International Trade Extra Notes :

Hecksher – Ohlin Theory - in economics, a theory of comparative advantage in international

trade according to which countries in which capital is relatively plentiful
and labour relatively scarce will tend to export capital-intensive products and import
labour-intensive products, while countries in which labour is relatively plentiful and capital
relatively scarce will tend to export labour-intensive products and import capital-intensive
products. The theory was developed by the Swedish economist Bertil Ohlin (1899–1979) on
the basis of work by his teacher the Swedish economist Eli Filip Heckscher (1879–1952).
For his work on the theory, Ohlin was awarded the Nobel Prize for Economics (the
Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel) in 1977.

Some countries are relatively well-endowed with capital: the typical worker has plenty of
machinery and equipment to assist with the work. In such countries, wage rates generally
are high; as a result, the costs of producing labour-intensive goods—such as textiles,
sporting goods, and simple consumer electronics—tend to be more expensive than in
countries with plentiful labour and low wage rates. On the other hand, goods requiring
much capital and only a little labour (automobiles and chemicals, for example) tend to be
relatively inexpensive in countries with plentiful and cheap capital. Thus, countries with
abundant capital should generally be able to produce capital-intensive goods relatively
inexpensively, exporting them in order to pay for imports of labour-intensive goods.

In the Heckscher-Ohlin theory, it is not the absolute amount of capital that is important;
rather, it is the amount of capital per worker. A small country like Luxembourg has much
less capital in total than India, but Luxembourg has more capital per worker. Accordingly,
the Heckscher-Ohlin theory predicts that Luxembourg will export capital-intensive
products to India and import labour-intensive products in return.

Despite its plausibility, the Heckscher-Ohlin theory is frequently at variance with the
actual patterns of international trade. One early study of the Heckscher-Ohlin theory was
carried out by Wassily Leontief, a Russian-born U.S. economist. Leontief observed that the
United States was relatively well-endowed with capital. According to the theory, therefore,
the United States should export capital-intensive goods and import labour-intensive ones.
He found that the opposite was in fact the case: U.S. exports are generally more labour-
intensive than the types of products that the United States imports. Because his findings
were the opposite of those predicted by the theory, they are known as the Leontief
Paradox.

HO Model - The Heckscher-Ohlin model is an economic theory that proposes that

countries export what they can most efficiently and plentifully produce. Also referred to as the H-O
model or 2x2x2 model, it's used to evaluate trade and, more specifically, the equilibrium of trade
between two countries that have varying specialties and natural resources.1

The model emphasizes the export of goods requiring factors of production that a country has in
abundance. It also emphasizes the import of goods that a nation cannot produce as efficiently. It takes
the position that countries should ideally export materials and resources of which they have an excess,
while proportionately importing those resources they need.

The primary work behind the Heckscher-Ohlin model was a 1919 Swedish paper written by Eli
Heckscher at the Stockholm School of Economics. His student, Bertil Ohlin, added to it in 1933.
Economist Paul Samuelson expanded the original model through articles written in 1949 and 1953.
Some refer to it as the Heckscher-Ohlin-Samuelson model for this reason.3
The Hecksher-Ohlin model explains mathematically how a country should operate and trade when
resources are imbalanced throughout the world. It pinpoints a preferred balance between two countries,
each with its resources. The model isn't limited to tradable commodities. It also incorporates other
production factors such as labour. The costs of labour vary from one nation to another, so countries with
cheap labour forces should focus primarily on producing labour-intensive goods, according to the
model.2

The Specific Factors Model - The Heckscher-Ohlin factor endowment theory was put into
doubt by the Leontief Paradox. Another objection against the validity of the H-O theory
was raised by Stephen Magee. An assumption has been taken in the H-O theory that the
factors of production are perfectly mobile within a given country although these are
perfectly immobile between the different countries. Magee disputed the contention about
mobility of factors in different industries within the same country.

According to him, the difficulty in the inter-industry mobility of factors is created by the
specificity of factors. Certain factors are suitable for specific use and these cannot be
transferred from one industry to another. Such factors can be called specific factors.
Suppose production in a country gets shifted from cotton cloth to steel, no magic wand
exists that can convert bales of cotton into iron ore.

