international economics (mid-term part 2)

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Labor Productivity andComparative

Advantage: TheRicardian Modelgi*'S ountries engage in ihternational trade fortwo basic.reasons, each of which# contributes to their gains fromtrade. First, countries trade because they are1&ru,"'differentfromeach other. Nations, like individuals,can benefit from theirdifferences by reaching an arrangement in whicheach does the things it does relativelywell.Second, countries trade to achieve economies of scale in production. That is, ifeach country produces only a limited range ofgoods, it can produce each of thesegoods ata largerscale and hence more efficientlythanifittriedtoproduce everything.ln the real world, patterns of international trade reflectthe interaction ofboth thesemotives. Asa fi rst step toward understanding the causes and effects of trade, however,it is usefulto look at simplified models inwhich only one of these motives is present.

The next three chapters develop tools to help us to understand how differences

between countries give rise to trade between them and why this trade is mutua lly ben-eJicial. The essential concept in this analysis is that of comparative advantage.Although comparative advantage is a simple concept, experience shows that it is a

surprisingly hard concept for many people to understand (or accept). Indeed, PaulSamuelson-the Nobel laureate economist who did much to develoo the models ofinternational trade discussed in Chapters 4 and 5-has described comparative advan-tage as the best example he knows of an economic principle that is undeniablytrue yetnot obvious to intelligentpeople.

In this chapter we begin with a general introduction to the concept of comparativeadvantage, then proceed to develop a specific model of how comparativeadvantagedetermines the pattern of international trade.

LearningGoalsAfterreading this chapter, you willbe able to:

. Explain howthe Ricardian model,the most basic model of international trade, .works and how it illustrates the principle of comparative advantage.

:. Demonstrate gains front trade and refute common fallacies about international :trade.

. Describetheempiricalevidencethatwagesreflectproductivityandthattrade ipatterns reflect relative productivity

cHAPTER 3 Labor Productivityand Comparative Advantage: The RicardianModel

The Concept of Comparative AdvantageOn Valentine's Day, 1996, which happened to fall less than a week before the crucial Feb-ruary 20 primary in NewHampshire, Republican presidqntialcandidate Patrick Buchananstopped at a nursery to buy a dozen roses for his wife. He tookthe occasion to make aspeech denouncing the growingimports of flowersinto the UnitedStates, whichhe claimedwere puttingAmerican flower growers out of business. And it is indeed true that a growingshare of the market for winter roses in the UnitedStates is being supplied by importsflownin fromSouth America. Butis that a bad thing?

The case of winter roses offers an excellent example of the reasons why international

trade can bebeneficial. Considerfirst howhard it is to supply American sweethearts with

fresh roses in February. The flowersmust be grown in heated greenhouses, at great expensein tems of energy, capital investment,and other scarce resources. Those resources couldhave been used to produce other goods. Inevitabiy,there is a trade-off. In order to producewinter roses, the U.S. economy must produce less of other things, such as computers.Economists use the term opportunity cost to describe such trade-offs: The opportunitycostof roses in terms of computers is the number of computers that could have been producedwiththe resources used to produce a given number of roses.

Suppose, for example, that the United States currentlygrows 10 millionroses for sale onValentine's Day and that the resources used to grow those roses could have produced100,000 computers instead. Then the opportunity cost of those 10 millionroses is 100,000computers. (Conversely, if the computers were produced instead, the opportunity cost ofttrose 100,000 computers would be l0 millionroses.)

Those 10 millionValentine's Day roses could instead have been grown in South Amer-ica. It seems extremelylikelythat the oppoftunitycost of tlose roses in tetms of computerswould be less than it would be in the United States. For one thing, it is a lot easier to grow

February roses in the Southern Hemisphere, where it is summet in February rather thanwinter. Furthermore,South Afirerican workersare less efficientthan their U.S.counterpadsat making sophisticatedgoods such as computers, whichmeans that a given amount ofresources used in computer production yields fewer computers in South America than in theUnited States. So the trade-offin South America mightbe something like 10 millionwinterroses for only30,000 computers.

This differencein opportunitycosts offers the possibility of a mutually beneficialrearrangement of worldproduction. Let the United States stbp growing winter roses anddevote the resources this frees up to producing computers; meanwhile, let South Americagrow those roses instead, shifting the necessary resources out of its computerindustry. Theresulting changes in production would looklike Table 3-1.

Look whathas happened: The world isproducing just as many roses as before, but it isnow producing möre computers. So this rearrangement of production,withthe UnitedStates concentrating on computers and South Americaconcentrating on roses, increases thesize of the world's economic pie. Because the worldas a whole is producingmore, it is pos-sible in principle to raise everyong's standard of living.

TABTE3-1 Hypothetical Changes in Production

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36 PART oNE Internätional Tlade Theorv

The Losses fromNontradeOur discussion of the gains from trade was consid-ered a "thought experiment" in whichwe compared

two situations: one in whichcountries Jo not trade

at all, another inwhich they havefree trade. It's ahypotheticalcase that helpsus to under-stand the prjn-

ciples of interna-tional economics,

but it does not havemuch to do with actual

events. Afterall, countrjes don't suddenly go from notrade to free trade or vice versa. Or do they?

As economic historian Douglas Irwin*has pointedout, in the early history of the United States the coun-try actually did carry out something veryclose to thethought experiment of moving from free hade to notrade. The historical cont ext was as follows:At thetime Britainand France were engaged in a massivemilitarystruggle, the Napoleonic Wars. Both coun-tries endeavored to bring economicpressures to bear:France tried to keep European countries from tradingwith Britain, while Britainimposed a blockade onFrance. Ttre young United States was neutral in theconflict butsuffered considerably. In particular, theBritish navyoften seized U.S. merchant ships and, onoccasion, forciblyrecruited their crews into its service.

In an effort topressure Britaininto ceasing thesepractices, President Thomas Jefferson declared acomplete bm on overseas shipping.This embargowoulddeprive both the UnitedStates and Britainofthe gains from trade, but Jefferson hoped that Britainwouldbe hurt more and would agree to stop itsdepredations.

Irwinpresents evidence suggesting that theembargo was quite effective: Althoughsome smug-gling took place, trade between the United States andthe rest of the world was drastically reduced. Ineffect, the UnitedStates gave up international tradefor a while.

The costs were substantial. Although quite a lot ofguesswork is involved, Irwinsuggests that realincome in *re United States rnay have fallen by about8 percent as a result of the embaryo. When you bearin mind that in the early l9th century only a fractionof output could be traded-transpod costs were stilltoo high, for example, to allow large-scale shipmentsof commodities like wheat across the Atlantic-that's a pretty substantial sum.

Unfortunatelyfor Jefferson's plan, Britaindidnot seem to feel equal pain and showed no inclina-tion to give in to U.S. demands. Fourteen monthsafter the embargo was imposed, it was repealed.Britain continued its practices of seizing Americancargoes and sailors; three years later the two coun-tnes went to war.

trHAprERB Labor Productivityand Comparative Advantage; The Ricardian Model 37

the business section of any Sunday newspaper or weeklynews magazine and you willprobably findat least one article that makes foolishstatements about intemational trade.Three misconceptions inparticular have proved highly persistent, and our simple modelofcomparativeadvantage can be used to see why they are incorrect.

Productivityand CompetitivenessMythl: Free trcLde is beneficialonly ifyour country is strong enougll to stand up to foreignconxpetitiotl,.This argument seems extremely plausible to many people. For example, awell-known historian recentlycriticized the case for free trade by asserting that it may failto hold in reality:"Whatif there is nothing you can produce more cheaply or efficientlythan anywhere else, except by constantly cuttinglabor costs?" he worried.2

The problem with this commentator's viewis that he failed tounderstand the essentialpoint of Ricaldo's model, that gains from trade depend on comparative rather than absoluteadvantage. He is concerned that your country may tum out not to have anything it producesmore efficientlythan anyone else-that is, that you may not have an absolute advantage inanything. Yetwhy is that such a terrible thing?In our simple numericalexample of trade,Home has lower unit laborrequirements and hence higher productivityin both the cheeseand wine sectors. Yet, as we saw both countries gain from trade.

It is always ternpting to suppose that the abilityto export a good depends on yourcountry having an absolute advantage in productivity.But an absolute productivityadvan-tage over other countries in producing a good is neither a necessa.ry nor a sufficient con-dition for havinga comparative advantage in that good. In our one-factormodel the reasonabsolute productivityadvantage in an industry is neither necessary nor sufficient toyieldcompetitiveadvantage is clear: The competitive advantage of an industry depends notonly on its prodactivityreldtiveto the foreign industry, but also on the domestic wage raterelative to the foreign wagd,rate. A country's wage rate, in turn, depends on relative pro-ductivityin its other industries, In our numerical example,Foreign is less efficient thanHome in the manufacture of wine, butat even a greater relative productivitydisadvantagein cheese. Because of its overal.l lower productivity, Foreign must pay lower wages thanHome, sufficientlylower that it ends up with lower costs in wine production.Similarly, inthe real world,Portugal has low productivityin producing, say, clothingas comparedwith theUnited States, but because Portugal's productivitydisadvantage is even greater inother industries, it pays low enough wages to have a comparative advantage in clothing allthe same.

