Lecture 4: Sources of

comparative advantage:
Factor Endowment
theory
CHAPTER 3
Factor Endowment Theory, also known as the Heckscher-
Ohlin Model (H-O model), explains international trade
patterns based on the differences in countries' factor
endowments—such as labor, land, and capital. The theory,
developed by Eli Heckscher and Bertil Ohlin, suggests that
countries will export goods that use their abundant and
relatively cheap factors of production intensively, while
importing goods that require factors that are scarce and
expensive domestically
•Factor Endowments: The relative abundance or scarcity of factors of production
(like labor, capital, and land) in different countries. A country might have a large
supply of labor but limited capital, or vice versa.
•Factor Intensity: Different industries or goods require different proportions of
factors of production. For instance, producing textiles might require a lot of labor but
little capital, while producing machinery might need more capital and less labor.
•Core Predictions of the Model:
•Countries that are rich in labor will specialize in producing and exporting labor-
intensive goods.
•Countries that are capital-rich will specialize in producing and exporting capital-
intensive goods.
•Factor Price Equalization: Over time, free trade in goods will lead to an
equalization of the prices of factors of production (wages, return on capital) across
countries. As countries trade, demand for the abundant factor will rise in the
exporting country, driving up wages or capital returns, while the opposite happens in
the importing country. This will narrow the wage or capital-return gap between
countries.
Assumptions:

1.Countries have different factor endowments.

2.Goods differ in the intensity with which they use factors.
3.Perfect competition in all markets.
4.Free trade with no transportation costs or trade barriers.

Example:
•Country A (labor-abundant) will export labor-intensive goods, like textiles.
•Country B (capital-abundant) will export capital-intensive goods, like cars or
machinery.
Theoretical Implications:
The Heckscher-Ohlin theory helps explain why a country like China
(which has an abundance of labor) tends to export labor-intensive goods,
while a country like Germany (which has abundant capital) tends to
export capital-intensive machinery. It contrasts with Ricardian theory,
which focuses on comparative advantage due to productivity differences,
by emphasizing the role of factor endowments in shaping trade patterns.
Limitations:
•The model assumes that production technologies are identical across
countries, which is not always true.
•The "Leontief Paradox" found that the U.S., a capital-abundant country,
was exporting labor-intensive goods, challenging the predictions of the H-
O model.
When applied to U.S.-China trade, this theory highlights the different endowments of
each country:
1.United States: The U.S. is relatively rich in human capital, specifically skilled labor in
scientific, engineering, and technological fields. Thus, the U.S. tends to specialize in
producing goods that are intensive in skilled labor, technology, and innovation. Exports
to China include:
1. Aircraft, ,software, Pharmaceuticals, High-tech machinery and components (like
semiconductors and medical equipment)
2.China: China, on the other hand, has an abundance of unskilled labor but is relatively
scarce in technological and scientific expertise compared to the U.S. As a result, China
tends to specialize in labor-intensive industries, and its exports to the U.S. consist of:
Apparel, Footwear, Toys, Final assembly of electronic goods (e.g., consumer
electronics like smartphones)
Empirical Evidence: The trade patterns observed between the U.S. and China,
particularly in the early 2000s (as noted with data from 2007), align broadly with these
predictions:
•The U.S. exported products that were high in skilled labor and technology.
•China exported products that relied heavily on unskilled labor.
• However, it's important to recognize that while the general
trends fit the theory, these patterns are influenced by many
other factors such as government trade policies, multinational
corporations, and global value chains.

• The final assembly of many high-tech products like

smartphones, for example, may take place in China, but the
intellectual property, design, and high-tech components come
from other countries like the U.S.
• Hence, while the factor-endowment theory helps explain some
patterns of trade, it is not a definitive proof and should be
considered alongside other trade theories like the new trade
theory or the theory of comparative advantage.
Is International Trade a Substitute for Migration?

International trade can indeed serve as a partial substitute for

migration by influencing labor markets and resource distribution
across countries.

According to the factor-endowment theory, international trade can

adjust the prices of resources such as labor, capital, and land,
achieving similar effects to what migration accomplishes.