The workers skilled in making cloth cannot be absorbed into the steel industry. Even the
capital stock employed in cotton textile industry is highly specific in the short period. Over
a period, no doubt, it can be diverted from one industry to another. Moreover, the different
industries can employ factors in specific quantities.

Suppose two commodities X and Y are produced in a country. Their production involves
the use of labour and capital. The supply of labour is fixed for the country as a whole and it
is perfectly mobile within these two industries. But each industry employs a specific
quantity of capital. Since capital in one industry cannot be substituted for capital in the
other country, there can be no way by which price of capital can be equal in two
industries. Wages in the two industries can, of course, get equalised.

Economies of scale - One important motivation for international trade is the efficiency
improvements that can arise because of the presence of economies of scale in production.
Although economists wrote about these effects long ago, models of trade developed after the
1980s introduced economies of scale in creative new ways and became known as the “New
Trade Theory.”

Another major reason that international trade may take place is the existence of economies of

scale (also called increasing returns to scale) in production. Economies of sca-le means that

production at a larger scale (more output) can be achieved at a lower cost (i.e., with economies

or savings). When production within an industry has this characteristic, specialization and
trade can result in improvements in world productive efficiency and welfare benefits that

accrue to all trading countries.

Trade between countries need not depend on country differences under the assumption of

economies of scale. Indeed, it is conceivable that countries could be identical in all respects

and yet find it advantageous to trade. For this reason, economies-of-scale models are often

used to explain trade among countries like the United States, Japan, and the European Union.

For the most part, these countries, and other developed countries, have similar technologies,

similar endowments, and to some extent similar preferences. Using classical models of trade

(e.g., Ricardian, Heckscher-Ohlin), these countries would have little reason to engage in trade.

Yet trade between the developed countries makes up a significant share of world trade.

Economies of scale can provide an answer for this type of trade.

Another feature of international trade that remains unexplained with classical models is the

phenomenon of intra industry trade. A quick look at the aggregate trade data reveals that

many countries export and import similar products. For example, the United States imports

and exports automobiles, imports and exports machine tools, imports and exports steel, and so

on. To some extent, intra industry trade arises because many different types of products are

aggregated into one category. For example, many different types of steel are produced, from

flat-rolled to specialty steels. It may be that production of some types of steel requires certain

resources or technologies in which one country has a comparative advantage. Another country

may have the comparative advantage in another type of steel. However, since all these types

are generally aggregated into one export or import category, it could appear as if the countries

are exporting and importing “identical” products when in actuality they are exporting one type

of steel and importing another type.

Nevertheless, it is possible to explain intra industry trade in a model that includes economies

of scale and differentiated products even when there are no differences in resources or

technologies across countries. This model is called the monopolistic competition model. Its

focus is on consumer demand for a variety of characteristics embodied in the goods sold in a

product category. In this model, advantageous trade in differentiated products can occur even

when countries are very similar in their productive capacities.

External Economies of Scale - External economies of scale occur outside of an individual company but
within the same industry. Remember that in economics, economies of scale mean that the more units a
business produces, the less it costs to produce each unit.

External economies of scale describe similar conditions, only for an entire industry instead of a
company. For example, if a city creates a better transportation network to service a particular industry,
then all companies in that industry will benefit from the new transportation network, and experience
decreased production costs.

As an industry grows larger or becomes clustered in one location—as with, say, the banking and
financial services in New York or London—than the average costs of doing business within that industry
over the long run become lower, and we have external economies of scale. With external economies,
costs also may fall because of increased specialization, better training of workers, faster innovation, or
shared supplier relationships. These factors are typically referred to as positive externalities; industry-
level negative externalities are called external diseconomies.

Businesses in the same industry tend to cluster in together. For example, a film studio might determine
that California is a particularly good location for year-round film-making, so it moves to Hollywood. New
movie producers also move to Hollywood because there are more camera operators, actors, costume
designers, and screenwriters in the area. Then, more studios might decide to move to Hollywood to take
advantage of the specialized labor and infrastructure already in place, thanks to the success of the first
firm.