But isn't a competitive advantage based on lowwages somehow unfair? Manypeoplethinkso; their beliefs are summarized by our second misconception.

The Pauper Labor ArgumentMyth 2:Foreign contpetition is unJairand hu.rts otlxer countries when it is based on lowwtges.'Ihis argument, sometimes*efered to as the pauper labor argument, is a particu-lar favoriteof laborunions seeking protection from foreigncompetition.People who adhereto this belief argue that industries should not have to cope withforeign industriesthat areless efficient but pay lower wages. This view is widesplead and has acquired considerablepoliticalinfluence. In 1993 Ross Perot, a self-made billionaireand formerpresidentialcandidate, warned that free trade between the United States and Mexico,with its muchlower wages, wouldlead to a "giantsucking sound" as U.S. industry moved south. ln the

*Douglas lrwin,"The Welfare Cost of Autarky:Evidence from the Jeffersonian Trade Embargo,1807-1809," National Bureauof Economic Research Working Paper no. 8692,Dec.200I.

comparative advantage and the nature of the gains from free trade. These misconceptionsappear so frequentlyin publicdebate about international economic policy, and even instatements by those who regard themselves as expe*s, that in the next section we take timeout to discuss some of the most common misunderstandings about comparative advantagein lightof our model.

MisconceptionsAboutComparative AdvantageThere is no shortage of muddled ideas in economics. Politicians, business leaders, andeven economists frequentlymake statements that do not stand up to careful economicanalysis. For some reason this seems to be especially true in internationaleconomics. Open -Paul Kennedy, "The Thrcat ofModernizatiottl'New Perspectives Quailerb, (Winter1995), pp. 3l-33


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38 PART ErNE International TradeTheorV

Do Wages Reflect Productivity?In the numericalexample that we use to puncturecommon misconceptions about comparative advan-tage, we assume that the relativewage of the twocountries reflects their relative prcductivity-specifically, thatthe ratio of Home to Foreignwages is in a range that gives each country a costadvantage in one of the two goods. This is a neces-sary implicationof our theoretical model. But manypeople are unconvinced by that model. In particular,rapid increases in productivityin "emerging"economies iikeChina have worried some Westemobservers, who argue that these countries willcon-tinue to pay lowwages even as their productivityincreases-putting high-wage countries ata costdisadvantage-and dismiss the contrary predictionsof orthodox economists as unrealistic theoreticalspeculation. Leavingaside the logic ofthis posi-tion. what is the evidence?

The answer is that in the real world,nationalwage rates do, in fact, reflect differences in produc-tivity.The figurebelow compares estimates of pro-ductivity withestimates of wage rates for a selec-tion of countries in 2000.

Bothmeasures

areexpressed as percentages of U.S. levels- Our esti-mate of productivityis GDP per worker measuredin U.S. dollars;as we'llsee in the second half ofthis book, that basis should indicate productivityinthe production of traded goods. Wage rates aremeasured by wages in manufacturing, where avail-able; data for China and India are wage rates paidby none other than McDonald's, an often usefuldata source.

trH.a,PTER 3 Labor Productivityand Comparative Advantage: The Ricardian Model 39

If wages were exactly proportional to productivi-ty, all the points in this chart would lie along theindicated 45-degree line. In reality, the fit isn'r bad.In particular, low wage rates in China and Indiarefl ect low productivity.

The low estimate of overall Chinese productivitymay seem surprising, given all the stories one hearsaboutAmericans who find themselves competing withChinese exports. The Chinese workers producingthose exports don't seem to have extremely lowpro-ductivity.But remember what the theory of compara-tive advantage says: Countries export the goods inwhich they have relativelyhigh productivity.So it'sonly to be expected that China's overall relative pro-ductivity isfar below the level in its export industries.

The hgure on the next page tells us that the ortho-dox economists'view that national wage rates reflectnational productivityis, in fact, verifedby the data ata point in time. It's also true that in the past, risingrelative productivityhas led to rising wages. Con-sider, for exarnple, the case of South Korea. In 2000,South Korea's labor productivitywas about 35 per-cent

ofthe

U.S. level, and its wage rate was about 38percent of the U.S. level. But it wasn't always thatway: In the not too distantpast, South Korea was alow-productivity, low-wage economy. As recently asI 975, South Korean wages were only5 percent thoseof the United States. But when South Korean pro-ductivityrose, so did its wage rate.

In short, the evidence strongly supports the view,based on economic rnodels, that productivity increas-es are reflected in wage increases.

Productivityand WagesA country's wage rate is roughlyproportional t0 the country's pro-ductivity.

Soürce.' International Labor 0rganization,World Bank, Bureau of Labor Statistjcs, snd0rleyAshenfElter and Stepan Juraida,"Cross-country Comparisons of WaqeBates," workingpaper, Princeton [Jniversity.

Hourly wage, aspercentage of U.S,'t20 .Japan

Germany.

. France

China . Mexico

100Produclivity, aspercentage of

This is fine forHome, but what about Foreign? Isn't there something wrong with basingone's exports on low wages? Certainly it is not an attractive position to be in, but the ideathat trade is good only ifyou receive high wages is our finalfallacy.

ExploitationMyth3: Trade exploits a country and mnkes it worse off if its workers receive much lowerwages than workers in othernations.Thisatgument is often expressed in emotional terms.For example, one columnistcontrasted the $2 millionincome of the chief executive offrcerof the clothing chain The Gap with the $0.56 per hour paid to the Central Americanwork-ers who produce some of its merchandise.3 It can seem hard-hearted to try tojustify the ter-

rifyingly lowwages paid to man of the world'sworkers.Ifone is asking about the desirabilityof free trade, however, the point is not toaskwhether low-wageworkers deserve to be paid more but to ask whether they and their country

3Bob Herbert, "sweatshop Beneficiuics: How to GetRich on 56 Cents o Hour," /VryYorkTiws (luly24,1995),p. AI3.

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same year Sir Jarnes Goldsrnith,another self-made billionairewho was an influentialmernber of the European Parliarnent, offered similar if less picturesquely expressed views inhis book The Trap, which becarne a best seller in France.

Again,our simple example reveals the fa'llacy of this argument. In the example, Home ismore productive than Foreign in both industries, and Foreign's lowercost of wine produc-tion is entirely due to its much lower wage rate. Foreign's lower wage rate is, however,irreleyant to the question of whetler Home gains from trade. Whether the lowercost ofwine produced in Foreignis due to high productivityor low wages does not matter. Allthatmatters to Home is that it is cheaper lr? terms of its own labor for Home to produce cheeseand trade it for wine than to produce wine for itself.


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46 PART oNE International Tiade Theory trHAPTER3 Labor Productivityand Comparative Advantage: The Ricardian Model 47

to 24 percent higher than American productivity.sIt is not hard to believe that this dispari_ty explainedmuch of Japan's abilityto export millionsof automobiles to the united Sätes.

In the case of automobiles, one might argue that the pattern of trade simply reflectedabsolute advantage: Japan had the highest productivityand was also the world's largestexporter. The principle of contparative advantage may be illustratedby the case of wirldtrade in clothing. By any measure, advanced countries like the unied States have higherlabor productivityin the manufacture of clothing than newly industrializingcountries likeMexico or china. But because the technologyofclothingmanufacture is relativelysimple,the productivityadvantage of advanced nations in the clothingindustry is less ttran theiradvantage in many other industries. For example,)n 1992 the average

u.S. manufacturingworker was probably about five times as productiveas the average Mexican worker;but iithe clothingindustry the productivityadvantage was onlyabout 50 percent. The result isthat clothing is a major export from low-wageto high-wagenatlons.

In sum, whilef'ew economists believe that the Ricardian model is a fullyadequate descrip-tion of the causes and consequences of worldtrade, its two principalimpiications-ttratpro-ductivitydifferences play an importantrole in international trade and that it is comparativerather than absolute advantage that matters---do seem to be supported bv the evidence.

: Figure 3-6Productivityatrd ExPorts

A comparative study showed that U.S.exports were high relative to Britishexports in industries in which theUnited States had high relative laborproductivity.Each dot represents a dif-ierent industrv.

Ratio ofU.S./Britishproductivity

line, also shown in the figure. Bearing in rnind that the data used for this comparison are, likeall economic data, subject to substantial measurement errors, the frt is remarkably close.

