IRC030 International Economics (GSIS)

1 International Economics
GSIS, Korea University

Course Overview

Salvatore: International Economics, 10th Edition © 2013 John Wiley & Sons, Inc.
 Course Overview
◼ Course: IRC030 International Economics
◼ Lecturer: Geunhyo Kim, Ph.D.
◼ Teaching:
◼ DISS314 International Economic Cooperation
(Undergraduate)
◼ IRC030 International Economics (Graduate)
◼ Research Interests:
◼ Structural reforms, Strategic trade policy, WTO,
Digitalization in finance and trade, Inclusive
growth, Firm behavior, Labor productivity

Salvatore: International Economics, 10th Edition © 2013 John Wiley & Sons, Inc.
 Course Overview
◼ Class Information:
◼ 9:00 ~ 11:45 am on Mondays
◼ 1st session – 9:00 ~ 10:15 am
◼ 2nd session – 10:30 ~ 11:45 am
◼ #423, International Studies Hall
◼ Textbook
◼ Dominick Salvatore, International Economics:
Trade and Finance, 11th edition, John Wiley &
Sons Inc., 2013
◼ Lecture notes(slides) will be provided in advance.
Salvatore: International Economics, 10th Edition © 2013 John Wiley & Sons, Inc.
 Course Overview
◼ Course Description:
◼ This course aims to investigate the
comprehensive and sophisticated theories and
principles of international economics.
◼ Students are expected:
◼ To understand how to apply important theoretical
frameworks to case studies of international trade
◼ To explore various aspects of international trade
policies
◼ To discuss relevant economic issues in the era of
globalization.
Salvatore: International Economics, 10th Edition © 2013 John Wiley & Sons, Inc.
 Course Overview
◼ Course Objectives:
◼ To learn the essential theories and principles
of international economics
◼ To investigate the important trade policies in
international commerce
◼ To discuss major issues in relation to
international trade and economic cooperation

Salvatore: International Economics, 10th Edition © 2013 John Wiley & Sons, Inc.
 Course Overview
◼ Course Structure

Lecture Lecture

Short Discussion
Break

Salvatore: International Economics, 10th Edition © 2013 John Wiley & Sons, Inc.
 Course Overview
◼ Course Evaluation:
◼ Attendance (10%)
◼ Group Presentation* (20%)
◼ Midterm Examination (35%)
◼ Final Examination (35%)
◼ *For group presentations, students are expected
to participate in peer evaluation and discussion
sessions for every presentation.

Salvatore: International Economics, 10th Edition © 2013 John Wiley & Sons, Inc.
 Course Overview
◼ National Holidays
◼ 9/9(Fri)~12(Mon): Chuseok (Korean Thanksgiving Day)
◼ 10/3(Mon): National Foundation Day of Korea
◼ 10/10(Mon): Hangul Proclamation Day

◼ Lectures on National holidays will be replaced by

recorded lectures by the instructor.
◼ The video lectures will be uploaded on Blackboard.

Salvatore: International Economics, 10th Edition © 2013 John Wiley & Sons, Inc.
 Course Overview
◼ Course Schedule and Tentative Weekly Topics
1. Course overview and introduction
2. Law of comparative advantage
3. Standard theory of international trade
4. Demand and supply, offer curves, and terms of trade
5. Factor endowments and H-O theory
6. Economies of scale, imperfect competition, and
international trade
7. Economic growth and international trade
8. Midterm exam

Salvatore: International Economics, 10th Edition © 2013 John Wiley & Sons, Inc.
 Course Overview
◼ Course Schedule and Tentative Weekly Topics
9. Trade Restrictions: Tariffs
10. Nontariff Trade Barriers and the New Protectionism
11. Economic Integration: Customs Unions and Free
Trade Areas
12. International Trade and Economic Development
13. International Resource Movements and
Multinational Corporations

Salvatore: International Economics, 10th Edition © 2013 John Wiley & Sons, Inc.
 Course Overview
◼ Course Schedule and Tentative Weekly Topics
14. Group presentation session 1
15. Group presentation session 2
16. Final Exam

*The course schedule is subject to change according to the progress.

Salvatore: International Economics, 10th Edition © 2013 John Wiley & Sons, Inc.
 Course Overview
◼ Group Presentation Session
◼ 3-5 Group presentations
(subject to change depending on the number of students)
◼ Peer evaluation
◼ Q&A and discussion sessions
◼ Grading for group presentation (20%)
◼ Peer evaluation (10%)
◼ Lecturer’s evaluation (10%)

Salvatore: International Economics, 10th Edition © 2013 John Wiley & Sons, Inc.
 CHAPTER O N E

1 International Economics
Eleventh Edition

Introduction
Dominick Salvatore
John Wiley & Sons, Inc.

Salvatore: International Economics, 10th Edition © 2013 John Wiley & Sons, Inc.
 Learning Goals:
◼ Understand the meaning and importance of
globalization.

◼ Understand the relationship between international

trade and the nation’s standard of living.

◼ Describe the subject matter (trade and monetary

aspects) of international economics.

◼ Identify the major international economic problems

and challenges today.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 1.1 The Globalization of the World Economy

◼ A globalizing world provides opportunities and

challenges to nations and people in the world.
◼ Flow of goods and services (Flow:import&exports)
◼ Flow of labor and jobs
◼ Migration
◼ High-skilled vs. low-skilled
◼ Flow of financial instruments, currency
◼ Investment abroad, purchase of financial
instruments (stocks and bonds) of any companies
around the world
◼ Currency exchange (KRW to USD or Euros)
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 1.1 The Globalization of the World Economy

◼ Tastes, production, competition, labor

markets and financial markets are rapidly
globalizing.
◼ This affects people’s lives deeply as
consumers, workers, investors and voters –
yes, we live in a global economy.

