Chapter1

Introduction
Chapter Organization

WhatIsInternationalEconomicsAbout?
TheGainsfromTrade
ThePatternofTrade
HowMuchTrade?
BalanceofPayments
ExchangeRateDetermination
InternationalPolicyCoordination
TheInternationalCapitalMarket
InternationalEconomics:TradeandMoney

Chapter Overview
Theintentofthischapteristoprovidebothanoverviewofthesubjectmatterofinternationaleconomics
andtoprovideaguidetotheorganizationofthetext.Itisrelativelyeasyforaninstructortomotivatethe
studyofinternationaltradeandfinance.Thefrontpagesofnewspapers,thecoversofmagazines,and
theleadreportsontelevisionnewsbroadcastsheraldtheinterdependenceoftheU.S.economywiththe
restoftheworld.Thisinterdependencemayalsoberecognizedbystudentsthroughtheirpurchasesof
importsofallsortsofgoods,theirpersonalobservationsoftheeffectsofdislocationsduetointernational
competition,andtheirexperiencethroughtravelabroad.
Thestudyofthetheoryofinternationaleconomicsgeneratesanunderstandingofmanykeyeventsthat
shapeourdomesticandinternationalenvironment.Inrecenthistory,theseeventsincludethecausesand
consequencesofthelargecurrentaccountdeficitsoftheUnitedStates;thedramaticappreciationofthe
dollarduringthefirsthalfofthe1980sfollowedbyitsrapiddepreciationinthesecondhalfofthe1980s;
theLatinAmericandebtcrisisofthe1980sandtheMexicancrisisinlate1994;andtheincreasedpressures
forindustryprotectionagainstforeigncompetitionbroadlyvoicedinthelate1980sandmorevocally
espousedinthefirsthalfofthe1990s.ThefinancialcrisisthatbeganinEastAsiain1997andspreadto
manycountriesaroundtheglobeandtheEconomicandMonetaryUnioninEuropehighlightedthewayin
whichvariousnationaleconomiesarelinkedandhowimportantitisforustounderstandtheseconnections.
Thesegloballinkageshavebeenhighlightedyetagainwiththerapidspreadofthefinancialcrisisinthe
UnitedStatestotherestoftheworld.Atthesametime,protestsatglobaleconomicmeetingsandarising
waveofprotectionistrhetorichavehighlightedoppositiontoglobalization.Thetextmaterialwillenable
studentstounderstandtheeconomiccontextinwhichsucheventsoccur.

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Chapter2WorldTrade:AnOverview4

Chapter1ofthetextpresentsdatademonstratingthegrowthintradeandtheincreasingimportanceof
internationaleconomics.Thischapteralsohighlightsandbrieflydiscussesseventhemeswhicharise
throughoutthebook.Thesethemesare(1)thegainsfromtrade;(2)thepatternoftrade;(3)protectionism;(4)
thebalanceofpayments;(5)exchangeratedetermination;(6)internationalpolicycoordination;and(7)
theinternationalcapitalmarket.Studentswillrecognizethatmanyofthecentralpolicydebatesoccurring
todaycomeundertherubricofoneofthesethemes.Indeed,itisoftenafruitfulheuristictousecurrent
eventstoillustratetheforceofthekeythemesandargumentswhicharepresentedthroughoutthetext.

OverviewofSectionI:
InternationalTradeTheory
SectionIofthetextconsistsofsevenchapters:
Chapter2WorldTrade:AnOverview
Chapter3LaborProductivityandComparativeAdvantage:TheRicardianModel
Chapter4SpecificFactorsandIncomeDistribution
Chapter5ResourcesandTrade:TheHeckscherOhlinModel
Chapter6TheStandardTradeModel
Chapter7ExternalEconomiesofScaleandtheInternationalLocationofProduction
Chapter8

FirmsintheGlobalEconomy:ExportDecisions,Outsourcing,andMultinational
Enterprises

nSection I Overview
SectionIofthetextpresentsthetheoryofinternationaltrade.Theintentofthissectionistoexplore
themotivesforandimplicationsofpatternsoftradebetweencountries.Thepresentationproceedsby
introducingsuccessivelymoregeneralmodelsoftrade,wherethegeneralityisprovidedbyincreasingthe
numberoffactorsusedinproduction,byincreasingthemobilityoffactorsofproductionacrosssectors
oftheeconomy,byintroducingmoregeneraltechnologiesappliedtoproduction,andbyexamining
differenttypesofmarketstructure.ThroughoutSectionI,policyconcernsandcurrentissuesareused
toemphasizetherelevanceofthetheoryofinternationaltradeforinterpretingandunderstandingour
economy.
Chapter2givesabriefoverviewofworldtrade.Inparticular,itdiscusseswhatweknowaboutthequantities
andpatternofworldtradetoday.Thechapterusestheempiricalrelationshipknownasthegravitymodel
asaframeworktodescribetrade.Thisframeworkdescribestradeasafunctionofthesizeoftheeconomies
involvedandtheirdistance.Itcanthenbeusedtoseewherecountriesaretradingmoreorlessthanexpected.
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Chapter1Introduction5

Thechapteralsonotesthegrowthinworldtradeoverthepreviousdecadesandusesthepreviouseraof
globalization(preWWI)asacontextfortodaysexperience.
Chapter3introducesinternationaltradetheorythroughaframeworkknownastheRicardianmodelof
trade.Thismodeladdressestheissueofwhytwocountrieswouldwanttotradewitheachother.This
modelshowshowmutuallybeneficialtradeariseswhentherearetwocountries,eachwithonefactorof
productionthatcanbeappliedtowardproducingeachoftwogoods.Keyconceptsareintroduced,suchas
theproductionpossibilitiesfrontier,comparativeadvantageversusabsoluteadvantage,gainsfromtrade,
relativeprices,andrelativewagesacrosscountries.