As expected, the evidence in Figure3-6 conhrms the basic insight that trade depends oncomparith,e,not absolute advantage. At the time to whichthe data refer, U.S. industry had

muÄhigher labor productivitythan Britishindustry-onaverage about twice as high. Thecommonlyheld misconception that a country can be competitiveonly if it can match othercountriesi productivity, which we discussed earlier in this chapter, would have led one topredict a U.S. export advantage acloss the board. The Ricardian model tells us, however,ihat having high productivityin an industry compared withforeigners is not enough toensure thai a countrywillexport that industry's products; the relative productivitymust behigh compared with relativeproductivityin other sectors. As it happens, U S' productivityexceeded Britishin all26 sectors (indicated by dots) shown in Figure 3-6, by marginsranging from I 1 to 366 percent. In 12 of the sectors, however, Britainactually had largerexports than the united States. A glance at the figuleshows that, in general, u.S. exportswere larger than U.K. exports only inindustries where the U.S. productivityadvantage wassomewhat more than two to one.

More recent evidence on the Ricardian model has been less clear-cut. In part, this is becausethe growtlof wollcltrade and tl-re resulting specialization of nalional economies means that wedo not get a chance to see what counfties do badly In the world economy of the 1990s'countries often do not produce goods for which they are at a compalativedisadvantage, sothere is no way to measure their productivityin those sectors. For example, most countries donot produce airplanes, so there are no data on what their unit labor requirements wouldbe ifthey dicl. Nonetheless, there are several pieces of evidence suggesting that differences in laborpr.oductivity conrinue to play an important role in detemrining worldtrade patterns.

Perhaps the most important point is that there continue to be both large differcnces inlabor productivitybetween countries and considerable variation in those productivitydif-ferencis across industries. For example, one study found that the average productivityoflabor in Japanese manufacturing in 1990 was 20 percent lower than labor productivity intheunited States. But in the automobileand auto parts industries Japanese productivitywas 16

The Ricardian Model is a criticalconcept for this course.

SUMMARY

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1. we examined the Ricardian model, the simplest model that shows how differencesbetween countries give rise to trade and gains from trade. In this model labor is rhe onlyfactor of production and countries differonly in the productivityof labor in differentindustries.

2. In the Ricardianmodel, co{fntrieswillexport goodsthat their laborproduces relativelyefficientlyand import goods that their labor produces relativelyinefficiently.In other

words, a country's productionpattern is determined by contparative advantage.3. That trade benefits a countrycan be shown in either of two ways. First, we can think of

tl'ade as an indirectmethod of production.Instead of pr.oducing a good for itself, a coun-try can produce another good and trade it for the desired good. The simple modelshows that whenever a good is imported it must be true that this indirect "production"

;--McKinseyClobaf lnstitute, Mantfactur.in|productivi4,, (Washington,D.C., I993_)


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48 PART ENE Int€rnationalTlade Theory

KEYTERMSabsolute advantage, p. 29

comparative advmtage, P. 26derived demand, p.42gains ftom trade, P. 33general equilibriumanalysis, p. 29nontraded goods, p. 44opportunity cost, p. 25partial equilibriumanalysis, p. 29

PROBLEMS

paupei labor argumenl. P. 31production possibilityfrontier,p. 26relative demand curve, P. 30relative supply curve, P. 30relative wage, p. 35Ricardian model, P.26unit labor requirement, P. 26

requires less labor than direct production. Second, we can show that trade enlarges a

country's consumption possibilities, implyinggains from trade'4. The distributionof th" gains from trade depends on the rclativeprices of the goods

countries produce. To determine these relative prices it is necessary to lookat therelative wirldsupply and demand for goods. The Ielative price implies a relative wagerate as well.

5.Thepropositionthattradeisbeneficia]isunqualified.Thatis'thereisnorequirementtt ut a "orntry

be "competitive"or that the tlade be "fair."In particular,we can show thatthree commonly held beliefs about tlade ale wrong. First, a country gains from ffadeeven if it has lowerproductivitythan its hading parhef in all industries. Second, trade

is beneficialeven if foreign industries are competitive only because of lowwages.Third, trade is beneficialeven if a counffy's exports embody more labor than its imports.6.Extendingtheone-factor,two.goodmodeltoaworldofmanycommoditiesdoesnot

alter these conclusions. The only difference is that it becomes necessary to focus direct-

ly on the relative demand for labor to determine relalive wages rather than to workviarelativedemand for goods. Also, a rnany-commoditymodel can be used to illustrate the

important point that kansportation costs can give rise to a situation in which somenontaded goods exist.

7. Whilesome of the predictions of the Ricardian model are clearly unrealistic, its basicprediction-thatcountlieswilltendtoexportgoodsinwhichtheyhaverelativelyhighproductivity-has been confirmedby a number of studies'

cH,a,PTER 3 Labor Productivityand Comparative Advantage: The RicardianModel

c. Describe the pattern of trade.d. Show rhat borh Home and Foreign gain from hade.

4' Suppose that instead of 1,200 workers, Home had 2,400. Find the equilibriumrelativeprice. What can you say about the efficiencyof worldproduction and the divisionof thegains fron fl'ade between Home and Foreign in this case?

5. Suppose that Home has 2,400 workers, but they are only halfas productive in bothindustries as we have been assuming. Construct the world relative supply curve anddetermine the equilibriumrelative price. Howdo the gains from trade compare withthose in the case described in problem4?

6. "Chinese workers eam only $.50 an hour; if we allowChina to export as much as itlikes, our workers willbe forced downto the same level. You can't importa $10 shirtwithout importingthe $.50 wage that goes with it."Discuss.

7. Japanese labor productivityis roughly the same as that of the UnitedStates in the man-ufacturingsector (higher in some industries, lower in others), while the UnitedStates isstillconsiderablymore productive in the service sector. But most services are nontrad-ed. Some analysts have argued that this poses a problem for the United States, becauseour comparative advantage lies in things we cannot sell on worldmarkets. What iswrong withthis argument?

8. Anyone who has visited Japan knows it is an incrediblyexpensive place; although Japan-ese workers eam about the same as their U.S. counterparts, the purchasing power of theirincomes is about onethird less. Extend your discussion from queslion 7 to explain thisobservation. (Hint:Think about wages and the impliedprices of nontraded goods.)

9. Howdoes the fact that many goods are nontraded affect the extent of possible gainsfrom trade?

10. We have focused on the case of trade involvingonly two countdes. Suppose that therea(e many countries capable of producingtwo goods, and that each countryhas only onefactor of production,labor What could we say about the pattern of productionand tradein this case? (Hint:Try constructingthe world relativesupply curve.)

FURTHERREADINGDonald Davis. "IntraindustryTrade: A Heckscher-Ohlin-Ricardo Approach." Journal of Intemation-

al Economics 39 (November1995), pp. 201J.?6. A recent revival ofthe Rica'dian approach toexplain tradebetween countdes withsimilarresources.

Rudiger Dornbusch, Stmley Fischer, and Paul Samuelson. "ComprativeAdvmtage, Trade md Pay-ments in a Ricardian Modelwith a Continuum of Goods." American Economic Review67(December 1977), pp.823-839. More recent theoretical modelingin the Ricardim mode, devel-oping the idea of simplifyingthe many-good Ricardianmodel by assuming that the number ofgoods is so large as to form a smooth continuum.

GiovanniDosi, Keith Pavitt, and Luc Soete. The EcortornicsofTechnical Change and IntemationalTrade. Brtghton: Wheatsheaf, 1988. An empirical exanination that suggests that internationaltrade in manufactured goods is lmgely drivenby di{ferences in national technological compe-tences.

G. D. A. MacDougall."Britishand American Exports: A Study Suggested by the Theory of Compar-ative Costs:' Ecortomic Journal 6l (December 1951), pp. 697--724,62 (September 1952), pp.487-521 . ln this famous study, MacDougallused comparative data on U.S. and U.K. productivi-ty to test the predictions of the Ricardian nodel.

John Stualt Mill.Prfuciples of Political Economy.I-nndon: Longmans, Green, 1917. Mill's1848 rrea-tise extended Ricardo's work intoa full-fledgedmodel of intemational trade.

DavidRicardo. ThePrinciplesof Poli.ticalEconomyand.Tmtion. Homewood, IL:Irwin,1963.Thebasic source for the Ricrdian model is Ricardo himself inthis book. firstpublished in 181 7.

1. Home has 1,200 units of laboravailable. It can produce two goods, apples and bananas'The unit labor requirement in apple production is 3, whilein banana production it is 2.a. Graph Home's production possibilityfrontier.b. What is the opportunity cost of apples in terms of bananas?c. In the absence of trade, what would the price of apples in telms of bananas be? why?

2. Horne is as described in problem 1. There is now also another countfy, Fofeign, witha

labor force of 800. Foreign's unit iabor requirement in apple ploduction is 5, whileinbanana production it is la. Graph Foreign's productionpossibilityfrontier.b. Construct the worldrelativesupply curve.

3. Nowsuppose world relative demand takes the followingform: Demand for apples/demandfor bananas = price ofbananas/price of apples.a, Graph the relative demand curve along with the relative supply curve'b. What is the equilibriumrelativeprice of apples?