As more and more firms succeed in the same area, new industry entrants can take advantage of even
more localized benefits. It makes sense for industries to concentrate in areas where they are already
strong.

Ricardian Theory of International Trade - The first theory section of this course develops models
that provide different explanations or reasons why trade takes place between countries. The

five basic reasons why trade may take place are summarized below. The purpose of each model

is to establish a basis for trade and then to use that model to identify the expected effects of

trade on prices, profits, incomes, and individual welfare.

Reason for Trade #1: Differences in Technology

Advantageous trade can occur between countries if the countries differ in their
technological abilities to produce goods and services. Technology refers to the
techniques used to turn resources (labor, capital, land) into outputs (goods and
services). The basis for trade in the Ricardian model of comparative
advantage in Chapter 2 "The Ricardian Theory of Comparative Advantage" is
differences in technology.

Reason for Trade #2: Differences in Resource Endowments

Advantageous trade can occur between countries if the countries differ in their
endowments of resources. Resource endowments refer to the skills and abilities of
a country’s workforce, the natural resources available within its borders (minerals,
farmland, etc.), and the sophistication of its capital stock (machinery,
infrastructure, communications systems). The basis for trade in both the pure
exchange model in Chapter 3 "The Pure Exchange Model of Trade" and the
Heckscher-Ohlin model in Chapter 5 "The Heckscher-Ohlin (Factor Proportions)
Model" is differences in resource endowments.

Reason for Trade #3: Differences in Demand

Advantageous trade can occur between countries if demands or preferences differ

between countries. Individuals in different countries may have different
preferences or demands for various products. For example, the Chinese are likely
to demand more rice than Americans, even if consumers face the same price.
Canadians may demand more beer, the Dutch more wooden shoes, and the
Japanese more fish than Americans would, even if they all faced the same prices.
There is no formal trade model with demand differences, although the monopolistic
competition model in Chapter 6 "Economies of Scale and International Trade" does
include a demand for variety that can be based on differences in tastes between
consumers.

Reason for Trade #4: Existence of Economies of Scale in Production

The existence of economies of scale in production is sufficient to generate

advantageous trade between two countries. Economies of scale refer to a
production process in which production costs fall as the scale of production rises.
This feature of production is also known as “increasing returns to scale.” Two
models of trade incorporating economies of scale are presented in Chapter 6
"Economies of Scale and International Trade".

Reason for Trade #5: Existence of Government Policies

Government tax and subsidy programs alter the prices charged for goods and
services. These changes can be sufficient to generate advantages in production of
certain products. In these circumstances, advantageous trade may arise solely due
to differences in government policies across countries. Chapter 8 "Domestic
Policies and International Trade", Section 8.3 "Production Subsidies as a Reason
for Trade" and Chapter 8 "Domestic Policies and International Trade", Section 8.6
"Consumption Taxes as a Reason for Trade" provide several examples in which
domestic tax or subsidy policies can induce international trade.

Summary

There are very few models of trade that include all five reasons for trade
simultaneously. The reason is that such a model is too complicated to work with.
Economists simplify the world by choosing a model that generally contains just one
reason. This does not mean that economists believe that one reason, or one model,
is sufficient to explain all outcomes. Instead, one must try to understand the world
by looking at what a collection of different models tells us about the same
phenomenon.

For example, the Ricardian model of trade, which incorporates differences in

technologies between countries, concludes that everyone benefits from trade,
whereas the Heckscher-Ohlin model, which incorporates endowment differences,
concludes that there will be winners and losers from trade. Change the basis for
trade and you may change the outcomes from trade.

In the real world, trade takes place because of a combination of all these different
reasons. Each single model provides only a glimpse of some of the effects that
might arise. Consequently, we should expect that a combination of the different
outcomes that are presented in different models is the true characterization of the
real world. Unfortunately, because of this, understanding the complexities of the
real world is still more of an art than a science.

The Doha Agenda - https://www.wto.org/english/tratop_e/dda_e/dda_e.htm