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Chapter1Introduction6

Chapter4presentstheSpecificFactorsmodelinwhichgoodsareproducedusingonefactorthatismobile
betweenindustriesandonefactorthatisspecifictothatindustry.Theadvantageofthismodeloverthe
simpleRicardianmodelisthatithighlightsthedistributionaleffectsoftrade,withsomesectorsofsociety
gainingandothersectorslosingeventhoughthenetwelfareeffectoftradeisagain.Thesedistributional
effectsoftradehighlightthecommonlyvoicedoppositionstofreetrade,andthischapterexaminesthree
reasonswhyprotectionismisaninefficientmethodfordealingwiththelossesfromtrade.Thechapter
concludeswithanapplicationoftheSpecificFactorsmodeltointernationallabormigration,focusing
againonthedistributionaleffectsoffreetradeinlabor.
Chapter5introduceswhatisknownastheclassicHeckscherOhlinmodelofinternationaltrade.Usingthis
framework,youcanworkthroughtheeffectsoftradeonwages,prices,andoutput.Manyimportantand
intuitiveresultsarederivedinthischapterincluding:theRybczynskitheorem,theStolperSamuelson
theorem,andtheFactorPriceEqualizationtheorem.ImplicationsoftheHeckscherOhlinmodelforthe
patternoftradeamongcountriesarediscussed,asarethefailuresofempiricalevidencetoconfirmthe
predictionsofthetheory.Thechapteralsointroducesquestionsofpoliticaleconomyintrade.Oneimportant
reasonforthisadditiontothemodelistoconsidertheeffectsoftradeonincomedistribution.Thisapproach
showsthatwhilenationsgenerallygainfrominternationaltrade,itisquitepossiblethatspecificgroupswithin
thesenationscouldbeharmedbythistrade.Thisdiscussion,andrelatedquestionsaboutprotectionismversus
globalization,becomesbroaderandevenmoreinterestingasyouworkthroughthemodelsanddifferent
assumptionsofsubsequentchapters.
Chapter6presentsageneralmodelofinternationaltrade,whichadmitsthemodelsoftheprevious
chaptersasspecialcases.Thisstandardtrademodelisdepictedgraphicallybyageneralequilibrium
trademodelasappliedtoasmallopeneconomy.Relativedemandandrelativesupplycurvesareusedto
analyzeavarietyofpolicyissues,suchastheeffectsofeconomicgrowth,thetransferproblem,andthe
effectsoftradetariffsandproductionsubsidies.TheAppendixtothechapterdevelopscurveanalysis.
Whileanextremelyusefultool,thestandardmodeloftradefailstoaccountforsomeimportantaspects
ofinternationaltrade.Specifically,whilethefactorproportionsHeckscherOhlintheoriesexplainsome
tradeflowsbetweencountries,recentresearchininternationaleconomicshasplacedanincreasing
emphasisoneconomiesofscaleinproductionandimperfectcompetitionamongfirms.
Chapter7isthefirstoftwochapterstoreflectthesedevelopmentsininternationaltradetheory.Withexternal
economiesofscale,averagecostsinanindustryfallasindustrialproductionrises(thoughnotnecessarily
theproductionofanyonefirminthatindustry).Asaresult,whentwocountriestrade,itmakessenseto
concentrateproductioninonecountryasthiswillleadtolowercoststhansplittingproductionacrosstwo
countries.Aswiththetrademodelspresentedinpreviouschapters,countrieswiththelowestproduction
costswillbeexporters,butinthiscase,thesourceoflowcostsisnotdrivenbydifferencesintechnology
orfactorendowments.Rather,acountrywithanestablishedindustrywillbemorecompetitivethanone
inwhichtheindustryhastostartfromscratch.Thisistrueeveniftheestablishedcountrywouldnotbe
thelowestcostproducerifbothcountriesstartedoffatthesamelevelofproduction.Thissuggeststhata
countrycouldbemadebetteroffbyclosingofffromtrade,thoughsuchcasesaredifficulttoidentifyand
thisformofprotectionismmayleadtounintendedconsequencessuchasretaliatorytariffs.
Chapter8examineshowtradecanbedrivenbyinternaleconomiesofscaleandmonopolisticcompetition.
Aninternaleconomyofscaleexistswhenafirmsaveragecostsdeclineasthatfirmincreasesitsproduction.
Suchasituationleadstoamodelofimperfectcompetition(thereareafewlargefirmsratherthanmany
smallfirms),anditcanbeusedtoexplainthehighdegreeofintraindustrytradeintheworld.Thechapter
concludeswithadiscussionofforeigndirectinvestment.Thedecisionbyamultinationaltoservea
foreignmarketthroughaforeignaffiliateortobreakupitsproductionchainisdrivenbyaproximity
concentrationtradeoffinwhichitmustbalanceeconomiesofscale(producingeverythinginoneplace)
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Chapter1Introduction7

withtradecostsanddifferencesinfactorprices.Thissubjectmatterisimportantbecauseitshowshow
gainsfromtrademayariseinwaysthatarenotsuggestedbythestandardmodelsofinternationaltrade.