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62 FART ENE International Ttade Theory trHAPTER4 Resources, Comparative Advantage, and Income Distribution o-1

, Figure 4-12' The Budget Constraint lof a, Trading Economy

Point 1 representsthe economy'sproduction. The economy's con-sumption must lie along a linethat passes through point 1 andhas a slope equal to minus therelativeprice of cloth-

Consumption ofcloth, D.Output öl cloth, Oc

production possibility frontier at the point that represents the economy's choice of produc-tion given the relativeprice ofcloth,shown in the figure as point 1. That is, the economycan always affordto consume what it produces.

We can now use the budget constraints of Home and Foreign to construct a picture of thetrading equilibrium.In Figure 4-13, we show the outputs, budget constraints, and con-sumptionchoices of Home and Foreign at equilibriumprices. In Home, the rise in the rel-ative price of cloth leads to a rise in the consumptionof food relativeto cloth and a fall inthe relative output of food. Home produces 0l of food but consumes Df;it thereforebecomes a cloth expofterand a food importer. In Foreign,the posttrade fall inthe relativeprice of cloth leads to a rise in the consumption of cloth relative to food and a fall in the rel-ative output of cloth; Foreigntherefore becomes a cloth importer and a food exporter. InequilibriumHome's expofts of cloth must exactly equal Foreign's imports and Home'sirnportsof food exactlyequal Foreign's exports. The qualities are shown by the equalityofthe two coloredtriangles in Figure 4-13.

To sum up what we have learned about the paftern of trade: Home has a higher ratiooflabor to land than Foreign; that is, Home is abundant in labor and Foreign is abundant inland. Cloth productionuses a higher ratio oflabor to land in its production than food; thatis, cloth is labor-intensiveand food is land-intensive.Home, the labor-abundant country,exports cloth, the labor-intensive good;Foreign, the land-abundzult country, expor.ts food,the land-intensivegood. The general statement of tle result is: Countries tend to exportgoods whose production is i.ntenslve in

factorswith tvhich thqt are abundantly endowed.

Trade and the Distributionof IncomeTrade produces a convergence ol relative prices. Changes in relative prices, in turn, havestrong effects on the r€lative eamings of laborand land. A rise in the price of clothraises thepurchasing power of labor in terms of both goods while loweringthe purchasing power ofland in terms of both goods. A rise in the price of foodhas the reverse effect. Thus interna-tional trade has a powerful effect on income distribution. InHome, where the relative price

Figure 4'1 1Trade Leads to a Gonvergence ofRelative Ptices

ln the absence of trade, Home's equi-libriumwouldbe at point l,wheredomestic relativesupplY8S intersectsthe relativedemand curve ß0. Similar-ly, Foreign's equilibrium wouldbe atpoint 3. Trade leads to a world relativeprice that lies bet\ /een the pretrade

prices, e.9., at point 2.

Relativepriceol cloih,Pc/PF

Consumptionof food,OFOutput of food, QF

Relative quantityO^+ A:

differ fromthe mix produced. while the amounts of each good that a country consumes andproduces may differ, however, a countrycannot spend more than it earns:The value of con-sumptionmust be equal to the value of production.That is'

Pcx Dc+ PFX DF: PcXQc+ PFxQF'(4'5)

Equation (4-5) can be reananged to yield the following:

Dr - Qr: erlPr) x (Qc - Dc). (4-6)Dr - Qr is the economy's food imports,lhe amount by which its consumption of food"*"""4rlt. pfoduction.The right-hand

side of the equation is the product of the relativeprice of cloth and the amount by which productionof cloth exceeds consumption, that is,-the

economy's erportJ of cloth. The €quation, then, stat€s that impoftsof food equal exportsof cloth tirnes the relative price of cloth. whileit does not tell us how much the economywillimportor export, the equation does show that the arnount the economy can afford toimport is limited,or constrained, by the amount it eKports. Equation (4-6) is thereforeknownrs a budget conslraint'l

Figure 4-12 illustrates two important features of the budget constraint for a tradingecon;my. First, the slope of the budget consttaint is minus PrlPp, the relative price of

cloth. The reason is that consuming oneless unit of clothsaves the economy P6; this is

enough to purchase P6lPo extra units of food. Second, the budget consüaint is tangent to the

SThe constraint that tbe value of consumption equals that of production (or, equivalently, that importsequalexports in value) may not hold when countries can borow frcm other countries or lend to them. For now weassume that these possibilities re not available and that the budget constraint (eqüation (4-6)) therefore holds.lnternationalbonowing md lending ile examined in Chapter 7, which shows that an economy's consumptionovelrize is stillconstrained by the nrcessity ofpaying its debts to foreign lende$'

-Et'-?ffT*.f-1'_-=":


12/19

64 PART trNE International Ttade Theory

l- Quantityoffooduantity olfood

nH nH Quantityofctoln

Home'scloth

exports(a) Home

OL D;

Foreign'scloth

imports(b) Foreign

Figure 4-13Trading Equilibrium

Home,simportsofloodareexact|yequaltoForeigntexports,andForeign'simportso{clothareexact|yequa|toHome'sexp0ns.

of cloth rises, people who get their income from labor gain fromtrade but those who derive

their income from land are rnade worse off In Foreign' where the relativeprice of clotlfalls'

the opposite happens: Laborers are made worse off and landowners aremade better off'

Theresourceofwhichurounoyhasarelativelylargesupply(laborinHome'landinForeign) is the abundant läctot in ihut "oontr.y'

and t}re resource of whichit has a relatively

small supply (land in Home, labor in Foreignj is the scarce.factor'The general conclusion

about tlre income distribution"ff"a'of ioäationaltrade is: Owners of a country's abun-

Zt"tj)ti.ltt"nfromtrade, but ou)ners oJ a country's sca,rc: factors lose: .' --,^-^r--#" rlff.ä" ,hortty that the trade pattern of the United States suggests that compared

with the rest of th" totta th" Unittd Siates is abundantly endowed with highly skilledlabor

and that low-skilledfuUo. i' "o*pondinglyscarce' ihi't"un' that international trade

tencls to make low-skilledworkers in the United States worse off-notjust temporarily'but

on a sustained basis. The negative effect of trade on low-skilledworkersposes a perslstent

ät,i";l;-bl"t. Industries äut ut" low-skilledlabor intensively'süchas apparel and

shoes, consistently demand protectionf'om foreign competition' andtheir demands attract

considerablesympathybecauselow-skilledworkersarerelativelybadlyofftobeginwith,

Factor-Price EqualizationIn the absence of trade' labor would earn less in Home than in Foreign'

and land would earn

more. without truo., tuto.*unäuntHome would have a lower relative price ofcloth than

land-abundant Foreign, and the difference in relative prices ofgoodsimplies an even larger

difference in the relative prices of lactors '

cHAPTER4 Resources, Comparative Advantage, and Income Distribution 65

. WhenHomeandForeignT.g.,ft:relativepricesofgoodsconverge.Thisconvergence,in turn, causes convergence of the relative prices of lani and rabor. ihus th"." ; ;l-ö;tendency toward equalization of factor prices. How far does this tendency go?The surprising answer is that in the moder the tendency goes aa the way. Intemationaltrade leads to comprete equalization of factor prices. Although Home has u hgr,", ,u,io orlabor to land than Foreign, once they trade witheach other the wage rate and the rent onland are the samein both countries. To see this, refer back to Figure 4-6, which shows thatgiven the prices of croth and food we can determine the wage rate and the rental rate with_out reference to the supplies of land and labor. IfHome ani Foreign face the same rerativeprices ofcloth and food, they willalso have the same factor prices.

. To understand how this equalizationoccurs, we have to rcalize that when Home and For-eign trade with each other more is happening than a simpre exchange of goods. In an indi-rect way the two countdes are in effect trading factors of producti.n.H-ome lets Foreignhave the use of some of its abundant labor, not by seiling the rabor directly but by tradiiggoods produced with a high ratio of labor to rand ior goÄ produced with a lowlaborlandratro. The goods that Home sells require more labor to produce than the goods it receives inreturn; rhat is, more labor is embodied in Home's expärts than in its imports. Thus Homeexports its labor, embodied in its labor-intensive exports. conversery,'Foreign's exportsernbody more land than its imports, thus Foreign is indirecttyexporting its rand. whenviewed this way, it is not surprising that h.ade r;ads to equarizationof the two countries,ractor Dflces.Although this viewof trade i*simpre ancl appearing, there is a major probrem: In the real

worldfactor prices are not equarized. Ror eiample,lhere is an extremely wide range ofwage rates across countries (Tabre 4-l).while some ofthese differences may reflecldif_t-erences in the quality of laboq they are too wide to be exprained away on this basis alo'e.. To understand why the model


13/19

66 PART BNE International Tlade Theory

1. To derive the wage and rental rates from the prices of cloth and food in Figure4-

6, we assumed that the country produced both goods' This need not' however'be the

case. A country witha very hiih ratio of labor to land might produce only cloth' whilea counfy witha very higtr ratä of tand to labor might produce only food This implies

thatfactor-priceequalizationocculsonlyifthecountriesinvolvedaresuff,rcientlysim-ilarintheirrelativetäctorendowments.(Amorethoroughdiscussionofthispointisglt""it Ä""pp"ndixto this chapter')

Thus' factor prices need not be equalized between

Soun*i",withradicallydiffe"nttatios of capital to labor or of skilled to unskilledlabor'

i. fn"propositionthat trade equalizes iactor prices willnot hold ifcountries havedifferent technologies of production' For example' a country with superior

technology

might have both a higher wage rate md a highei rental rate than a country with an infe-rioitechnology.As describeJ later in this chapter' recent work suggests that it

is essen-

tial to allow-torsuch differences in technology to reconcile the factor-proportlonsmodel withactual data on world trade'

3. Finally,the proposition of complete factor-priceequalization depends on t:T-pr"t""onu".g.o""

of Ä"p'it"'of gooäs' In the leal world' prices of goods are not fullyäqoalirea Uiint"rnationa-ltrade Tiis lack of convergence is due to both natural barriers

(such as transportation "ost')and barriers to trade such as tariffs' impofiquotas' and

other restrictions.