Salvatore: International Economics, 10th Edition © 2013 John Wiley & Sons, Inc.
 1.1 The Globalization of the World Economy

◼ Three periods of rapid globalization

1980 to
1870-1914 1945-1980
present

Salvatore: International Economics, 10th Edition © 2013 John Wiley & Sons, Inc.
 1.1 The Globalization of the World Economy

◼ Three periods of rapid globalization

◼ 1870-1914
◼ Resulted from Industrial Revolution in Europe and
the opening up of new, resource-rich, but sparsely
populated lands
▪ in North America (U.S., Canada), South America
(Argentina, Chile, Uruguay), Australia and New
Zealand, and South Africa.
▪ Millions of immigrants, vast amounts of foreign
investments, increased production
▪ “Regions of recent settlement”
◼ Ended with breakout of World War I in 1914
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 1.1 The Globalization of the World Economy

◼ “Regions of recent settlement”

◼ The term Regions of Recent Settlement was
adopted by Ragnar Nurkse to designate those
areas which successfully developed during the
late nineteenth and early twentieth centuries
◼ in response to the stimulus of expanding world
trade which accompanied the industrialization
of the North Atlantic economies.

Source: Fogarty, J. P. (1981). The comparative method and the nineteenth century regions of recent settlement. Australian Historical Studies, 19(76), 412-429.
 1.1 The Globalization of the World Economy

◼ Achieved through massive transfers of

European people, capital and technology in
response to the growth of international
market opportunities.
◼ Regarded these areas as the fortunate
beneficiaries of an expansive phase in the
international economy.

Source: Fogarty, J. P. (1981). The comparative method and the nineteenth century regions of recent settlement. Australian Historical Studies, 19(76), 412-429.
 1.1 The Globalization of the World Economy

◼ Three periods of rapid globalization

◼ 1945-1980 (second phase)
◼ End of WWII in 1945
◼ Rapid increase of international trade
◼ Dismantling (open their eco for other nations, like trading)
of heavy trade protection that had been put in
place during the Great Depression that began
in the U.S. in 1929 and during WWII

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 1.1 The Globalization of the World Economy

◼ Three periods of rapid globalization

◼ 1980 to present
◼ Most pervasive and dramatic period of globalization
◼ Fueled by improvements in telecommunications and

transportation
◼ Many Countries did Elimination of restrictions on

capital flows led to massive international capital

movements
◼ Participation of most countries around the world

◼ GFC in 2008 (the deepest economic crisis of the

postwar period) slowed down the march of

globalization
Salvatore: International Economics, temporarily.
11th Edition © 2013 John Wiley & Sons, Inc.
Factors Driving Globalization

1. Liberalization of trade and investment

◼ End of WWII and establishment of General
Agreement on Tariffs and Trade (GATT) in 1947
(signed by 23 nations in Geneva)
◼ The multilateral negotiations for tariff reduction/
elimination and freer movement of factors
◼ Establishment of WTO in 1995
◼ Deregulation measures on capital and services
markets, expansion of international trade
Factors Driving Globalization (Cont.)

2. Economic growth and income increase

◼ Economic growth increases import demand (e.g.
consumer durable goods).
◼ Consumer durable goods: automobiles, furniture,
household appliances and mobile phones
◼ Income increase generates cross-border demand
for services (e.g. tourism, education, health care
etc.).
Factors Driving Globalization (Cont.)

3. Development of transportation and ICT

(Information and communications technology)
◼ Technological progress promotes international
trade by creating a technological gap between
countries.
◼ Facilitating international trade by shortening
geographical and temporal distances
◼ Development of ICT since the 1980s, international
transactions that transcend time and space have
become available.
◼ Expanding commercial services (e.g. finance, insurance,
education etc.)
◼ Reducing transaction costs
Factors Driving Globalization (Cont.)

4. Proliferation of MNCs (multinational

corporations)
◼ Linking international exports and imports
through international sales network within
corporations
◼ Promoting global movement of factors
through local production and allocation of
production bases
◼ Increasing trend of intra-industry trade rather
than inter-industry trade due to MNCs →
vertical intra-industry trade ↑
Factors Driving Globalization (Cont.)

5. Spread of GVC (Global Value Chain)

◼ Global production network
◼ Design, R&D, Production, Marketing,
Distribution, Services
◼ Supply fragmentation
◼ Producing the parts in the region with the
most favorable production conditions
◼ Advanced economies: production costs ↓,
global competitiveness ↑
◼ Developing economies: employment ↑,
technology ↑
 Factors Driving Globalization (Cont.)

Salvatore: International Economics, 10th Edition © 2013 John Wiley & Sons, Inc.
 1.1 The Globalization of the World Economy

Some raise questions that:

◼ Globalization brings more benefits and
advantages? Or more disadvantages or side
effects?
◼ Does getting cheaper or better goods and
services from abroad justify sacrificing
domestic jobs?
◼ Why are some people in some countries very
rich while others dismally poor and starving?

Salvatore: International Economics, 10th Edition © 2013 John Wiley & Sons, Inc.
 1.1 The Globalization of the World Economy

◼ Anti-Globalization Movement
◼ Negative aspects of globalization have given rise
to a rethinking of the age-old belief in free trade
and to a strong anti-globalization movement
◼ Claims globalization sacrifices human and
environmental well-being to corporate profits of
multinationals
◼ Globalization is blamed for:
◼ World poverty and child labor in poor countries
◼ Job losses and lower wages in rich countries
◼ Environmental pollution and climate change
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
Various aspects of globalization

◼ Efficient resource allocation

◼ Expansion of GVCs → globalization of
production and market
◼ Economies of scale ↑, competitiveness ↑,
efficient resource allocation ↑ → welfare ↑

◼ Accelerating economic integration

◼ Freer movement of goods, services, people and
capital → One global market
 Various aspects of globalization (Cont.)

◼ Significant roles of international organizations

◼ Production, export, import, employment, price
level, international balance of payments are more
affected by external shocks.
◼ Increasing roles of international organizations
and norms that regulate international order and
relations
◼ E.g., The WTO supports multilateralism under GATT
system.
Various aspects of globalization (Cont.)

◼ Diversification of international trade entities

◼ Main entities of globalization: Individual
countries and MNCs + RTAs, International
organizations
Various aspects of globalization (Cont.)