Chapter2
WorldTrade:AnOverview
Chapter Organization
WhoTradeswithWhom?
SizeMatters:TheGravityModel
UsingtheGravityModel:LookingforAnomalies
ImpedimentstoTrade:Distance,Barriers,andBorders
TheChangingPatternofWorldTrade
HastheWorldGottenSmaller?
WhatDoWeTrade?
ServiceOffshoring
DoOldRulesStillApply?
Summary

Chapter Overview
Beforeenteringintoaseriesoftheoreticalmodelsthatexplainwhycountriestradeacrossbordersandthe
benefitsofthistrade(Chapters311),Chapter2considersthepatternofworldtradewhichweobservetoday.
Thecoreideaofthechapteristheempiricalmodelknownasthegravitymodel.Thegravitymodelisbased
ontheobservationsthat(1)countriestendtotradewithnearbyeconomiesand(2)tradeisproportionalto
countrysize.Themodeliscalledthegravitymodel,asitissimilarinformtothephysicsequationthat
describesthepullofonebodyonanotherasproportionaltotheirsizeanddistance.
ThebasicformofthegravityequationisTijAYiYj/Dij.Thelogicsupportingthisequationisthatlarge
countrieshavelargeincomestospendonimportsandproducealargequantityofgoodstosellasexports.
Thismeansthatthelargerthateithertradepartneris,thelargerthevolumeoftradebetweenthem.Atthe
sametime,thedistancebetweentwotradepartnerscansubstituteforthetransportcoststhattheyfaceas
wellasproxyformoreintangibleaspectsofatradingrelationshipsuchastheeaseofcontactforfirms.This
modelcanbeusedtoestimatethepredictedtradebetweentwocountriesandlookforanomaliesintrade
patterns.Thetextshowsanexamplewherethegravitymodelcanbeusedtodemonstratetheimportance
ofnationalbordersindeterminingtradeflows.Accordingtomanyestimates,theborderbetweenthe
UnitedStatesandCanadahastheimpactontradeequivalenttoroughly2,000milesofdistance.Other
factorssuchastariffs,tradeagreements,andcommonlanguagecanallaffecttradeandcanbeincorporated
intothegravitymodel.

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Chapter1Introduction2

Thechapteralsoconsidersthewaytradehasevolvedovertime.Whilepeopleoftenfeelthatglobalization
inthemoderneraisunprecedented,infact,weareinthemidstofthesecondgreatwaveofglobalization.
Fromtheendofthe19thcenturytoWorldWarI,theeconomiesofdifferentcountrieswerequite
connected,withtradeasashareofGDPhigherin1910thanin1960.Onlyrecentlyhavetradelevels
surpassedpreWorldWarItrade.Thenatureoftradehaschanged,though.Themajorityoftradeisin
manufacturedgoodswithagricultureandmineralproductsmakinguplessthan20percentofworldtrade.
Evendevelopingcountriesnowprimarilyexportmanufactures.Acenturyago,moretradewasinprimary
productsasnationstendedtotradeforthingsthatliterallycouldnotbegrownorfoundathome.Today,
themotivationsfortradearevariedandtheproductswetradeareincreasingindiversity.Despiteincreased
complexityinmoderninternationaltrade,thefundamentalprinciplesexplainingtradeatthedawnofthe
globalerastillapplytoday.Thechapterconcludesbyfocusingononeparticularexpansionofwhatis
tradabletheincreaseinservicestrade.Moderninformationtechnologyhasgreatlyexpandedwhat
canbetradedasthepersonstaffingacallcenter,doingyouraccounting,orreadingyourXraycanliterally
behalfwayaroundtheworld.Whileserviceoutsourcingisstillrelativelyrare,thepotentialforalarge
increaseinserviceoutsourcingisanimportantpartofhowtradewillevolveinthecomingdecades.
Thenextfewchapterswillexplainthetheoryofwhynationstrade.

Chapter3
LaborProductivityandComparative
Advantage:TheRicardianModel
Chapter Organization
TheConceptofComparativeAdvantage
AOneFactorEconomy
ProductionPossibilities
RelativePricesandSupply
TradeinaOneFactorWorld
DeterminingtheRelativePriceAfterTrade
Box:ComparativeAdvantageinPractice:TheCaseofBabeRuth
TheGainsfromTrade
ANoteonRelativeWages
Box:TheLossesfromNontrade
MisconceptionsAboutComparativeAdvantage
ProductivityandCompetitiveness
ThePauperLaborArgument

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Chapter1Introduction3

Box:DoWagesReflectProductivity?
Exploitation
ComparativeAdvantagewithManyGoods
SettingUptheModel
RelativeWagesandSpecialization
DeterminingtheRelativeWageintheMultigoodModel
AddingTransportCostsandNontradedGoods
EmpiricalEvidenceontheRicardianModel
Summary