Trade and Income Distributionin the Shoil BunIn lookingat the politicsof trade policy, it's irnportant to realize that we've been using

a

model in which the earnings of iu"toitof productiondon't depend on which-industry

".fioy,,t.., Workers earnthe same wage ii cloth and food production'andland receives

tne saÄe rent in both industries ln the real world'the same factor of productionmay tem-

forarilyearn quite differentamounts in differentindustries'because it takes time for factors

io roou" betw.en industries. Only in the long run' after there is time to move resourcesbetween industries, willearnings be equalized again'

International "cono-rst,reflr. to factors of production that are "stuck" in an industry, at

t"u.fi".por-ity,as specifrc factors' Because many factors are specitic in the short-run' thedistinction between the short run ancl the long run is very impoftant in practice'

Suppose

that trade willlead to a fall in the relative pricJ of cloth. In our long-run model this isgood

for landowners and bad lbr workersButin the short run owners of land that is cunently

usedinclothproducüonmaysuffer,whileworkerswhoarecurrentlyproducingfoodmayg"t".etJ*"ft short-tun gains and losses often seem to determine politicalpositions indebates over trade PolicY.

North-SouthTrade and lncome InequalityThedistributionofwagesintheUnitedStateshasbecomeconsiderab|ymoreunequal

iF,if,'ffifi il#ä;T;iTäää,'":".llffin:fiti;ätl;:;il:fiT,;i;T,'"fsh"r*::uitl"3:**r:l"x:;lJ:.HJil:iffi#,T::

ffiCascS|_crdl

cHAFTeR 4 Resources, Comparative Advantage, and Income Distribution 67

withcollege degrees eamed anJrourly_wage onry 21 percent higher than that ofmen withonly a high school education. By 2002 the coltege piemium had widened to ++ p"r""ni.why has wage inequalityincreased? Many-oüs"rv"rsattribute trre ctungä to *r"rowth of world trade and in particular to the growing expofts of manufu.toräOeo;,rom newly induskializingeconomies (NIEs), Juch ur"Souh K;;äi;;.;f;ä.1970s trade between advanced industrialnations and less_;";;ü;;;;;;i;rä;ä;referred to as'.North-South,' trade because most advanced nati;;;ä;ä;ä:perate zone of the NorthernHemisphere-consisted overwhelmingrv

"r,, "*r;;g"'"rorthern manufactures for Southern raw materials and agn

and coffee. From 1970 onward, however, former *.' -"r;:t1f;"Si."1';r"r"i::;lP"gun j: sell manufactured goods to high_wagecountri;fk";"ü;;il;r;";:learned in Chapter 2, developing countries have dramaticallychanged ,'r"il;;;f;;;they export, moving away from their traditional reliance on agriculturar and mineralproducts to a focus on manufacfured goods. whiteMEr atso p.oiiaeJa il;;ffi;arker for erports from rhe high-wagenations, rhe expods ofthe n.*ry;naurtiuiirineconomies obviousry differed greatly in factor inteasity fromtheir impo.t.ä""riwhelrningly,NIE exports to advanced nations consisted of ilcarivelyuisophisti"ui.aproiu.r, whose producrio" ,, ,nr.n.,"3ilt;;ffilfli;:tifi:advanced-country exports to the NIEs consisted of capir'_ ". rf.iif_.i""ri;;;.ä;as chemicals and aircraft.

To many observers the conclrrsion seemed sfaightforward: What was happening wasa move toward factor-price equalization. Trade between advanced cou"t i", tt ut *"iurn-dant in capital and skilland MEs with their abundant supply of unskilled rabor was rais-ing the wages of highlyskilledworkers and loweringthe;6;f l"*;ktil'il;#;the skill-and capitar-abundant countries, jurt ur t*äro.-piop*io;il;;;ä;"1"This is an argument withmuch moie than pu."fyuJuaä;i.ö;;;ä:il;"regards the growing inequality of income in uauun""inution,

", , ;;i;;;;il.,;;many people do, and if one arso believes that growing worrd trade i, ,h" #;;;; ;;hat problem, it becomes difficultto maintain-thetraätionai ,rpd;;;;;;äfree trade. (As we point out below, in principletux., and goffset the effect ort ua" ooin"o."distriburion,but o""-", *:::äT,"ä:1,?fi",ffi;ilhappen in practice.) Some influentialcommentarors h^"";g"ätü ;;;;#ä;,willhave ro res'.ict rhei. ..ade with low-wagecountries tf th;t;;l; 'äffi#öiddle-cIass sociedes.

whilesome economists believe that growing trade with low-wagecountries has beenü" T31 cause of growing inequality of income in the United Stares, however. mosrempiricalworkers believed at rhe time of wriringthar international ;r;" i."r;";;;i;;;a contributing facror to that growth, and that th-e -uin .uur", ri*-"rr"*t;;;lä;'rk"*ticism rcsts on three main observations..,Fi1t' tf facror-proporlions moder says thar internationai trade aflects the income ais-urDulronvra a crrange in relative goods prices. So

ilinterrational

trade was the rnain

6Antong the impoilantentdes in the discussion of the impact of trade on income distributioDhave been Robef{Lauence and Matthew Slaughrer,.,Trade md U.S. Wagei: Ciant Suckingsounoor Snall Hicctp?,,BtookingsY::::1:1:.:","Activiry*1: t.gs3; Jerftty Sachs and"Howard sr,*r,':i?uo."no r"bs in U.s. Manufacrurins,,,7::.:::: .:.r: :::,i:,^:cono,tnic activirl,l: r 994; and Adrian wo od, North_southrm.te, Emptolment,and rncomeInequaIth'uxtor(l: cldendon'I994 Forasurveyoftbisdebateandrelatedissues.seeRobertLawrence,.tirgleW)id,Dh'kletlNations: Globulitnioncnttl OECDLrhor Markerr., paris: OECD, t995.


14/19

6a PART c]NE Intemational TladeTheory trHApTER4 Resources, Comparative Advantage, and Income Distdbution 69

drivingforce behind growing income inequality, there ought to O" "T*:,ll*:"::l:rise iitheprice of skillintensive products compared with^those ol unsKlleo-laDor-ini"n.iu"gooOr. Studies of internatiäd price Oata'however' failedto findclear'evidenceof such a change in relativeprices.

Second, the model predicts that relative factor prices 'l":ldt:t"-:lC-":ii::9:i":1skiliedworkers are risingand those of unskilled workers-fallingin the-skill-abundantcountry the reverse should be happening in the labor-abuld:o'"o:ntt{l:t-Ytt :lincomä distribution in developing countries that have opened themselves to trade have

shown that in at least in some cases the reverse was true' In Mexico'in parücular' care-

ful studies have shown that the tansformationofthe country's trade inthe late l9S s-

Mexico opened itself to imports and became a major exporter of manufactured goods:was accompanied by rising *tÄ r"t sr


15/19

PART t]NE International T?ade Theory cHAP-rER4. Resources, Comparative Advantage, and Income Distrilrution ?l

The fundamental reason why trade potentially benefits a country is that it expands theecononty's choices. This expansion of choice means that it is always possible to ledistributeincome in such a way that everyone gains from trade''

That everyone coildgainfrom trade unfortunatelydoes not mean that everyone actual-ly does. In the real wodd, the presence of losers as well as winners from trade is one of themost important reasons why tl ade is not fiee.

0ptimalTradePolicYSuppose a government wants to maximize the welfare of its population' If everyone were

exactlythe same in tastes and in income there wouldbe a straightforward solution: The

government wouldchoose policies thatmake the representative individualas well off aspossible. In thishomogeneous economy, free international trade wouldclearlyserve thegoverurnent's objective

When people are not exactly alike, however, the government's problem is less welldefined. The government must somehow weigh one person's gain against another person's

loss. If, for example, the Home govemment is relatively more concerned about hurtinglandowners than about helping workers, then international trade, which in our analysisbenefited labor and hurt landowners in Home, might be a bad thing from the Home gov-ernment's point of view.