◼ Income inequality
◼ Competitive environment ↑ (Free trade)
◼ Income inequality between countries, industries
and people
◼ Capital-intensive vs. labor-intensive
▪ High-skilled vs. low-skilled
◼ High-tech industries vs. low-tech industries
◼ Manufacturing vs. services
◼ High-tech industries → technological gap
between advanced economies(capital-intensive)
and developing economies (labor-intensive)
Various aspects of globalization (Cont.)

◼ Movement toward knowledge-intensive

industry
◼ Initial stage: R&D, Capital, Time ↑
◼ After: Winner-take-all
◼ Winner-take-all? → Mobile phones, semi-
conductor, pharmaceuticals → Advanced
economies?
Various aspects of globalization (Cont.)

◼ Environmental and health issues

◼ Border opening and expansion of free trade →
firms’ profit maximization → mass production
and mass utilization of resources → risks for
resource depletion
◼ Damage or environmental pollution of the
shared resources, COVID-19 pandemic
◼ Concept of “sustainable” growth and
development ⇑
Various aspects of globalization (Cont.)

◼ Extinction of sociocultural diversity

◼ The failure to preserve the traditional and
cultural assets of uncompetitive regions or
peoples is also a dark side of globalization.
◼ As globalization spreads, a country’s domestic
policies become more influenced by foreign
countries, which are interdependent, and thus,
policy autonomy is limited.
◼ The independence of each country's economic
policy may be lost, and the uncertainty of the
national economy may increase.
 1.1 The Globalization of the World Economy
CONCLUSION

◼ Globalization has many social, political, legal

and ethical aspects.
◼ Globalization is still important in that:
◼ It increases efficiency in the production of
goods and services.
◼ It is inevitable in our lives, and we would like
globalization to be sustainable, humanizing
and fair.

Salvatore: International Economics, 10th Edition © 2013 John Wiley & Sons, Inc.
 1.2 International Trade and the Nation’s
Standard of Living

◼ Interdependence
◼ Economic relationship among nations
◼ Roughly measured as ratio of a nation’s imports
and exports of goods and services to GDP
◼ GDP refers to the total value of all goods and
services produced in the nation in a year.
◼ Much larger for smaller industrial and
developing countries than for larger and
advanced countries like the United States
(see Figure 1.1)

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 FIGURE 1-1 Imports and Exports as a Percentage of GDP in
Various Countries, 2011 data.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Imports and Exports as a Percentage of GDP in
Various Countries (2016-2020)

2016 2017 2018 2019 2020

Country
Exports Imports Exports Imports Exports Imports Exports Imports Exports Imports

Korea 33.03 27.08 35.34 29.48 35.06 31.02 32.84 30.49 31.28 28.55

Japan 13.10 12.34 14.34 13.81 14.90 15.11 13.93 14.24 - -

Mexico 34.60 1.92 35.23 1.93 36.75 1.98 36.22 - 38.68 -

U.S. 7.74 11.67 7.92 11.97 8.08 12.31 7.67 11.65 - -

Belgium 83.74 79.76 85.67 81.59 86.24 83.72 83.81 80.23 81.48 76.87

Netherlands 59.75 52.08 63.47 55.53 64.35 57.03 63.59 56.76 60.43 53.14

Poland 43.15 42.24 44.49 44.39 44.86 45.77 44.74 44.52 45.60 43.26

U.K. 14.65 21.41 15.86 22.67 15.88 22.56 15.67 22.00 14.08 20.09
Source: Author’s compilation based on KOSIS (Unit: Percent).
 1.2 International Trade and the Nation’s
Standard of Living

◼ Even though the U.S. relies to a relatively small

extent on international trade, a great deal of its
high standard of living depends on it.
◼ Sources of potential gain for United States:
◼ Access to items with limited availability
domestically (e.g. coffee, bananas, copper and
other minerals)
◼ Access to lower cost products
◼ Access to greater product variety

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 1.2 International Trade and the Nation’s
Standard of Living

◼ Economic interdependence has been

increasing over the years.
◼ World trade has increased faster than world
production, except in 2001 and 2009
(see Figure 1.2).
◼ Economic recession in the U.S. in 2001 and fear of
terrorism following September 11, 2001 (attack on
World Trade Center in NYC and the Pentagon in
Washington, D.C.)
◼ Deepest recession of the postwar period triggered
by GFC in 2009

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 FIGURE 1-2 Growth of World Production and Trade, 2000-2011
(annual percentage changes).
In all likelihood, trade will continue to serve as a strong stimulus to world growth in the future.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 1.2 International Trade and the Nation’s
Standard of Living

◼ Trade makes nations interdependent, but there

are other channels of interdependence as well.
◼ Economic events and policies in one nation
significantly affect other nations (vice versa).
◼ Economic stimulus in the U.S. results in
increased demand in other nations, stimulating
their economies as well.
◼ An increase in U.S. interest is likely to attract
funds (capital) from abroad and increase the
international value of dollar.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 1.2 International Trade and the Nation’s
Standard of Living

◼ Trade negotiations have effects on volumes

of trade and on wages and employment in
industries at home and abroad that produce
export goods.
◼ Trade negotiations that reduce trade barriers
across nations → increase in the exports of high-
technology goods (computers) → increase in the
employment and wages in those industries in the
U.S. → increase in the imports of shoes and
textiles (despite reducing employment and wages
in those sectors)

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 1.2 International Trade and the Nation’s
Standard of Living

◼ We see how closely linked, or

interdependent, nations are in today’s world
and how government policies aimed at
solving domestic issues can have
international repercussions.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 1.3 The International Flow of Goods, Services,
Labor and Capital

◼ Gravity Model
◼ Other things equal, the bilateral trade between
two countries is proportional, or at least
positively related, to the product of the two
countries’ GDPs; the greater the distance
between the two countries, the smaller is their
bilateral trade.