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Chapter1Introduction4

Chapter Overview
TheRicardianmodelprovidesanintroductiontointernationaltradetheory.Thismostbasicmodelof
tradeinvolvestwocountries,twogoods,andonefactorofproduction,labor.Differencesinrelativelabor
productivityacrosscountriesgiverisetointernationaltrade.ThisRicardianmodel,simpleasitis,generates
importantinsightsconcerningcomparativeadvantageandthegainsfromtrade.Theseinsightsarenecessary
foundationsforthemorecomplexmodelspresentedinlaterchapters.
Thetextexpositionbeginswiththeexaminationoftheproductionpossibilityfrontierandtherelativeprices
ofgoodsforonecountry.Theproductionpossibilityfrontierislinearbecauseoftheassumptionofconstant
returnstoscaleforlabor,thesolefactorofproduction.Theopportunitycostofonegoodintermsoftheother
equalsthepriceratiosincepricesequalcosts,costsequalunitlaborrequirementstimeswages,andwages
areequalineachindustry.
Afterdefiningtheseconceptsforasinglecountry,asecondcountryisintroducedwhichhasdifferent
relativeunitlaborrequirements.Generalequilibriumrelativesupplyanddemandcurvesaredeveloped.
Thisanalysisdemonstratesthatatleastonecountrywillspecializeinproduction.Thegainsfromtrade
arethendemonstratedwithagraphandanumericalexample.Theintuitionofindirectproduction,thatis
producingagoodbyproducingthegoodforwhichacountryenjoysacomparativeadvantageandthen
tradingfortheothergood,isanappealingconcepttoemphasizewhenpresentingthegainsfromtrade
argument.StudentsareabletoapplytheRicardiantheoryofcomparativeadvantagetoanalyzethree
misconceptionsabouttheadvantagesoffreetrade.Eachofthethreemythsrepresentsacommon
argumentagainstfreetradeandtheflawsofeachcanbedemonstratedinthecontextofexamplesalready
developedinthechapter.Thefirstmythisthattradeisdrivenbyabsoluteadvantage.Thischapterclearly
demonstratesthatitiscomparativeadvantagethatmatters.Thesecondisthepauperlaborargument,with
poorcountrieshavinganunfairadvantageintradegivenlowcostlabor.Thechapterhighlightsthatthe
gainsfromtradeareirrelevanttothesourceofcomparativeadvantage.Finally,themythofworkersin
poorcountriesbeingexploitedbytradeisexposedbyaskingwhethertheseworkerswouldbebetteroff
withouttrade.Asthenumericalexampleinthischapterdemonstrates,theanswerisaresoundingno.
Whiletheinitialintuitionsaredevelopedinthecontextofatwogoodmodel,itisstraightforwardtoextend
themodeltodescribetradepatternswhenthereareNgoods.Comparativeadvantageinthismodelisdriven
byrelativewagesbetweencountriesratherthanrelativeprices.However,theimplicationthatcountrieswill
exportgoodsforwhichtheyhavethelowestopportunitycostremains.
TheNgoodmodelisusedtodiscusstherolethattransportcostsplayinmakingsomegoodsnontraded.
Astransportcostsrise,thegainsfromtradedecrease,andinsomecasestheyarecompletelyeliminated.
ThechapterendswithadiscussionofempiricalevidenceoftheRicardianmodel.Theauthorsarecareful
topointoutthatwhiletherathersimplifiedmodelcannotexplainalltradepatterns,thebasicpredictionthat
countriestendtoexportgoodsforwhichtheyhaveacomparativeadvantage(highrelativeproductivity)
hasbeenconfirmedbyanumberofstudies.

Chapter4
SpecificFactorsandIncomeDistribution
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Chapter1Introduction5

Chapter Organization
TheSpecificFactorsModel
Box:WhatIsaSpecificFactor?
AssumptionsoftheModel
ProductionPossibilities
Prices,Wages,andLaborAllocation
RelativePricesandtheDistributionofIncome
InternationalTradeintheSpecificFactorsModel
IncomeDistributionandtheGainsfromTrade
ThePoliticalEconomyofTrade:APreliminaryView
CaseStudy:TradeandUnemployment
IncomeDistributionandTradePolitics
InternationalLaborMobility
CaseStudy:WageConvergenceintheAgeofMassMigration
CaseStudy:ImmigrationandtheU.S.Economy
Summary
APPENDIXTOCHAPTER4:FurtherDetailsonSpecificFactors
MarginalandTotalProduct
RelativePricesandtheDistributionofIncome

Chapter Overview
InChapter3,theRicardianmodeloftradewasintroducedwithlaborasthesinglefactorofproduction
exhibitingconstantreturnstoscale.Whileinformative,thismodelfailstohighlighttheobservedopposition
tofreetrade.Inthischapter,theSpecificFactorsmodelispresentedtogainabetterunderstandingofthe
distributionaleffectsoftrade.Aftertrade,theexportingindustryexpandswhiletheimportcompeting
industryshrinks.Asaresult,thefactorspecifictotheexportingindustrygainsfromtradewhilethefactor
specifictotheimportcompetingindustrylosesfromtrade.However,theaggregategainsfromtradeare
greaterthanthelosses.