There aie many reasons why one grcup might matter more than another, but one of themost cornpell:ingreasons is that some groups need special reatment because they arealready r.elatively poor. There is widespread sympathy in the united states for lestrictionsoni-portofgarmentsandshoes,eventhoughtherestrictionsraiseconsumerprices'becauie workeis in these industr.ies are already poorlypaid. The gains 1hat affluent con-sumers would realize if more imports were allowed do not matter as much to the U'S'

public as the losses low-paidshoe andgarment

workerswould sutfer'

Does this mean that hade should be allowed only if it doesn't hurt lower-incomepeople?Few internationaleconomists would agree. In spite of the real importance of income distri-bution, most economists remain stronglyin favorof morc or less free trade There are threemain reasons why econornists do nol generally stress the income distributioneffects of trade:

1. Income distributioneffects are not specific to internationaltrade. Every change ina nation's economy, including technological progless, shiftingconsumer prefetences,exhaustion of old resources and discoveryof new ones, and so on, affects income dis-tribution. Ifevery change in the economy were allowedonly aftel it had been examinedfor its distributionaleffects, economic plogress could easily end up snarled in red tape.

2. It is always better to allow tlade and compensate those who are hurt by it than toprohibit the tr.ade. (This applies to other fonns of economic change as well.)Allmodernindust|ial countries providesome sort of "safety net" of income support programs(such as unemployment benefits ancl subsidized retrainingand relocation programs) thatcan cushion the losses of groups huft by trade. Economists would argue tl-rat if this cush-

ion is felt to be inadequate, more suppolt rather than less trade is the rightanswer.3. Those wl]o ständ to lose from increased trade are typicallybetter organized thanthose who stand to gain. This irnbalance creates a bias in the politicalplocess that

TThe argument that trade is beneficial because it enlarges an economy's choices is much more genefal than thispictufe. Fora thorough discussion, see Paul sanruelson, "The cains flomIntemationalTrade Once Again,"Econonic Journcl '12 ( 1 962)' pp 820-829

requres a counterweight.It is the traditionalrole of economists to strongly support freetrade, pointing to the overallgains; those who are hun usuallyhave littletioubie makingtheir complaints heard.

Most economists, then, while acknowledging the effects of internationaltrade on incomedistribution,believe that it is more imponant to stress the potentialgains fiomtrade than thepossible losses to some groups in a country. Economisti do not, -however, often have thedeciding voice in economic policy, especially when conflictingint"r"r,,are at stake. Anyrealistic understanding of how trade policyis determined musi look at the actual motiva-tions of policy.

Income Distributionand Trade politicsIt is easy to see why groups that lose from trade lobby their governmenrs ro restnct tradeand protect their incomes. You might expect that those who guin f.o- tr.ade would lobby asstrongly as those who lose fromit, but this is rarely the caie. In the United States and inmost countdes, those who want trade limitedare more effectivepoliticallythan those whowant it extended. Typically,those who gain from rrade in any particular product are amuch less concentrated, infbrmed, and organized group than those who lose.A good example ofthis contrast between the two sldes is the u.S. sugar industry. TheUnitedStates has limitedimports of sugar for many years; at the time of writingthe price ofsugar in the U.S. market was about twice its price in the worldmarket. Most estimates putthe cost of U.S. consumers of this import lirnitationat about $2 billiona year-that is, about$8 a year for every man, woman, and child.The gains to producers are much smalrer,probably less than half as large.

Ifproducers and consumers were equally able to get their interests represented, thispolicywould never have been enacted. In absolute ter;s, however, each consumer sul.ersvery little.Eight dollals a year is not much; furthermore, most of the cost is hidden, becausemost sugar is consumed as an ingredient in other foods rather than purchased directly.Thus most consumers are unawale that the imporrquota even exists, let alone that it reducestheir standard of tiving. Even if they were a\&are, $g i, oot a large enough sum to provokepeople into organizing protests and writingletters to their cong.lssionai."p."sentatives.

The sugar producers'situation is quite different.The averag sugar producer gains thou-sands of doilars. a year finm the import quota. Furthermore,*g- .oäu""., ar.e organizedinto trade associations and cooperatives that activelypursue their members'politicalinrer-ests' So the complaints of sugar producers about the effects of imports are loudtyandeffectivelyexpressed.

As we willsee in Chapters 8 through 11, the politics of import restdction in the suga.industry are an extren]e example of a kind ofpoliticalprocess that is common jn interna-tional trade- That world trade in general becanre steaclily fleer fron 1945 to l9g0 clepend-ed, as rve willsee in Chapter 9, on a special set of circumstances tltat controlled what isprobablyan inherent politicalbiafagainst internatronal trade.

EmpiricalEvidence on theHeckscher-OhlinModel

Since the factor-proportions theory of trade is one of the most influentialideas in intema-tional economics, it has been the subject of extensive ernpiricaltesting.


16/19

72 PART trNE Internationäl Tlade Theory

Income Distributionand the Beginnings of Trade Theory

trHAPTER4 Resources, Comparative Advantage, and Income Distribution

The modem theory of intemational trade began withthe demonstration by David Ricardo, writingin l8l7'that trade is mutuallybeneficialto countries' We stud-

ied Ricardo's nrodel in ChaPter3. Ricudo used his model to

argue for free trade, inparticularfor an end to

the tarifttthat restrict-';*S, ed England-s imPortsof food. Yet almostsurely the Britisheconorny of 1817 wasbetter described bY amodel withseveralfactors of productlonthan by the one-factotmodel Ricardo Pre-

sented.To understand the sit-

uation, recall that from thebeginning of the French Revo-

lution in 1789 until the defeat of Napoleon at Water-loo in 1815, Britainwas almost continuously at war

with France. This war inter{eredwithBt'itain's trade:Privateers tpirates licensed by foreigngovernments)raided shipping and the French attempted to imposea blockade on Britishgoods. Since Britainwas anexporter of manufacturesand an importer of agricul-

tural products, this limitationof trade raised the rela-tive price of food in Britain.Workers' wages and theprofits of manufäcturers sufiered, but landownersactually prospered duling the Iong war.

Afterthe war, food prices in Britainfell. To avoidthe consequences, the politicallyinfluential landown-ers were able to get legislation,the so-called ComLaws, tbat imposed fees to discourage impofiationofgain. lt was against tllese Corn l-aws that Ricardowas arguing.

Ricarclo knerv that repeal of the Corn Laws wouldmake capitalists better off but landowners worse off'Fron his point of view this was all to the good; aLondon businessman hirnself, he preferred hard-work-ing capitalists to idle landed aristocrats. But he choseto prtsent his argument in the form of a model thatassumed away issues of internal income distribution'

Whydid he clo this? Almostsurely the answer ispolitical: WhileRicardo was in realityto some extentrepresenting the interest of a single group, he empha-sized the gains to lhe nation as a whole. This was aclever and Lhoroughlymodern strategy. one that pio-neered the use of economic theory as a political

instrument. Then as now, politicsand intellectualprogress arc not incompatible: The Corn Laws wererepealed more than a century and a half ago, yetRicudo's model of trade remains one of the greatinsiehts in econolnics.

I Capitalpermilliondollars $2,132,000 $1,876000 lI Labor (person-years) permilliondollars lD 131 lj Capital-laborratio(dollarsperworker) $17,916 $14,321|, Average years ofeducarion per worker g.g l0.l

, Pro-portion ofengineers rnd scientists in workforce 0.0lgg 0.0255I :ou:cq-l9rrtBaldwin,"Determinants of the commoditystructure of u.s. 'rrade:. American Economic

t,

I Review 6l (MuchI97t),pp. 126_145.

Table 4-2 illuskates the Leontiefparadox as wellas other information about u.S. tradepatterns. We compare the factors ofproductionused to produce $i millionworth of 1962u.S. exports with those used to produce the same varue-of r962u.s. imports.As the firsttwo lines in the table shou Leontief'sparadox was stillpresent in that year: U.S. exportswere produced witha rower ratio of capital to labor than u.S. imports. As the rest of thetable shows, however, other comparisons of imports and exports are more in tine withwhat one might expect. The U.S. exported products that were more skiiledlabor-intensivethan its imports as measured by average years of education. we also tended to export prod-ucts that were "technology-intensive,"requiring more scientists and engineers pe. unlt orsales. These observations are consistent with the positionof the united sä", u, u t ign_.hucountry, witha comparative advantage in sophisticated products.

why, then, do we observe tbe Leontief paradox? No one is quite sure. A prausible expra-nation, however, might be the following:The united States has a special aduantug" in pro-ducing new products or goods made with innovative technologies such as aircraftandsophisticated computer chips. Such products may wellbe /ess capitar-intensivethan prod-ucts whose technology has had tiure to mature and become suitable for mass productiontechniques. Thus the united States may be exporting goods that heavily use skiued laborand innovative entrepreneurship, while^imporlingheavy manufactures (such as automo-biles) that use large amounts of capital.eTests on Global ßara Economists have arso attempted to test the Heckscher-ohlin modelusing data for a rarge number of countries. An impoitant study by Harry p Bowen, EdwardE. Leamer, and Leo Sveikauskasr. was based on the idea, äescribed-earlier, trruit uainggoods is actually an indirect way of trading factors of production. Thus if we were to caiculate the factors of production embodied in a country's expofis and imports, we shouldfind that a country is a net exporter of the factor.s of pr:oduction with which it is relativelyabundantly endowed, a net importer of those with which it is relativeryp.or1y endowed.

