads among firms in the area

Overlapping Demands as a Basis for Trade

Theory of overlapping demands, Linder, 1960s

Factor-endowment theory - explains trade in primary products and agricultural goods

Not trade in manufactured goods

Force influencing manufactured-good trade

Domestic demand conditions

Firms within a country – manufacture goods for which there is a large domestic market

A nation’s exports - extension of the production for the domestic market

Overlapping Demands as a Basis for Trade

Theory of overlapping demands, Linder, 1960s

Consumer demand - conditioned strongly by income levels

A country’s average or per capita income will yield a particular pattern of demand

Nations with high per capita incomes will demand high-quality manufactured goods (luxuries)

Nations with low per capita incomes will demand lower-quality goods (necessities)

Overlapping Demands as a Basis for Trade

Theory of overlapping demands, Linder, 1960s

Nations with similar per capita incomes

Overlapping demand structures

Consume similar types of manufactured goods

Wealthy (industrial) nations

More likely to trade with other wealthy nations

Poor (developing) nations

More likely to trade with other poor nations

Intra-industry Trade

Intra-industry specialization, trade

Trade models so far have dealt with inter-industry trade and CA

Production of particular products or groups of products within a given industry

The opening up of trade does not generally result in the elimination or wholesale contraction of entire industries within a nation

The range of products produced and sold by each nation changes

Emphasized by advanced industrial nations

Intra-industry Trade

Intra-industry specialization, trade

Involves flows of goods with similar factor requirements

Conducted mostly among industrial countries with similar resource endowments

Firms – in oligopolies (markets with only a few firms)

Trade in homogeneous goods

Transportation costs may be lowered

Seasonal

Trade in differentiated products

Unmet need

Overlapping demand segments in trading nations

Economies of scale

Intra-industry trade examples: selected U.S. exports and imports, 2007 (in millions of dollars)

TABLE 3.6

Technology: The Product Cycle Theory

Technological innovations

Different nations, at different rates of speed

Result in:

New methods of producing existing commodities

Production of new commodities

Commodity improvements

Often transitory

Technology: The Product Cycle Theory

Product life cycle theory

Predictable trade cycle:

Manufactured good is introduced to home market

Domestic industry shows export strength.

Foreign production begins

Domestic industry loses competitive advantage

Import competition begins

International product cycle

U.S. and Japanese radio manufacturers

U.S. and Japanese pocket calculators manufacturers

FIGURE 2.3