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Chapter1Introduction6

TheSpecificFactorsmodelassumesthatthereisonefactorthatismobilebetweensectors(commonly
thoughtofaslabor)andproductionfactorsthatarespecifictoeachsector.Thechapterbeginswithasimple
economyproducingtwogoods:clothandfood.Clothisproducedusinglaboranditsspecificfactor,capital.
Foodisproducedusinglaboranditsspecificfactor,land.Giventhatcapitalandlaborarespecifictotheir
respectiveindustries,themixofgoodsproducedbyacountryisdeterminedbyshareoflaboremployedin
eachindustry.ThekeydifferencebetweentheRicardianmodelandtheSpecificFactorsmodelisthatinthe
latter,therearediminishingreturnstolabor.Forexample,productionoffoodwillincreaseaslaborisadded,
butgivenafixedamountofland,eachadditionalworkerwilladdlessandlesstofoodproduction.
Asweassumethatlaborisperfectlymobilebetweenindustries,thewageratemustbeidenticalbetween
industries.Withcompetitivelabormarkets,thewagemustbeequaltothepriceofeachgoodtimesthe
marginalproductoflaborinthatsector.Wecanusethecommonwageratetoshowthattheeconomywill
produceamixofgoodssuchthattherelativepriceofonegoodintermsoftheotherisequaltotherelative
costofthatgoodintermsoftheother.Thus,anincreaseintherelativepriceofonegoodwillcausethe
economytoshiftitsproductiontowardthatgood.
Withinternationaltrade,thecountrywillexportthegoodwhoserelativepriceisbelowtheworldrelative
price.Theworldrelativepricemaydifferfromthedomesticpricebeforetradefortworeasons.First,as
intheRicardianmodel,countriesdifferintheirproductiontechnologies.Second,countriesdifferinterms
oftheirendowmentsofthefactorsspecifictoeachindustry.Aftertrade,thedomesticrelativepricewill
equaltheworldrelativeprice.Asaresult,therelativepriceintheexportingsectorwillriseandtherelative
priceintheimportcompetingsectorwillfall.Thiswillleadtoanexpansionintheexportsectoranda
contractionoftheimportcompetingsector.
Supposethataftertrade,therelativepriceofclothincreasesby10percent.Asaresult,thecountrywill
increaseproductionofcloth.Thiswillleadtoalessthan10percentincreaseinthewageratesincesome
workerswillmovefromthefoodtotheclothindustry.Therealwagepaidtoworkersintermsofcloth
(w/PC)willfallwhiletherealwagepaidintermsoffood(w/PF)willrise.Thenetwelfareeffectforlaboris
ambiguousanddependsonrelativepreferencesforclothandfood.Ownersofcapitalwillunambiguously
gainsincetheypaytheirworkersalowerrealwagewhileownersoflandwillunambiguouslyloseasthey
nowfacehighercosts.Thus,tradebenefitsthefactorspecifictotheexportingsector,hurtsthefactor
specifictotheimportcompetingsector,andhasambiguouseffectsonthemobilefactor.Despitethese
asymmetriceffectsoftrade,theoveralleffectoftradeisanetgain.Stateddifferently,itistheoretically
possibletoredistributethegainsfromtradetothosewhowerehurtbytradeandmakeeveryonebetteroff
thantheywerebeforetrade.
Giventhesepositivenetwelfareeffects,whyistheresuchoppositiontofreetrade?Toanswerthisquestion,
thechapterlooksatthepoliticaleconomyofprotectionism.Thebasicintuitionisthatthethoughthetotal
gainsexceedthelossesfromtrade,thelossesfromtradetendtobeconcentrated,whilethegainsarediffused.
ImporttariffsonsugarintheUnitedStatesareusedtoillustratethisdynamic.Itisestimatedthatsugartariffs
costtheaverageperson$7peryear.Addedupacrossallpeople,thisisaverylargelossfromprotectionism,
buttheindividuallossesarenotlargeenoughtoinducepeopletolobbyforanendtothesetariffs.However,
thegainsfromprotectionismareconcentratedamongasmallnumberofsugarproducers,whoareableto
effectivelycoordinateandlobbyforcontinuedprotection.
Whilethelosersfromtradeareoftenabletosuccessfullylobbyforprotectionism,thechapterhighlights
threereasonswhythisisaninefficientmethodoflimitingthelossesfromtrade.First,theactualimpact
oftradeonunemploymentisfairlylow,withestimatesofonly2.5percentofunemploymentdirectly
attributabletointernationaltrade.Second,thelossesfromtradearedrivenbyoneindustryexpanding
attheexpenseofanother.Thisphenomenonisnotspecifictointernationaltradeandisalsoseenwith
changingpreferencesornewtechnology.Whyshouldpolicybesingledouttoprotectpeoplehurtbytrade,

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Chapter1Introduction7

andnotforthosehurtbytheseothertrends?Finally,itismoreefficienttohelpthosehurtbytradeby
redistributingthegainsfromtradeintheformofsafetynetsforthosetemporarilyunemployedandworker
retrainingprogramstoeasethetransitionfromimportcompetingtoexportsectors.
Finally,thechapterusestheframeworkoftheSpecificFactorsmodeltoanalyzethedistributionaleffects
ofinternationallabormigration.Withfreemigrationoflaboracrossborders,wagesmustequalizebetween
countries.Workerswillmigratefromlowwagecountriestohighwagecountries.Asaresult,wagesinthe
lowwagecountrieswillriseandthoseinthehighwagecountrieswillfall.Thoughtheneteffectoffree
migrationispositive,therewillbebothwinnersandlosersfrommigration.Workerswhostayedbehind
inthelowwagecountrywillbenefit,aswillownersofcapitalinthehighwagecountry.Workersinthe
highwagecountrywillbehurt,aswillownersofcapitalinthelowwagecountry.