◼ That is, the larger (and more equal in size) and

the closer two countries are, the larger the
volume of trade between them is expected to be.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
1.3 The International Flow of Goods, Services,
Labor and Capital

◼ Factors in gravity model that may determine

factors that increase trade!
bilateral trade
1) Size of economies: Similarly sized economies
are more likely to trade with each other.
2) Geographical proximity: Countries close
together have lower transport costs, similar
customs and familiarity (Best for a shared
border)

Source: Economics Help (Gravity theory)

1.3 The International Flow of Goods, Services,
Labor and Capital

3) Shared history
4) Language similarities: This strengthens the
bonds of trade. It is easier to communicate
and there is likely to be shared cultural
factors.
5) Similar time zones
1.3 The International Flow of Goods, Services,
Labor and Capital

6) Similarities in consumer preferences:

▪ A country which has high levels of education
and technology will produce high tech, high
value added goods and services.
▪ So it is likely to trade with a country of
similar GDP per capita.
▪ It is hard to sell financial services and high
tech IT to developing economies.
1.3 The International Flow of Goods, Services,
Labor and Capital

India EU

UK
 1.3 The International Flow of Goods, Services,
Labor and Capital

◼ Gravity Model
𝑌1 ∗𝑌2
◼ 𝑇=𝐶 ∗ , where
𝐷
◼ T = volume of trade between countries 1 and 2
◼ C = a constant
◼ Y = GDP
◼ D = distance between countries 1 and 2

◼ Other factors that increase trade: same language,

similar culture, lack of trade restrictions etc.

Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.
 1.3 The International Flow of Goods, Services,
Labor and Capital

U.S.
More gains from trade with

Others
Closer Larger
(Language,
nations economies
culture etc.)

Salvatore: International Economics, 10th Edition © 2013 John Wiley & Sons, Inc.
 1.3 The International Flow of Goods, Services,
Labor and Capital

◼ Table 1.2 Major trade partners of the U.S. in 2011

(Unit: USD billions)

Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.
APPENDIX – Merchandise, 2010

World top and largest industrial countries are China and U.S.
Leading exporters are also leading importers for the most part.
 APPENDIX – Commercial Services, 2010

U.S. and Germany are the largest leading exporters and importers of commercial services.
Nowadays, the trade in services is now rapidly increasing more quickly than the
merchandise trade as a reflection of the shift toward the service economy in most countries.
 1.3 The International Flow of Goods, Services,
Labor and Capital

◼ The International Flow of Labor

◼ About 190 million people live in a country other
than where they were born.
◼ Nearly 60% of them are in rich countries.
(36 million in Europe and 38 million in the U.S.)

◼ Migration is primarily for economic reasons,

although nations place many restrictions on
migration.
◼ More restricted and regulated than the
international flow of goods, services and capital.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 1.3 The International Flow of Goods, Services,
Labor and Capital

◼ The International Flow of Capital

◼ In general, capital flows more freely than
labor, particularly financial capital.
◼ Financial or portfolio capital (bank loans and
bonds) generally move to nations and markets
where interest rates are higher.
◼ FDI in plants and firms flows to nations where
expected profits are higher.
◼ This leads to more efficient use of capital and
generally benefits both lenders and borrowers.

Salvatore: International Economics, 10th Edition © 2013 John Wiley & Sons, Inc.
 1.3 The International Flow of Goods, Services,
Labor and Capital

◼ Table 1.3 Major net exporters and importers

of capital in 2011

Since mid-1980s, U.S. has become an increasingly large net borrower from the
rest of the world to cover its excess of spending over production.
Salvatore: International Economics, 10th Edition © 2013 John Wiley & Sons, Inc.
 1.3 The International Flow of Goods, Services,
Labor and Capital

◼ Globalization after the Financial Crisis

◼ After peaking in 2007, the process of globalization
declined sharply during 2008-2009.
◼ This has improved recently but has not returned to the
pre-recession peak.
◼ Share of people living outside their home country has
remained stable at about 2.7% since 1980.
◼ Exception is short-term travel and students enrolled

in foreign universities, which has increased.

◼ Cross-border flow of data and communications has

increased even more.

Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.
 FIGURE 1-3 Goods, Services, and Financial Flows, 1980-2014.

Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.
 1.4 International Economic Theories and Policies

◼ International Trade Theory (Ch. 2-7)

◼ Analyzes the basis of and the gains from
international trade.
◼ International Trade Policy (Ch. 8-12)
◼ Examines the reasons for and the effects of
restrictions on international trade.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 1.4 International Economic Theories and Policies

◼ Balance of Payments
◼ Measures a nation’s total receipts from and total
payments to rest of the world.
◼ The current account: a nation's net trade in goods
and services, net earnings on cross-border
investments, and net transfer payments.
◼ The capital account: a nation's transactions in
financial instruments and central bank reserves.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 1.4 International Economic Theories and Policies

◼ Adjustments in the Balance of Payments

◼ Focuses on the relationship between internal
and external aspects of the economy of a
nation, and their interdependence with rest of
the world economy under different
international monetary systems.

Salvatore: International Economics, 8th Edition © 2013 John Wiley & Sons, Inc.
 1.5 Current International Economic Problems

◼ Slow Growth and High Unemployment in

Advanced Economics after the “Great Recession”
◼ GFC in 2008: U.S. subprime housing mortgage market
crisis
◼ U.S. and other advanced nations’ response by rescuing
banks and financial institutions from bankruptcy ⇢
slashing interest rates and introducing huge economic
stimulus packages
◼ Still serious problems in Greece, Portugal, Spain and
Italy → Deep crisis from overborrowing, unsustainable
budget deficits, and loss of international
competitiveness power.
Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.
 1.5 Current International Economic Problems

◼ Trade Protectionism in Advanced Countries

in a Rapidly Globalizing World
◼ US-China trade war
◼ Trump and Biden administration’s revision of
FTAs and domestic bills to produce more US
products and strengthen rules of origins
◼ Excessive Fluctuations and Misalignments in
Exchange Rates, and Financial Crises
◼ Periodic financial crises have led to financial
and economic instability (AFC ⇢ GFC ⇢ …)
Salvatore: International Economics, 8th Edition © 2013 John Wiley & Sons, Inc.
 1.5 Current International Economic Problems