Instead of workers or capital moving between countries, trade in

products that embody these resources allows countries to specialize
in industries aligned with their resource abundance.
How Trade Substitutes for Migration
Resource Redistribution through Trade: Countries rich in labor but with low wages can
export labor-intensive goods to countries where labor is scarce and expensive. By
doing so, the exporting country's labor demand increases, driving up wages. This
mechanism helps balance wage differences between nations, reducing the incentive
for workers to migrate.
For example, when Polish workers migrate to France, wages in Poland rise due to the
labor shortage, while wages in France decline due to an increase in labor supply.

However, if France imports labor-intensive goods from Poland, Polish industries grow,
raising wages in Poland without the need for workers to physically migrate.
NAFTA Example: The North American Free Trade Agreement (NAFTA), signed in 1995,
aimed to reduce wage gaps between Mexico and the U.S. by boosting trade. The idea
was that economic growth in Mexico, driven by trade, would increase Mexican
workers' incomes and reduce the need for them to migrate to the U.S. While NAFTA
did help mitigate migration to some extent, other factors like high birth rates and
economic crises in Mexico kept migration levels high
Limitations and Complements to Trade as a Substitute
However, international trade and migration are not always perfect
substitutes; they may even be complements, especially in the short run:
1.Displacement from Trade: Trade can lead to job losses in certain sectors of an
economy as industries face competition from imports. Workers displaced by
trade may seek jobs abroad where opportunities are better, resulting in an
increase in migration. For instance, Mexico lost many jobs to China in the
2000s due to China's lower wage rates and competitive exports. This job loss
incentivized further migration of Mexican workers to the U.S.
2.Time Lag in Effects: While trade can help reduce migration in the long run by
equalizing resource prices and wages, the effects are not immediate. Economic
growth in developing countries through trade might take decades before
significantly reducing the incentive for migration, especially if other economic
and social challenges persist, such as high birth rates or economic instability.
Does Trade Make the Poor Even Poorer?

1.Trade and Wages:

1.International Trade: When the U.S. imports goods from countries like
China and Mexico, where unskilled labor is cheaper, it reduces the
demand for unskilled labor domestically. This leads to stagnating or
declining wages for U.S. workers in industries that can be outsourced or
rely on low-skilled labor, such as manufacturing and textiles. As a result,
unskilled U.S. workers might experience lower wages or even job losses,
which could explain why many believe that trade makes them poorer.
2.Conversely, U.S. exports tend to be high in skilled labor and technology,
benefiting workers in these fields. As demand for skilled labor increases
due to trade and technological advancements, their wages rise. This
trend has contributed to wage inequality in the U.S., with skilled workers
seeing wage increases while unskilled workers face stagnation.
Technological Change:
•Skill-biased technological change (SBTC) also plays a significant role in wage inequality. As
technology advances, it tends to complement skilled labor while replacing unskilled labor
(e.g., automation in manufacturing). This drives up the demand for skilled workers and their
wages, while reducing opportunities for unskilled workers, further widening the wage gap.

Immigration:
•The influx of unskilled immigrant labor increases the supply of unskilled workers, which can
lower wages in sectors that rely on such labor. As more unskilled workers enter the
workforce, the relative scarcity of skilled labor increases, driving up the wages of skilled
workers even more. This dynamic again reinforces income inequality.

Education and Training:

•On the other hand, access to education and training can increase the supply of skilled
workers. When more workers acquire skills, the supply of skilled labor rises, potentially
lowering the wage premium for skilled workers and reducing income inequality. In the
absence of such opportunities, however, the wage gap between skilled and unskilled
workers is likely to persist or widen
Wage Inequality Framework:
Figure 3.3 (which you mentioned) highlights how shifts in the
demand and supply of skilled workers relative to unskilled workers
can affect wage inequality:
•Trade and Technological Change: These factors shift the demand
curve for skilled labor upward, leading to a higher wage ratio
(wages of skilled workers rise relative to unskilled workers).
•Immigration of Unskilled Labor: This increases the supply of
unskilled workers, causing a rise in the wage ratio as the supply
curve shifts, increasing inequality.
•Education and Training: Expanding opportunities for education
increases the supply of skilled workers, potentially reducing the
wage gap if demand remains constant.
External Economies of Scale and Comparative Advantage
External economies of scale occur when the average costs of production for firms decrease
due to factors external to the individual firm but tied to the growth of the overall industry
within a specific geographic area. These external factors create comparative advantages for
industries concentrated in specific locations.
Key elements of external economies of scale include:
1.Labor Pooling: As an industry grows in a particular area, a specialized labor force develops.
For example, the carpet industry in Dalton, Georgia, benefits from a local labor force skilled in
carpet-making techniques.
2.Knowledge Spillovers: Proximity allows firms to share technological advancements or
production methods. Knowledge transfer can happen directly between firms or as employees
move between companies.
3.Supplier Networks: Geographic concentration of an industry attracts suppliers and other
complementary businesses, reducing costs and improving efficiency. In Dalton’s case, it is not
just carpet plants but also local yarn manufacturers, machinery suppliers, dye plants, and
other businesses supporting the industry.
These factors contribute to the creation of comparative advantage for a region. For example:
•New York has a comparative advantage in financial services due to the concentration of
Overlapping Demands as a Basis for Trade (Linder Hypothesis)
The Linder Hypothesis, formulated by Staffan Linder, offers a different perspective
from the factor-endowment theory, particularly for manufactured goods. Linder
argues that trade in manufactured goods is driven by domestic demand conditions
and that countries will export goods that meet their own domestic market needs to
other countries with similar demand patterns.
Key points of the Linder Hypothesis:
1.Domestic Market Focus: Firms tend to produce goods that cater to their domestic
market first. When they look to export, they find that countries with similar income
levels and consumer demands are the most promising markets for their goods.
2.Similar Income Levels: Countries with similar per capita incomes will likely have
overlapping demand structures, meaning they consume similar types of goods. This
leads to trade between these countries, particularly in high-quality, luxury
manufactured goods for high-income nations and lower-quality, essential goods for
low-income nations.
3. Trade Among Wealthy Nations: Linder’s theory suggests that high-income,
industrialized nations (e.g., the U.S., Japan, Canada, European countries) are more
likely to trade manufactured goods with each other.
This trade often involves intra-industry trade (the exchange of similar products like
cars, electronics, etc.).
Linder’s hypothesis explains why wealthy nations tend to trade similar manufactured
goods with each other. For example:
•Germany exports luxury cars to the U.S., and the U.S. may export high-end
electronics back to Germany. Both countries have wealthy consumers with
overlapping demands for high-quality products.
Exceptions to Linder’s Theory:
•Developing Countries: Linder’s hypothesis does not fully explain trade patterns
involving developing nations. Low-income countries often trade more with high-
income nations than with other low-income countries. This is because developing
nations often export primary products (e.g., raw materials or agricultural goods) to
wealthier nations rather than focusing on manufacturing for domestic or similar-
Implications of Both Concepts on Trade Patterns:
•External economies of scale help explain why specific industries
(e.g., financial services in New York or carpets in Dalton) thrive in
certain locations, creating comparative advantages not directly
related to factor endowments.
•The Linder Hypothesis emphasizes that similarities in domestic
consumer demand (driven by income levels) shape trade in
manufactured goods, particularly between countries with similar per
capita incomes.
The trade models mentioned highlight the distinction between interindustry
trade and intra-industry trade.

Interindustry Trade:
•Nature: It involves the exchange of goods between industries, such as trading
computers for textiles or raw materials for finished goods.
•Factor Requirements: Nations with different resource endowments engage in
this trade. For instance, a country rich in natural resources exports resource-
intensive goods, while a country with skilled labor exports technology-
intensive goods.
•Comparative Advantage: This trade follows the Heckscher-Ohlin model,
where each country specializes in industries that align with its comparative
advantage, leading to the exchange of goods that have different factor
requirements.
Intra-industry Trade:
•Nature: It refers to two-way trade within the same industry, where countries
export and import similar goods. For example, the U.S. exports and imports
vehicles or computers from different manufacturers.
•Post-WWII Specialization: Intra-industry trade has become more significant
among industrialized nations, especially in areas like manufactured goods such as
machinery, chemicals, and vehicles. This trade doesn't eliminate entire industries
but rather allows countries to specialize in specific products or segments within an
industry.
•Product Differentiation: This trade occurs due to the differentiation of products
within a broad category (e.g., different car models or varieties of wines). This
allows consumers more choice and can satisfy niche market segments that might
not be catered to by domestic producers.
•For instance, U.S. consumers may prefer IBM computers, while also purchasing
Hitachi computers from Japan, or California exporting wine while importing French
Key Points of Intra-Industry Trade:
1.Similar Factor Requirements: Unlike interindustry trade, intra-industry trade
involves products that have similar factor requirements. It is mostly practiced
among industrialized nations with similar levels of development and resource
endowments, such as Western Europe.
2.Market Segmentation: Overlapping market segments, such as the preference
for luxury cars among high-income buyers, facilitate intra-industry trade,
explained by Linder’s theory of overlapping demand. Industrial countries, with
similar income levels, have similar tastes, driving this form of trade.
3.Economies of Scale: Intra-industry trade is also driven by economies of scale.
Specializing in a narrow segment of a product range (e.g., subcompact cars with
specific features) allows firms to lower costs through longer production runs,
while their foreign competitors do the same with different variations. This
specialization reduces unit costs and promotes two-way trade in similar goods.
Intra-Industry Trade vs. Interindustry Trade:

•Adjustments: Intra-industry trade generally causes fewer adjustment

issues compared to interindustry trade. The reason is that resources shift
within the same industry, reducing the need for workers to change
industries or locations. This reduces the risk of structural unemployment,
which can occur in interindustry trade when resources must move from
import-competing industries to export-expanding ones.
SOURCES OF COMPARATIVE ADVANTAGE

• TECHNOLGY
• INDUSTRIAL POLICY
• REGULATIONS
• TRANSPORTATION
Technology as a Source of Comparative Advantage:The Product
Cycle Theory

1. Technology and Comparative Advantage:

•Technological improvements are vital in determining a country's
comparative advantage. For example, Japan became the world's largest
exporter of automobiles due to innovations in production techniques that
allowed it to outproduce competitors like the U.S. and Europe. This
technological advantage can enhance a nation's capacity to export goods,
making it a global leader in certain industries
2. Product Life Cycle Theory:
The Product Life Cycle (PLC) Theory explains how technological innovation
affects trade patterns over time. The theory outlines five key stages for
manufactured goods:
•Stage 1: A new product is introduced to the home market.
•Stage 2: The product becomes competitive, and the domestic industry shows
export strength.
•Stage 3: Foreign production begins, as overseas markets become relevant and
foreign competitors adopt the product.
•Stage 4: The domestic industry loses its competitive advantage as foreign
producers become more efficient.
•Stage 5: Import competition begins as foreign producers start exporting the
product back to the original innovating country, often at lower costs.
This process is seen in industries like electronics and automobiles, where
production starts in high-cost, innovation-driven nations and eventually shifts
to lower-cost countries, like China or Malaysia, as production techniques
3. Technological Advantage is Temporary:

•Technological advantages are transitory. As knowledge spreads, often freely due

to the diffusion of technology, other countries catch up. For instance, while Japan
gained a technological edge in automobile production, over time, this advantage
diminished as other nations adopted similar techniques.
•The PLC theory emphasizes that over time, foreign producers will imitate
innovative production processes. The original innovating country may eventually
import the product it once pioneered, as its comparative advantage shifts to other
industries or innovations.

4. Globalization and Technological Diffusion:

•Globalization has accelerated the rate at which technology spreads across
borders. This means that countries like the U.S., which often lead in innovation,
must maintain a rapid pace of technological innovation to offset the faster
diffusion of technology. Otherwise, they risk losing their gains from trade.
Firm-Level Implications:
For firms, continuous innovation is critical to sustaining competitiveness in
global markets. For example, Toyota’s approach to improving production
efficiency illustrates how firms must innovate to stay ahead. By simplifying
manufacturing processes and increasing output speed, Toyota aims to
prevent rivals from catching up and avoid entering the declining phase of the
product life cycle. This is a direct attempt to stave off the challenges
presented by the PLC theory.
The Role of Technological Progress:
1. Technological advancements play a key role in reshaping comparative
advantages over time. Japan’s focus on industries like electronics and
automobiles allowed it to move from being a high-cost producer to a low-
cost, highly competitive exporter in a few decades.
2. By fostering technological progress, a nation can increase labor productivity,
reduce unit costs, and enhance its position in global trade. In contrast,
Ricardo’s static theory does not account for these long-term shifts.
Beggar-Thy-Neighbor Risks:
3. Critics also warn that widespread adoption of industrial policies, particularly
trade restrictions and export subsidies, could lead to a beggar-thy-neighbor
situation, where nations engage in protectionism that harms global trade.
4. In this scenario, each country might impose trade barriers to promote its
industries, leading to a trade war that reduces overall global economic
welfare.
Industrial Policy as a source of comparative advantage