Chapter5
ResourcesandTrade:TheHeckscherOhlinModel

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Chapter1Introduction8

Chapter Organization
ModelofaTwoFactorEconomy
PricesandProduction
ChoosingtheMixofInputs
FactorPricesandGoodsPrices
ResourcesandOutput
EffectsofInternationalTradeBetweenTwoFactorEconomies
RelativePricesandthePatternofTrade
TradeandtheDistributionofIncome
CaseStudy:NorthSouthTradeandIncomeInequality
FactorPriceEqualization
EmpiricalEvidenceontheHeckscherOhlinModel
TradeinGoodsasaSubstituteforTradeinFactors
PatternsofExportsBetweenDevelopedandDevelopingCountries
ImplicationsoftheTests
Summary
APPENDIXTOCHAPTER5:FactorPrices,GoodsPrices,andProductionDecisions
ChoiceofTechnique
GoodsPricesandFactorPrices
MoreonResourcesandOutput

nChapter Overview
InChapter3,tradebetweennationswasmotivatedbydifferencesinternationallyintherelativeproductivity
ofworkerswhenproducingarangeofproducts.InChapter4,theSpecificFactorsmodelconsidered
additionalfactorsofproduction,butonlylaborwasmobilebetweensectors.InChapter5,thisanalysis
goesastepfurtherbyintroducingtheHeckscherOhlintheory.

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TheHeckscherOhlintheoryconsidersthepatternofproductionandtradewhichwillarisewhencountries
havedifferentendowmentsofsuchfactorsofproductionaslabor,capital,andland;wherethesefactors
aremobilebetweensectorsinthelongrun.Thebasicpointisthatcountriestendtoexportgoodsthatare
intensiveinthefactorswithwhichtheyareabundantlysupplied.Tradehasstrongeffectsontherelative
earningsofresources,andaccordingtotheory,leadstoequalizationacrosscountriesoffactorprices.
Thesetheoreticalresultsandrelatedempiricalfindingsarepresentedinthischapter.
Thechapterbeginsbydevelopingageneralequilibriummodelofaneconomywithtwogoodswhichare
eachproducedusingtwofactorsaccordingtofixedcoefficientproductionfunctions.Theassumptionof
fixedcoefficientproductionfunctionsprovidesanunambiguousrankingofgoodsintermsoffactor
intensities.(Amorerealisticmodelallowingforsubstitutionbetweenfactorsofproductionispresented
laterinthechapterwiththesameconclusions.)Twoimportantresultsarederivedusingthismodel.The
firstisknownastheRybczynskieffect.Increasingtherelativesupplyofonefactor,holdingrelativegoods
pricesconstant,leadstoabiasedexpansionofproductionpossibilitiesfavoringtherelativesupplyofthe
goodwhichusesthatfactorintensively.
ThesecondkeyresultisknownastheStolperSamuelsoneffect.Increasingtherelativepriceofagood,
holdingfactorsuppliesconstant,increasesthereturntothefactorusedintensivelyintheproductionof
thatgoodbymorethanthepriceincrease,whileloweringthereturntotheotherfactor.Thisresulthas
importantincomedistributionimplications.
Itcanbequiteinstructivetothinkoftheeffectsofdemographic/laborforcechangesonthesupplyof
differentproducts.Forexample,howmightthepatternofproductionduringtheproductiveyearsofthe
BabyBoomgenerationdifferfromthepatternofproductionforpostBabyBoomgenerations?What
doesthisimplyforreturnstofactorsandrelativepricebehavior?Whateffectwouldamorerestrictive
immigrationpolicyhaveonthepatternofproductionandtradefortheUnitedStates?
ThecentralmessageconcerningtradepatternsoftheHeckscherOhlintheoryisthatcountriestendtoexport
goodswhoseproductionisintensiveinfactorswithwhichtheyarerelativelyabundantlyendowed.Comparing
theUnitedStatesandMexico,forexample,weobservearelativeabundanceofcapitalintheUnitedStatesand
arelativeabundanceoflaborinMexico.Thus,goodsthatintensivelyusecapitalinproductionshouldbe
cheapertoproduceintheUnitedStatesandthoseintensivelyusinglaborshouldbecheapertoproducein
Mexico.Withtrade,theUnitedStatesshouldexportcapitalintensivegoodslikecomputers,whileMexico
shouldexportlaborintensivegoodsliketextiles.Withintegratedmarkets,internationaltradeshouldlead
toaconvergenceofgoodsprices.Thus,thepricesofcapitalintensivegoodsintheUnitedStatesand
laborintensivegoodsinMexicowillrise.AccordingtotheStolperSamuelsoneffect,ownersofa
countrysabundantfactors(e.g.,capitalownersintheUnitedStates,laborinMexico)willgainfromtrade,
whileownersofthecountrysscarcefactors(laborintheUnitedStates,capitalinMexico)willlosefrom
trade.TheextensionofthisresultistheFactorPriceEqualizationtheorem,whichstatesthattradeingoods
(andthuspriceequalizationofgoods)willleadtoanequalizationoffactorprices.Theseincome
distributioneffectsaremoreorlesspermanent,giventhatfactorabundancesdonotquicklychangewithin
acountry.Whiletheoretically,thegainsfromtradecouldberedistributedsuchthateveryoneisbetteroff,
suchaplanisdifficulttoimplementinpractice.Thepoliticalimplicationsoffactorpriceequalization
shouldbeinterestingtostudents.
AfterpresentingthebasictheorybehindtheHeckscherOhlintheory,therestofthechapterexaminesempirical
testsofthemodel,beginningwithacasestudylookingatincomeinequalityintheUnitedStatesWagespaid
toskilledworkersintheUnitedStateshavebeenrisingatamuchfasterratethanthosepaidtounskilled
workersoverthepastfewdecades.Atthesametime,therehasbeenalargeincreaseininternationaltrade.
GiventhattheUnitedStatesisrelativelyabundantinskilledlabor,theHeckscherOhlintheorywould
predictthatincreasedtradeshouldleadtohigherwagesforskilledworkersandlowerwagesforunskilled
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Chapter1Introduction10