Table 4-3 shows one of the key tests of Bowen et ar. For a sarnple of 27 countries and1 2 factors of production, the authörs carculated the ratio of each country,s e'crowment ofeach factor to the world supply. They then compared these rahos wrtheach countrv,s

- Later studies poirrtto trre disappeara'ce of th€ Leontiefpamdox by the early 1970s, For example, see Robefi M.SternandKeithE.Maskus,..DeterminantsofthestructuieofU.s.-no.eigniiaoe, l95g l6l,JoumaloJhtenu,tionalEconomics lr (Mayr98l),pp.207124. Thesestudiessho*,io*"ver,thecontinuingimportanceofhuman capiLalin explainingU.S. exports.l0see Bowen'Leamer, and Sveikauskas, "Multicountry,MultifäctorTests ol the Factor Abundauce Tbeory,',American Econonic Revietv jj (December l9g7), pp. 791_g09.

Tesling the Heckscher-0hlin ModelTests on ll,s, Bafa Untilrecently, and to some extent even now, the united States has beena special case among countries. The united states was untila few years ago much wealth-ier-than other countries, and U.S. workers visiblywor-ked with more capital per person than

their counterpafts in otber countries. Even now, although some Western European countnes

and Japan have caught up, the United States continues to be high oü the scale of countries

as ranked by capitallabol ratios.one would expect, tlren, that the united states wouldbe arl expoltel of capital-intensive

goods and an importerof labor-intensive goods. sulprising'ly,however, this was not the case;n rhe 25 years after World War ll. In a famous study published in 1953, eco.omist Wassi-lv Leontief(winner of the Nobel Prize in 1973) forrncl that u.S. expolts were less capital-intensive than U.S. imports.8Thisresult is known as the Leo'tiefparadox. It is the singlebiggest piece of evidence against tlle factor-prcportionstheory'

s S"" L.*,ief,*D-estic Productionard Foreign Trade: The American CaPital Position Re-Examined"'Ptoceedings ofthe Anterican PhilosopltitalSociet)'91 (1953)' pp 33l-349'


17/19

PART oNE International Tlade TheorycH.APTER 4 Resources, Comparative Advantage, and Income Distribution

lrnslr+-rTestinstheHecksch"er'0-hlinMld-9"-.."." - I*rt9iel.rrd"t e--,-,--- -Eegst'lY"q9":"".--- -iI Capital :-.: ii Labor 0'67 ii Professional workers 0 79 i

Managerial workers 0 22 jClerical workers 0'59 I

I Sares workers i;.{, Ii

Service workersX::

i

i Asriculturalworkers 0'63 I070 |, Production worKers : :: Ij Arable land 0'70 |i Pu.n". r"na 05? II :-"'-:---- o.7o jlFot"rt..-_ -----"-l*F.actionofcountiesforwhichnetexportsoffactorrunsinpredicteddirution'I

^:l

Sor."", H*yP. Bowen, Edwdd E Leamer' and Leo Sveikauskas' "Multicountry'Y:ldj.*ttiI Tests of the Factor Abundance TheoryI' American Economic Review17 (December 1987)'

ppl

I ier+oo. - "---- - I| '_--*.-. ...-,....

intensive products such as chemicals and machinery, while chinese exports stillconsist toa large degree of simpler, labor-intensive products such as clothing. one wourd thereforeexpect that the predictions of the Heckscher-ohlin model might look considerably betterwhen applied to North-southtrade thal they do for overalr international ,.oa". Äa ,rri,turns out to be true in most studies.llThese findings do not, however, contradict theobservation that overall the Heckscher-ohlinmodel does not seem to work very well,because Nofth-south trade in manufactures accounts for onry about l0 percent;ftotaiworld trade.

The case of the Missing Trade In an influentialpaper, Danielrreflerr2poinred out a pre-viouslyoverlooked empirical problem with the Heckscher-ohlin model. He noted that ifone thinks about trade in goods as an indirectway of trading factors ofproduction, this pre_dicts not only the dircctionbut the volume of that trade. Faitor trade in general turns ou-t 1obe much smaller than the Heckscher-Ohlinmodel predicts.

A large part of the reason for this disparity comes from a false prediction of large-scaretrade in labor between rich and poor nations. consider the united States, on one side, andChina on the other. The united states has abour 25 percent of worrdincome uut only auoui5 percent of the world'sworkers; so a simpre factor-proportionsstory wourd suggest thatu.S' imports of labor embodied in trade should be huge, something like four timeillargeas the nation's own labor force. In fact, calculations of the factor content of u.s. trade showonly small net imports of labor. conversely, China has less than 3 percent of worldincomebut approximately I 5 percent of the world'sworkers;it therefore i.should', export most ofits labor via trade-but it does nor.

Many trade economists now believe that this puzzre can be resolved only by droppingthe Heckscher-ohlin assumption that technologies are the same across countries. The waythis resolutionworks is roughly as follows:If workers in the united states are much morefficient tlran those in China, then the "effective"labor supply in the united states is muchlarger compared with that of China than the raw data suggest-and hence the expectedvolume of trade between labor-abundant China and labor-scarce America is correipond-inglyless. As we pointed out earlier, technological differences across countnes arc also onelikelyexplanation for the dramatic failureof factor-price equalization to hold, as docu-mented in Table 4-1.

Ifone makes the workingassumption that technologicaldifferences between countriestake a simple multiplicativeform-thatis, that a given set of inputsproduces only ö timesas much inchina as it does in the united states, where 6 is some number less than l-it ispossible to use data on factor trade to estimate the relativeefficiency of productionin dif-ferent countries. Table 4-5 shows Trefler's estimates for a sample of countries; they suggestthat technological differences are in fact very large.

But in any case, once we conclude that technology varies across countries, why should weassume that it is the same across all industries? why not suppose instead that differentcoun-tries have specific arcas of expertise: the Britishare good at .software, the Italians at furniture,the Americans at action movies, and so on? In that case the patten

ofinternationaltrade mightbe determined as much by these dilrering technological capacities as by factor endowments.

" a- ^rt"^"*'*iveHrckscher and o hrin achance " wertwirtschardrches Archiv130 lanuary 1994),pp.2049.12 Daniel rrefler, '"rhe case of the Missing Trade and other Mys teries:' Ameic*Econonic Review,g5 (Drcem-ber 1995), pp. 1029-1046.

shareofworldincome.Ifthet.actor-pfoportionstheorywasright,acountrywouldalways;ö;f"";;;; for which tf,"f*to'shä ex"eeaed the income share' importfactors forwhichitwasless.Infact,fortwo+hirdsofthefactorsofproduction,traderaninthepre-dicteddirectionlessthanT0percentofthetime.ThisresultconfirmstheLeontiefparadoxonabroaderlevel:TradeottendoesnotruninthedirectionthattheHeckscher-ohlintheory Predicts.

Tests on North-South Trade Although the overall pattem-of international trade doesnot

seem to be very *"ttu""ount"iiot by"a pure HecksJher-Ohlinmodel' North-Southtradein

manufactures seems to fit ttre theory much better (as our case study on North-soulhtrade

and income distributionalreadf sugiested) Consider' for example'Table 4-4' wficti-'s|gwi

some elements of the trade betweeiähina and the,.Big 3" advanced.economies (the united

States, Japan, and the European Union')Clearlythe goods that the Big 3 importfromChina are very different

from the- e11ls

tt"V""p".t

i" äturn. And it's atro clear that Big 3 exports tend to be sophisticated' skill-

rnert n-q rlade Borween chinu un@

Nonelectrical machineryClothing

ofProduct C in"99

HAF TER 4


18/19

/o PART trNE InternationalTlade Theory

ThailandHong KongJapan

cHAF,TER 4 Resources, Comparative Advantage, and Income Distribution

I/"rtG=t-o y -. ----''-.-.'- 0.78 I i Source;Trefler,'4rrcticanEconomicReview(December1995),p1037' i

lmplications ol the TestsThe mixed results of tests of the factor-proportionstheory place internationaleconomists in

a difficultposition. We saw in Chaptlr3 that empiricalevidence broadly supports theRicardian Äodel's prediction that countries willexport goods in which their labor is espe-ciallyproductive.Most internationaleconomists, however, regard the Ricardian model as

too imited to serve as their basic model of internationaltrade. By contrast, the Heckscher-Ohlin model has long occupied a central placc in trade theory' because it aliows a simulta-

neous treatment of isiues of income distributionand the pattern of trade. so the model that

Dredictstradebestistoolimitingforotherpulposes,whilethereisbynowstrongevidenceagainst the pure Heckscher-Ohlinmodel.