◼ Structural Imbalances in Advanced Economies, and

Insufficient Restructuring in Transition Economies
◼ U.S.: excessive spending and inadequate national
saving (more borrowing abroad) → unsustainable
trade deficits and unstable financial conditions
◼ Japan: bubbles in economy, and serious
inefficiencies in distribution system → slowing
their growth
◼ Transition economies: need for restructuring to
establish full-fledged market economies and
achieve more rapid growth
Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.
 1.5 Current International Economic Problems

◼ Deep Poverty in Many Developing Countries

Sub-Saharan Africa: deep poverty,
◼
unmanageable international debts, economic
stagnation, and inequality level ⇡
◼ Resource Scarcity, Environmental Degradation,
Climate Change, and Unsustainable Development
◼ Price of petroleum and other raw materials rise
sharply ⇡⇡
◼ Air pollution, unusual weather conditions, and
reckless logging in Amazon Forest

Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.
 Summary
◼ Significance of globalization
◼ Efficiency growth
◼ Inevitable since international competition
requires it.
◼ Globalization is blamed for
◼ Income inequality
◼ Child labor
◼ Environmental pollution and others
◼ Giving rise to a strong anti-globalization movement

Salvatore: International Economics, 10th Edition © 2013 John Wiley & Sons, Inc.
 Summary (Cont.)
◼ Interdependence in the world economy is
reflected in the flow of goods, services, labor
and capital across nations.
◼ The gravity model postulates that (other
things equal), the bilateral trade between two
countries is proportional or at least positively
related to the product of the countries’ GDPs.
◼ The greater the distance between the two
countries / the smaller the GDPs.
◼ Current International Economic Problems
Salvatore: International Economics, 10th Edition © 2013 John Wiley & Sons, Inc.
 Problems
A. Does the trade between the U.S. and Brazil
and Argentina follow the prediction of the
gravity model? page:47
B. What does consumer demand theory predict
will happen to the quantity demanded of a
commodity if its price rises while everything
else is held constant?
C. What do you predict would happen to the
quantity of imports of a commodity if its
price to domestic consumers rose?
Salvatore: International Economics, 10th Edition © 2013 John Wiley & Sons, Inc.
 Problems (Cont.)
D. How can a government eliminate or reduce a
budget deficit?
E. How can a nation eliminate or reduce a
balance-of-payments deficit?
F. How can we deduce that nations benefit from
voluntarily engaging in international trade?
G. If nations gain from international trade, why
do you think most of them impose some
restrictions on the free flow of international
trade?
Salvatore: International Economics, 10th Edition © 2013 John Wiley & Sons, Inc.
 Problems (Cont.)
H. Can you think of some ways by which a
nation can gain at the expense of other
nations from trade restrictions?
I. When the value of the USD falls in relation
to the currencies of KRW, what do you think
will happen to the quantity of the U.S.
▪ Imports?
▪ Exports?

Salvatore: International Economics, 10th Edition © 2013 John Wiley & Sons, Inc.
 CHAPTER T W O

2 International Economics
Eleventh Edition

The Law of Comparative Advantage

Dominick Salvatore
John Wiley & Sons, Inc.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Learning Goals:
◼ Understand the law of comparative
advantage.

◼ Understand the relationship between

opportunity costs and relative commodity
prices.

◼ Explain the basis for trade and show the gains

from trade under constant cost conditions.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 2.1 Introduction
◼ Basic questions:
◼ What is the basis for trade?
◼ What are gains from trade?
◼ How are gains from trade generated? How large
are the gains and how are they divided among
the trading nations?
◼ What is the pattern of trade?
◼ What commodities are traded and which
commodities are exported and imported by each
nation?
◼ Assume two-nation, two-good world
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 2.2 The Mercantilists’ Views on Trade

◼ Mercantilism
◼ Economic philosophy in 17th and 18th
centuries, in England, Spain, France, Portugal
and the Netherlands.

◼ Belief that nation could become rich and

powerful only by exporting more than it
imported.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 2.2 The Mercantilists’ Views on Trade

◼ Mercantilism
◼ Export surpluses brought inflow of gold and
silver.
◼ Trade policy was to encourage exports and
restrict imports.
◼ One nation gained only at the expense of
another.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 2.2 The Mercantilists’ Views on Trade

◼ Mercantilists measured wealth of a nation by

stock of precious metals it possessed.

◼ In contrast, these days, we measure wealth of

a nation by its stock of human, man-made
and natural resources available for producing
goods and services.
◼ The greater the stock of resources, the greater the
flow of goods and services to satisfy human
wants, and the higher the standard of living.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 2.3 Trade Based on Absolute Advantage:
Adam Smith

◼ Adam Smith started with the simple truth:

◼ Two nations trade with each other voluntarily,
and both nations must gain.
◼ If one nation gained nothing or lost, it would
simply refuse to trade.

➢ However, how does this mutually beneficial trade

take place, and from where do these gains from
trade come?

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 2.3 Trade Based on Absolute Advantage:
Adam Smith

◼ A nation has absolute advantage over another

nation if it can produce a commodity more
efficiently.

◼ When one nation has absolute advantage in

production of a commodity, but an absolute
disadvantage with respect to the other nation in a
second commodity, both nations can gain by
specializing in their absolute advantage good and
exchanging part of the output for the commodity
of its absolute disadvantage.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 2.3 Trade Based on Absolute Advantage:
Adam Smith

◼ Examples:
◼ Canada is efficient in growing wheat but
inefficient in growing bananas.
◼ Nicaragua is efficient in growing bananas,
inefficient in growing wheat.
◼ Canada has absolute advantage in wheat,
Nicaragua has absolute advantage in bananas.
◼ Mutually beneficial trade can take place if both
countries specialize in their absolute advantage.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 2.3 Trade Based on Absolute Advantage:
Adam Smith

◼ Specialization and trade benefit both countries.

◼ Adam Smith and other classical economists
advocated a policy of laissez-faire, or
minimal/little government interference with
economic activity.
◼ Free trade would cause world resources to be
utilized most efficiently, maximizing world
welfare.
◼ Exceptions, such as protection of industries
important for national defense
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 2.3 Trade Based on Absolute Advantage:
Adam Smith

U.S. U.K.
Wheat (bushels/hour) 6 1
Cloth (yards/hour) 4 5

▪ U.S. has an absolute advantage over U.K. in wheat.