1.Industrial policy refers to government strategies aimed at revitalizing,

improving, or developing key industries to enhance national productivity
and global competitiveness.
2.Examples of industrial policy measures include tax incentives, subsidies
for research and development (R&D), low-interest loans, trade
protection, and antitrust immunity.
3.Proponents argue that governments should direct resources toward
“sunrise” industries (emerging sectors with high growth potential), such
as semiconductors or high-tech industries, to maintain long-term
competitiveness.
Criticism of Industrial Policy:
1.Critics argue that government involvement in identifying “winners” and
“losers” can lead to inefficiencies, political favoritism, and suboptimal
allocation of resources.
2.While Japan’s industrial policies helped some industries, they also targeted
losers like petrochemicals and aluminum, where returns on investment
were disappointing.
3.Many successful Japanese industries, such as motorcycles and bicycles, did
not receive significant government support, suggesting that the private
sector’s profit motive may be a more effective driver of comparative
advantage than government intervention.
Government Regulations as a source of comparative advantage

Regulatory Agencies:
•In the United States, agencies like the Occupational Safety and Health Administration
(OSHA), Consumer Product Safety Commission (CPSC), and the Environmental Protection
Agency (EPA) impose regulations on businesses to ensure safety standards and environmental
protection.
•Although these regulations benefit society by ensuring safer workplaces, product reliability,
and a healthier environment, they often result in higher costs for domestic producers, which
can hinder their competitiveness, especially in industries like steel manufacturing.

Impact on Competitiveness:
•U.S. steel producers, despite being technologically advanced and environmentally
responsible, face significant regulatory burdens that may impair their global competitiveness.
•Higher costs due to stringent regulations can erode competitive advantages for U.S. firms
compared to countries with less stringent regulatory requirements, such as South Korea or
China. These additional costs can make U.S. products more expensive, reducing their ability to
compete in both domestic and international markets.
Trade and Comparative Advantage:

•The impact of government regulations on trade and comparative advantage

is illustrated in industries like steel production. In a world where the U.S. and
South Korea both produce steel, stricter pollution regulations in the U.S. can
increase production costs.
•Without trade, the U.S. steel market operates at a different cost structure
compared to South Korea, leading to variations in price and quantity
produced. When regulations increase the costs of production, the
comparative advantage may shift towards countries with laxer regulatory
environments.
•This shift can lead to higher imports of foreign-produced steel and a
reduction in the competitiveness of domestic firms, causing job losses in
industries that are unable to absorb the added costs.
Policy Concerns:
•While regulations are often justified on social welfare grounds, there
is a trade-off between improving the quality of life for citizens and
maintaining industrial competitiveness. Policies that significantly
increase costs for export-oriented or import-competing industries can
have negative economic effects, including job losses.
•Governments must balance these considerations when designing
regulations. Failure to do so may result in declining industries,
reduced exports, and a shift in comparative advantage to other
countries, which may not adhere to similar standards.
Impact of Environmental Regulations:
•The U.S. Environmental Protection Agency (EPA) imposes pollution regulations on domestic
steel producers to reduce environmental harm. This increases production costs for U.S. steel
companies, shifting the supply curve leftward, leading to higher prices.
•As U.S. production costs rise, South Korean steel companies, unburdened by these
regulations, gain an additional comparative advantage, allowing them to increase production
and exports to the US.

Trade-offs of Environmental Regulations:

•Environmental regulations create a policy trade-off for the U.S. On one hand, they lead to a
comparative disadvantage for U.S. steel producers, making the U.S. more dependent on
foreign steel imports. On the other hand, these regulations benefit the public by improving
water quality, air quality, and overall public health.
•Other industries, like forestry products, may indirectly benefit from the cleaner
environment, enhancing their competitiveness.
Transportation Costs and Comparative Advantage:

•Transportation costs also influence comparative advantage, affecting the

volume and composition of trade. These costs include freight charges,
packing, handling expenses, and insurance premiums.
•Countries that can minimize transportation costs for exports may maintain or
enhance their comparative advantage.
•However, high transportation costs can act as a barrier to trade and reduce
the gains from trade liberalization.
•In this scenario, transportation costs between South Korea and the U.S.
would also play a role in determining the overall cost competitiveness of
imported steel and could either enhance or limit South Korea’s comparative
advantage