Whilethe Heckscher-Ohlinmodel has been less successful at explaining the actual pat-

tensofintel.nationaltradethanonemighthope,itremainsvitalforunderstandingtheeffectsoftrade,especiallyitseffectsonthedistributionofincome'Indeed'thegrowthoftiorttr-Souttrtrade-in manufactures-a trade in which the factor intensity of the North'simportsisverydifferentfromthatofitseKports-hasbroughtthefactof'proportionsaoproach into ihe center of practical debates over intemational trade policy'

The Heckscher-OhlinModel is a criticaiconcept for thisGer^heedorüe*rve course. MyEconlab Practice Tests and Study Plan can help

you master this important concept by helping you focus your study effort' Tum to page

4? for instructions and then log in to wwwrnyeconlab'conlkrugman'

4. A country that has a rarge suppry of one resource rerative to its supply of other resourcesis abundant in that resource. A counry wiltend to produce retutiu"tymore of gooclsthat use irs abundant resources intensively. The result is the basic Heckscher-bhlintheory of trade: countries tend to export goods that are intensive in the factors withwhich they are abundantly supplier:I.

5. Because changes in relative prices of goods have very strong effects on the relative earn-ings of resources, and because t.ade changes relaiive prices, international tr.ade hasstrong income distributioneffects. The owners of a country's abundant factors gain fromtrade, but the owner.s of scarce factors lose.

6- In an idealized model international trade wo,ld actualy lead to equalization of theprices of factors such as

labor and capital between countries. In realiry, comple teJitctor-price equalization is not observecl because ofwide differences in resources, bariiers totrade, and internationaldifferences in technoloEv.

7.Trad'e produces loseLs as weil as winners. guiih.r"are stil gains fr.om trade in thelimitedsense that the winners could compensäte the losers, and everyone wourd bebetter off.

8' Most economists do not regard the effects of internationaltrade on income distrjbutionas a good reason to limitthis h'ade. In its distributionaleffects, tfade is no differentfrommany other forms of economic change, which are not normallyregulated. Further_more, economists would preferto add'ess the problem of income distributiondirectlv.rather than by interferingwjthtrade flows.

9. Nonetheless, in the actual politicsof trade poricyincome distributionis of cruciarlmportance.This is true in particular because those who lose from trade are usually amuch more informed, cohesive, and organized group than those who gain.

10. Empirical evidence is mixed o' the Heckscher-ohiin model, but moit r.esear.chers donot believe that differcnces in resources alone can explain the pattern of worldtrade orworld factor prices. Instead, it seems to be necessary to allowfor substantial interna_tionaldifferences in technorogy. Nonetheless, the Heckscher-ohlin moder is extremelyuseful, especially as a way to anaryze the effects of trade on income distribution.

o.t70.400.70

SUMMARY

KEYTERMS

PROBLEMS

abundant factor, p. 64biased expansion of prcductionpossi-

bilities,p. 60budget constaint, p. 62equalization of factor prices, p. 65factor abundmce, p. 50factor intensiLy, p. 50

1äctor prices, p. 54factor-proportions theüy, p. 50Heckscher,Ohlin theory, p. 50Leontiefparadox,p. 72scarce factor, p. 64specific factor, p. 66

1. To understand the role of resources in trade we clevelop a model in whichtwo goods are

produced using two factorsof production.The two goods differin thek factor intensi-r fy, that is, at any gtven wage-rental ratio, production of one ol the goods willuse a

higher ratio of land to labor than productionof the other'2. AJtong as a countryproduces both goods, there is a one-to-one relationship between d.rerelativJprices of gc,oJs and the relative prices of/actors used to produce the goods A rise

in the relativeprice of the labor-intensivegood willshift the distributionof income infavorof labor. and will


19/19

78 FART oNE International T?ade Theory

a, Suppose that the economy's total resources are 600 hours of labor and 60 acres ofland. Use a diagram determine the allocation of resources'

b. Now suppose that the labor supply increases first to 800, then 1,000, then l'200hours. Using a diagram like Figure 4-9, luace out the changing allocation ofresources.

c. What would happen if the labor supply were to increase even further?3. "The world's poorest countries cannot find anythingto export. There is no resource that

is abundant--+ertainly not capital nor land,and in smallpoor nations not even labor isabundant." Discuss.

4. The U.S. Iabor movement-which mostly represents blue-collar workers rather than

professionals and highlyeducated workers-has traditionallyfavored limitson importsfrom less-affluent countries. Is this a shortsighted policyor a rationalone in view ofthelnreresß of union members? How does the answer depend on the model of trade?

5. Recently, computer programrners in developing countries such as India have begundoing work formerly done in the United States. This shift has undoubtedly led to sub-stantial pay cuts for some prograrnmers in the United States. Answerthe following twoquestions: How is this possib'le when the wages of skilled labor are rising in the UnitedStates as a whole? What argument wouldtrade economists make against seeing thesewage cuts as a reason to block outsourcingof computer progranming?

6. Explain why the Leontief paradox and the more recent Bowen, Leamer, andSveikauskas results reported in the text contradict the factor-proportionstheory.

7. In the discussion of ernpirical results on the Heckscher-Ohlin model, we noted thatrecent work suggests that the efnciency of factors of production seems to differinter-nationally. Explain how this would affectthe concept of factor-price equalization.

FURTHERREADINGDonald Davis and David Weinsteil. 'An Account of Global Factor Trade." NationalBureau of Eco-nomic Research WorkingPaper No. 6785, 1998. The authors review the history of tests of theHeckscher-Ohlin model and propose a modifiedversion-backed by extensive statisticalanalysis--that allows for technology differences, specialization, and transPortation costs.

Alan Deardorff.'Testing Trade Theories and Predicting Trade Flows,"in Ronald W Jones md PeterB. Kenen, eds. Haftdbook oJ Intemational Economics. Vol. 1. Amsterdam: North-Holland,1984.A survey of empiricalevidence on trade theories, especially the factor-proportions thory.

Gordo Hanson and Ann Hanison. "Trade md Wage Inequality in MexicoI' Industrialand lnbor Rela-tions Reyiew 52 ( 1999), pp. 27 1-288. A careful studyof the effects of trade on income inequalityin our neuest neighbor, showing that frctor prices have moved in the opposite direction fromwhatone mighthave expected from a simple factor-proportionsmodel. The authors also put forwudhypotheses about why thismay have happened

Ronald W. Jones. "Factor Proportions and the Heckscher-Ohlin Theorem." Reviewof EconomicStud-ies 24 (1956), pp. 1-10. Exrends Sarnuelson's 1948-1949 analysis (cited below),whichfocusesprimarilyon the relationsl']jpbetween trade and income distribution, into an overall model of inter-national trade.

Ronald W. Jones. "The Srructure of Simple General EquilibriumModels." Journal oJ PoliticalEcon'oruy 73 (1965), pp. 557-572. A rcstatement 01'the Heckscher-Ohlin-Sanuelson model in terms ofelegant algebra.

Ronald W. Jones and J. Peter Neary. "The Positive Theory ofInlernational Trade," in RonaldW. Jonesand Peter B. Kenen, eds. Handbook oJ Intentational Economics. Vol. l..Amsterdam:North-Hol-lmd, 1984. An up-to-date survey of many trade theories, including the factor-proportions theory.

HAFTER4 Resources, Comparative Advantage, and Income Distribution 7g

Bertilohlin' Interregionar and rntematiorcrTrade. cambridge: Havard universitypress, 1g33.he originalohlilbook prcsenting the factor-prop"*""r"?"r "r ""de

remains interesting_its;"#:iä:liri,:l,viewof trade contrasts wititr," ,or" .ieo.ou. and simplifiedmatrrematicai

Robeft Reich' The work of Natiore. New york Basic Books, lggl. An influentiar tract that argues thathliäffi:r;ffi"$:il.,Teunited states in th"*",rää"".yr, *ia"ningtr," gup-u"i*""i

Paul Samuelson' 'llnternationalrrade and the Equalisation of Factor prices.,, E'con omic Journar 5g1948), pp. 163-184, and "IntemationarFactoipriceEq;;i.;i;;;"."Again;, Economic Joumar9 (1949)' pp. r81-196.The most influential formalize;;iöhlin,sideas is paul samuersonagain ), whose two Economic Joumlpaper. on therub;"ci*"-"fur*1"..

international economics (mid-term part 2)

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