▪ U.K. has an absolute advantage over U.S. in cloth.
▪ Both nations can gain from specializing in production
and then trading.
▪ With trade, the U.S. would specialize in the production of
wheat and exchange part of it for the British cloth.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 2.3 Trade Based on Absolute Advantage:
Adam Smith
For one hour U.S. U.K.
Wheat (bushels/hour) 6W 1W
Cloth (yards/hour) 4C 5C

◼ U.S. 6W Exchange→ U.K. 6C

◼ U.S. gains 2C or saves ½ hour of labor time.
◼ U.K. receives 6W (equivalent to production of six-
hour labor in the U.K.).
◼ Six-hour labor in the U.K. = 30C in the U.K. (6 hours times 5
yards of cloth per hour)
◼ By being able to exchange 6C (requiring a little over
one hour to produce in the U.K.) for 6W with the U.S.,
the U.K. gains 24C or saves almost five hours of labor.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 2.4 Trade Based on Comparative Advantage:
David Ricardo

◼ Law of Comparative Advantage

◼ D. Ricardo presented the law of comparative
advantage in “Principles of Political Economy
and Taxation.”
◼ According to the law of comparative
advantage, even if one nation is less efficient
than the other nation in the production of both
commodities, there is still a basis for mutually
beneficial trade.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 2.4 Trade Based on Comparative Advantage:
David Ricardo

◼ The first nation should specialize in the

production and export of the commodity in
which its absolute disadvantage is smaller
and import the commodity in which its
absolute disadvantage is greater.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 2.4 Trade Based on Comparative Advantage:
David Ricardo

U.S. U.K.
Wheat (bushels/hour) 6 1
Cloth (yards/hour) 4 2
◼ U.K. has an absolute disadvantage in both goods.
◼ Since U.K. labor is half as productive in cloth but six
times less productive in wheat compared to U.S., the
U.K. has a comparative advantage in cloth.
◼ U.S. has a comparative advantage in wheat.
◼ Both nations can gain if the U.S. specializes in wheat
and exports some of it in exchange for British cloth.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 2.4 Trade Based on Comparative Advantage:
David Ricardo

The Gains from Trade

◼ Both countries can gain from trade.
◼ The U.S. gains as long as 6W trade for more
than 4 C.
◼ The U.K. would not trade if it had to give up
more than 2C for 1W.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 2.4 Trade Based on Comparative Advantage:
David Ricardo

U.S. U.K.
Wheat (bushels/hour) 6 1
Cloth (yards/hour) 4 2
◼ U.S. 6W Exchange→ U.K. 6C
◼ U.S. would gain 2C or save ½ hour of labor time.
◼ For the U.K., 6W would require 6 hours to produce in
the U.K.
◼ U.K. instead use these 6 hours to produce 12C and
export 6C for 6W from the U.S.
◼ U.K. would gain 6C or save three hours of labor time.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 2.4 Trade Based on Comparative Advantage:
David Ricardo

◼ U.S. would gain if it could trade 6W for more than 4C

from U.K.
◼ U.K. → 6W = 12C (6 hours to produce)
◼ Anything less than 12C that U.K. must give up to obtain
6W from U.S. represents a gain from trade for U.K.
◼ U.S. gains to the extent that it can exchange 6W for
more than 4C from U.K.
◼ U.K. gains to the extent that it can give up less than 12C
for 6W from U.S.
◼ Thus the range for mutually beneficial trade is:
4C < 6W <12C

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 2.4 Trade Based on Comparative Advantage:
David Ricardo

◼ What is the total gain from this trade?

◼ When 6W are exchanged for 6C, U.S. gains
____ and U.K. ____ , making a total of ____ .
◼ The closer the rate of exchange is to 4C = 6W
(U.S. domestic rate), the smaller is the share of
the gain going to U.S. and the larger is the
share of the gain going to U.K.
◼ The closer the rate of exchange is to 6W = 12C
(U.K. domestic rate), the greater is the gain of
U.S. relative to that of U.K.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 2.4 Trade Based on Comparative Advantage:
David Ricardo

◼ What if U.S. exchanges 6W for 8C with U.K.?

◼ What if U.S. exchanges 6W for 10C?

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 2.4 Trade Based on Comparative Advantage:
David Ricardo

No Comparative Advantage
◼ The rare exception to the Law of Comparative
Advantage occurs when the absolute
disadvantage that one nation has relative to the
other nation is in the same proportion for both
commodities.
◼ Then there is no basis for mutually beneficial
trade.
U.S. U.K.
Wheat (bushels/hour) 6 3
Cloth (yards/hour) 4 2
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 2.4 Trade Based on Comparative Advantage:
David Ricardo

◼ Wages in the two countries will adjust to reflect

productivities
◼ Suppose that the wage rate in the U.S. is $6/hour,
and wages in the U.K. are ₤1/hour.
◼ In the U.S., 1 worker hour produces 6 bushels of
wheat, each bushel of wheat will cost $1.
◼ Likewise, in the U.K., 1 worker hour will produce 2
yards of cloth, so a yard of cloth will cost ₤0.50.
◼ If the exchange rate is ₤1 = $2, we can show each
country’s prices in terms of U.S. dollars.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 2.4 Trade Based on Comparative Advantage:
David Ricardo

U.S. U.K.
Price of one bushel of wheat $1.00 $2.00
Price of one yard of cloth 1.50 1.00

◼ The table reflects an exchange rate of ₤1 = $2.