workers.Onthesurface,thisappearstobeanempiricalconfirmationofthetheory.However,otherstudies
arguethatrisingwageinequalitycanonlypartiallybeexplainedbyincreasedtrade.Accordingtothe
HeckscherOhlinmodel,theincreaseinskilledwagesshouldbedrivenbyanincreaseinthepriceofskill
intensivegoodsfollowingtrade.However,skillintensivegoodspriceshavenotincreasedbynearlythe
sameproportionasskilledwages.IfrisingwageinequalityinarichcountryliketheUnitedStatesis
drivenbyfactorpriceequalization,thenweshouldalsoobserveanarrowinggapindevelopingcountries
thatareexportinglowskillintensivegoods.However,incomeinequalityinthesenationsisactuallylarger
thaninrichcountries.Finally,tradebetweenrichandpoornationsissimplynotlargeenoughtobeentirely
responsibleforthesizeoftheincomegap.Rather,theincreasingskillpremiumismostlikelyduetoskill
biasedtechnicalinnovationslikecomputersthathaveincreasedtheproductivitiesofskilledworkersmore
thanunskilledworkers.
AnotherempiricalobservationtestingvalidityoftheHeckscherOhlintheoryistheLeontiefparadox.This
istheobservationthatthecapitalintensityofU.S.exportsisactuallylowerthanthatofU.S.imports,exactly
theoppositeofwhatthetheorywouldpredictforacapitalabundantcountry.Furtherevidenceofthisparadox
isfoundinglobaldata,withacountrysfactorabundancedoingarelativelypoorjobofpredictingitstrade
patterns.Finally,thetheorypredictsamuchlargervolumeoftrade(givenobserveddifferencesinfactor
endowments)thanweactuallyseeinthedata.AcountrylikeChina,forexample,hasasignificantabundance
inlabor.However,Chinasnetexportsoflaborintensivegoodsarelowerthanwhatthetheorywouldpredict.
Similarly,U.S.netimportsoflaborintensivegoodsarelowerthanwhatwouldbeexpectedgivenitsrelative
laborscarcity.Anexplanationforthismissingtradeisthattheassumptionofidenticaltechnologyacross
countriesisflawed.Rather,therearesignificantdifferencesinproductivityacrosscountries.Thatsaid,when
thesampleisrestrictedtotradebetweendevelopedanddevelopingcountries(i.e.,NorthSouthtrade),the
HeckscherOhlintheoryfitswell(e.g.,theUnitedStatesimportsmorelowskillproductsfromBangladesh
andmorehighskillproductsfromGermany).Thisobservationhasmotivatedmanyeconomiststoconsider
motivesfortradebetweennationsthatarenotexclusivelybasedondifferencesacrosscountries.These
conceptswillbeexploredinlaterchapters.Despitetheseshortcomings,importantandrelevantresults
concerningincomedistributionareobtainedfromtheHeckscherOhlintheory.

Chapter6
TheStandardTradeModel

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Chapter1Introduction11

Chapter Organization
AStandardModelofaTradingEconomy
ProductionPossibilitiesandRelativeSupply
RelativePricesandDemand
TheWelfareEffectofChangesintheTermsofTrade
DeterminingRelativePrices
EconomicGrowth:AShiftoftheRSCurve
GrowthandtheProductionPossibilityFrontier
WorldRelativeSupplyandtheTermsofTrade
InternationalEffectsofGrowth
CaseStudy:HastheGrowthofNewlyIndustrializingCountriesHurtAdvancedNations?
TariffsandExportSubsidies:SimultaneousShiftsinRSandRD
RelativeDemandandSupplyEffectsofaTariff
EffectsofanExportSubsidy
ImplicationsofTermsofTradeEffects:WhoGainsandWhoLoses?
InternationalBorrowingandLending
IntertemporalProductionPossibilitiesandTrade
TheRealInterestRate
IntertemporalComparativeAdvantage
Summary
APPENDIXTOCHAPTER6:MoreonIntertemporalTrade

nChapter Overview
Previouschaptershavehighlightedspecificsourcesofcomparativeadvantagewhichgiveriseto
internationaltrade.Thischapterpresentsageneralmodelwhichadmitspreviousmodelsasspecialcases.
Thisstandardtrademodelistheworkhorseofinternationaltradetheoryandcanbeusedtoaddressawide
rangeofissues.Someoftheseissues,suchasthewelfareanddistributionaleffectsofeconomicgrowth,
transfersbetweennations,andtariffsandsubsidiesontradedgoods,areconsideredinthischapter.