◼ For mutually beneficial trade, the price of a bushel
of wheat must be between $1 and $2.
◼ Changes in exchange rates will change gains from
trade and possibly patterns of trade.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 2.5 Comparative Advantage and
Opportunity Costs

◼ Ricardo based the law of comparative

advantage on many assumptions:
1) Only two nations and two commodities
2) Free trade
3) Perfect mobility of labor within each nation but
immobility between two nations
4) Constant costs of production
5) No transportation costs
6) No technical change
7) Labor theory of value

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 2.5 Comparative Advantage and
Opportunity Costs

◼ The original idea of comparative advantage

was based on the labor theory of value:
◼ The value or price of a commodity depends
exclusively on the amount of labor used to
produce it.
◼ Can use the opportunity cost theory to
explain comparative advantage:
◼ The opportunity cost of a good is the amount of a
second good that must be given up to release just
enough resources to produce one additional unit
of the first good.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 2.5 Comparative Advantage and
Opportunity Costs

◼ Therefore, the nation with the lower

opportunity cost in the production of a
commodity has a comparative advantage in
that commodity (and a comparative
disadvantage in the second commodity).
◼ If in the absence of trade the U.S. must give up
two-thirds of a unit of cloth to release just
enough resources to produce one additional
unit of wheat domestically, then the
opportunity cost of wheat is two-thirds of a unit
of cloth.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 2.5 Comparative Advantage and
Opportunity Costs

◼ Production Possibilities Frontier

◼ A curve that shows alternative combinations of the
two commodities a nation can produce by fully
using all resources with best available technology.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 FIGURE 2-1 The Production Possibility Frontiers of the
United States and the United Kingdom.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 2.5 Comparative Advantage and
Opportunity Costs

◼ In Figure 2.1, the PPF of U.S. and U.K. are

straight lines that reflects the opportunity
costs are constant.
◼ For each additional 1W to be produced, the
U.S. must give up 2/3C, and the U.K. must
give up 2C, no matter from which point on its
PPF the nation starts.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 2.5 Comparative Advantage and
Opportunity Costs

◼ Constant opportunity costs arise when:

1. Resources are either perfect substitutes for
each other or used in fixed proportion in
production of both commodities, and
2. All units of the same factor are homogeneous
of exactly the same quality.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 2.5 Comparative Advantage and
Opportunity Costs

◼ Opportunity costs and relative commodity prices

◼ (Absolute) slope of PPF or transformation curve →
Marginal rate of transformation
◼ The slope of the U.S. transformation curve is
120/180=2/3 =Opportunity cost of wheat in the
U.S. and remains constant.
◼ The slope of the U.K. transformation curve is
120/60=2=Opportunity cost of wheat in the U.K.
and remains constant.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 2.5 Comparative Advantage and
Opportunity Costs

◼ On the assumptions that prices equal costs of

production and that the nation does produce
both some wheat and some cloth, the
opportunity cost of wheat is equal to the price
of wheat relative to the price of cloth.

𝑃𝑊 /𝑃𝐶

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 2.5 Comparative Advantage and
Opportunity Costs

𝑃𝑊 2 𝑃𝑐
◼ = in the U.S.; inversely = 1.5
𝑃𝐶 3 𝑃𝑤
𝑃𝑊 𝑃𝑐 1
◼ = 2 in the U.K.; inversely =
𝑃𝐶 𝑃𝑤 2
◼ The lower 𝑃𝑤 /𝑃𝑐 in the U.S. is a reflection of its
comparative advantage in wheat.
◼ The lower 𝑃𝑐 /𝑃𝑤 in the U.K. reflects its
comparative advantage in cloth.
◼ Demand considerations don’t enter at all in the
determination of relative commodity prices.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 2.6 The Basis for and the Gains from Trade
under Constant Costs

◼ In the absence of trade, a nation can only

consume the commodities that it produces.
◼ Then, a nation’s production possibilities
frontier also represents its consumption
frontier.
◼ Which combination of commodities the
nation actually chooses to produce and
consume depends on the people’s tastes, or
demand considerations.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 In the absence of trade - US at Point A on PDF
- UK at Point A' on PDF
With the possibility Us specicialites in wheat A-B

Consumtion at Point E

FIGURE 2-2 The Gains from Trade.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 2.6 The Basis for and the Gains from Trade
under Constant Costs

◼ Increased consumption of both wheat and

cloth in both nations was made possible by
the increased output that resulted as each
nation specialized in the production of
commodities of its comparative advantage.
◼ In the absence of trade, the U.S. produced 90W
and U.K. 40W, for a total of 130W.
◼ With specialization in production and trade,
180W are produced (all in the U.S.).
◼ Similarly, 120C are produced (all in the U.K.).
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 2.6 The Basis for and the Gains from Trade
under Constant Costs

◼ Increased output resulting from

specialization and trade represents nations’
gains from trade, allowing nations to
consume outside production possibilities
frontier.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 1: Combined supply curve Sw & SC -> using all Resources
2: 0B = 180W = Max Q of wheat in US at the constant O.C of Pw/Pc = 2/3

FIGURE 2-3 Equilibrium-Relative Commodity Prices with

Demand and Supply.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 2.6 The Basis for and the Gains from Trade
under Constant Costs

◼ Under constant cost conditions, nations will

completely specialize in their comparative
advantage .

◼ With complete specialization in both nations,

the equilibrium-relative commodity price of
each commodity lies between the pretrade
relative commodity price in each nation.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 2.6 The Basis for and the Gains from Trade
under Constant Costs

◼ Suppose that world demand for wheat

intersects world supply in the portion of the
supply curve between zero and B in the left
panel of the previous graph.
◼ Then trade takes place at the pretrade price in
the U.S., which will not completely specialize,
and all the gains from trade accrue to the U.K.
◼ This is the small country case, demonstrating
“the importance of being unimportant.”