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Chapter1Introduction12

Thestandardtrademodelisbaseduponfourrelationships.First,aneconomywillproduceatthepointwhere
theproductionpossibilitiescurveistangenttotherelativepriceline(calledtheisovalueline).Second,
indifferencecurvesdescribethetastesofaneconomy,andtheconsumptionpointforthateconomyis
foundatthetangencyofthebudgetlineandthehighestindifferencecurve.Thesetworelationshipsyield
thefamiliargeneralequilibriumtradediagramforasmalleconomy(onewhichtakesasgiventhetermsof
trade),wheretheconsumptionpointandproductionpointarethetangenciesoftheisovaluelinewiththe
highestindifferencecurveandtheproductionpossibilitiesfrontier,respectively.
Youmaywanttoworkwiththisstandarddiagramtodemonstrateanumberofbasicpoints.First,anautarkic
economymustproducewhatitconsumes,whichdeterminestheequilibriumpriceratio;andsecond,opening
aneconomytotradeshiftsthepriceratiolineandunambiguouslyincreaseswelfare.Third,animprovement
inthetermsoftradeincreaseswelfareintheeconomy.Fourth,itisstraightforwardtomovefromasmall
countryanalysistoatwocountryanalysisbyintroducingastructureofworldrelativedemandandsupply
curveswhichdeterminerelativeprices.
TheserelationshipscanbeusedinconjunctionwiththeRybczynskiandtheStolperSamuelsontheorems
fromthepreviouschaptertoaddressarangeofissues.Forexample,youcanconsiderwhetherthedramatic
economicgrowthofcountrieslikeJapanandKoreahashelpedorhurttheUnitedStatesasawhole,and
alsoidentifytheclassesofindividualswithintheUnitedStateswhohavebeenhurtbytheparticulargrowth
biasesofthesecountries.Inteachingthesepoints,itmightbeinterestingandusefultorelatethemtocurrent
events.Forexample,youcanleadaclassdiscussionontheimplicationsfortheUnitedStatesofthe
provisionofformsoftechnicalandeconomicassistancetotheemergingeconomiesaroundtheworldor
thewaysinwhichaworldrecessioncanleadtoafallindemandforU.S.exportgoods.
TheexampleprovidedinthetextconsidersthepopularargumentsinthemediathatgrowthinJapanor
KoreahurtstheUnitedStates.Theanalysispresentedinthischapterdemonstratesthatthebiasofgrowth
isimportantindeterminingwelfareeffectsratherthanthecountryinwhichgrowthoccurs.Theexistence
ofbiasedgrowthandthepossibilityofimmiserizinggrowtharediscussed.TheRelativeSupply(RS)and
RelativeDemand(RD)curvesillustratetheeffectofbiasedgrowthonthetermsoftrade.Thenewterms
oftradelinecanbeusedwiththegeneralequilibriumanalysistofindthewelfareeffectsofgrowth.Ageneral
principlewhichemergesisthatacountrywhichexperiencesexportbiasedgrowthwillhaveadeterioration
initstermsoftrade,whileacountrywhichexperiencesimportbiasedgrowthhasanimprovementinits
termsoftrade.Acasestudypointsoutthatgrowthintherestoftheworldhasmadeothercountriesmore
liketheUnitedStates.ThisimportbiasedgrowthhasworsenedthetermsoftradefortheUnitedStates.
Thesecondareatowhichthestandardtrademodelisappliedaretheeffectsoftariffsandexportsubsidies
onwelfareandtermsoftrade.Theanalysisproceedsbyrecognizingthattariffsorsubsidiesshiftboththe
relativesupplyandrelativedemandcurves.Atariffonimportsimprovesthetermsoftrade,expressedin
externalprices,whileasubsidyonexportsworsenstermsoftrade.Thesizeoftheeffectdependsuponthe
sizeofthecountryintheworld.Tariffsandsubsidiesalsoimposedistortionarycostsupontheeconomy.
Thus,ifacountryislargeenough,theremaybeanoptimum,nonzerotariff.Exportsubsidies,however,
onlyimposecostsuponaneconomy.Internationally,tariffsaidimportcompetingsectorsandhurtexport
sectorswhilesubsidieshavetheoppositeeffect.
Thechapterthencloseswithadiscussionofinternationalborrowingandlending.Thestandardtrademodelis
adaptedtotradeinconsumptionacrosstime.Therelativepriceoffutureconsumptionisdefinedas1/(1r),
whereristherealinterestrate.Countrieswithrelativelyhighrealinterestrates(newlyindustrializing
countrieswithhighinvestmentreturnsforexample)willbebiasedtowardfutureconsumption,andwill
effectivelyexportfutureconsumptionbyborrowingfromestablisheddevelopedcountrieswithrelatively
lowerrealinterestrates.

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