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 2.7 Empirical Tests of the Ricardian Model

◼ McDougall (1951 and 1952)

◼ Argued that costs of production would be lower
in the U.S. in industries where U.S. labor was
more than twice as productive as U.K. labor.
◼ Found positive relationship between labor
productivity and exports; industries with
relatively productive labor in U.S. have higher
ratios of U.S. to U.K. exports, supporting
Ricardian theory of comparative advantage.
◼ Results supported by Balassa, Stern and Golub in
later studies.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 FIGURE 2-4 Relative Labor Productivities and Comparative
Advantage–United States and United Kingdom.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Summary
◼ The mercantilists believed that a nation could gain in
international trade only at the expense of other nations.
◼ Advocating import restrictions and strict
government regulations for economic activities
◼ Adam Smith argued that trade is based on absolute
advantage and benefits both nations.
◼ Each nation specializes in the production of the
commodity of its absolute advantage and exchange
part of its output for the commodity of its absolute
disadvantage.
◼ Limitation of absolute advantage to explain
international trade today
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Summary (Cont.)
◼ David Ricardo introduced the law of
comparative advantage.
◼ Even if one nation is less efficient than the other
nation in the production of two commodities,
there is still a basis for mutually beneficial
trade.
◼ The less efficient nation specialize in the
production and export of the commodity in
which its absolute disadvantage is smaller.
◼ Still limitations in terms of the labor theory of
value
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Summary (Cont.)
◼ According to the opportunity cost theory, the
cost of a commodity is the amount of a
second commodity that must be given up to
release just enough resources to produce one
additional unit of the first commodity.
◼ Opportunity cost of a commodity is equal to
the relative price of that commodity, and is
given by the slope of the PPF.
◼ Straight-line PPF: Constant O.C.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Summary (Cont.)
◼ In the absence of trade, a nation’s PPF is also its
consumption frontier.
◼ With trade, each nation can specialize in producing
the commodity of comparative advantage and
exchange the part of its output with the other
nation for the commodity of its comparative
disadvantage.
◼ With complete specialization, the equilibrium-
relative commodity prices will be between
pretrade-relative commodity prices prevailing in
each nation.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 ◼ Copyright 2013 John Wiley & Sons, Inc.

◼ All rights reserved. Reproduction or translation of this work beyond

that permitted in section 117 of the 1976 United States Copyright Act
without express permission of the copyright owner is unlawful.
Request for further information should be addressed to the
Permissions Department, John Wiley & Sons, Inc. The purchaser may
make back-up copies for his/her own use only and not for distribution
or resale. The Publisher assumes no responsibility for errors, omissions,
or damages caused by the use of these programs or from the use of the
information herein.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
CHAPTER T H R E E

3 International Economics
Eleventh Edition

The Standard Theory

Of International Trade
Dominick Salvatore
John Wiley & Sons, Inc.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Learning Goals:

◼ Understand how relative commodity prices

and the comparative advantage of nations are
determined under increasing costs.
◼ Show the basis and the gains from trade
under increasing costs.
◼ Explain the relationship between
international trade and deindustrialization in
the U.S. and other advanced nations.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 The Production Frontier with Increasing Costs

◼ Increasing Opportunity Costs

◼ A nation must give up more and more of one
commodity to release just enough resources to
produce each additional unit of another
commodity.

◼ Increasing cost production possibilities

frontier is concave to the origin (not a straight
line).

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 FIGURE 3.1 Production Frontiers of Nation 1 and Nation 2 with
Increasing Costs.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 The Production Frontier with Increasing Costs

◼ FIGURE 3.1 Production Frontiers of Nation 1 and

Nation 2 with Increasing Costs.
◼ Concave production frontiers reflect increasing
opportunity costs in each nation in the production of
both commodities.
◼ Nation 1 must give up more and more of Y for each
additional batch of 20X that is produces (illustrated
by downward arrows of increasing length).
◼ Nation 2 incurs increasing opportunity costs in terms
of forgone X (illustrated by increasing length of the
leftward arrows) for each additional batch of 20Y it
produces.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 The Production Frontier with Increasing Costs

◼ The marginal rate of transformation (MRT)

increases as more units of good X are
produced.
◼ MRT of X for Y: Amount of Y that a nation must
give up to produce each additional unit of X
◼ The marginal rate of transformation is another
name for opportunity cost.
◼ The value of MRT is given by the slope of the
PPF.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 The Production Frontier with Increasing Costs

◼ In Figure 3.1, if the slope of production

frontier (MRT) of Nation 1 at point A is ¼ , the
Nation 1 must give up ¼ of a unit of Y to
release just enough resources to produce one
additional unit of X at this point.

◼ If MRT equals 1 at point B, Nation 1 must

give up one unit of Y to produce one
additional unit of X at this point.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 The Production Frontier with Increasing Costs

◼ A movement from point A to B along the

production frontier of Nation 1 involves an
increase in the slope (MRT) from ¼ to 1, and
reflects the increasing opportunity costs in
producing more X.

◼ This is in contrast to the case of a straight-line

production frontier where the opportunity cost of
X is constant regardless of the level of output and
is given the constant value of the slope (MRT) of
the production frontier.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Reasons for increasing opportunity costs and
different production frontiers

◼ How do increasing opportunity costs arise? And

why are they more realistic than constant
opportunity costs?
◼ Increasing OC arise since resources or factors of
production
1) are not homogeneous (i.e., all units of the same
factor are not identical or of the same quality)
2) and are not used in the same fixed proportion or
intensity in the production of all commodities.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Reasons for increasing opportunity costs and
different production frontiers

◼ This means that as the nation produces more

of a commodity, it must utilize resources that
become progressively less efficient or less
suited for the production of that commodity.

◼ As a result, the nation must give up more and

more of the 2nd commodity to release just
enough resources to produce each additional
unit of the 1st commodity.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Reasons for increasing opportunity costs and
different production frontiers

Example of wheat and milk production

◼ Suppose some of a nation’s land is flat and
suited for growing wheat, and some is hilly
and better suited for grazing and milk
production.
◼ The nation originally specialized in wheat but
now wants to concentrate on producing milk.
◼ By transferring its hilly areas from wheat
growing to grazing, the nation gives up very
little wheat and obtain a great deal of milk.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Reasons for increasing opportunity costs and
different production frontiers

◼ Thus, the OC of milk in terms of the amount

of wheat given up is initially small.
◼ But if this transfer process continues,
eventually flat land, which is better suited for
wheat growing, will have to be used for
grazing.
◼ As a result, the OC of milk will rise, and the
production frontier will be concave from the
origin.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Reasons for increasing opportunity costs and
different production frontiers

◼ The difference in the production frontiers of

Nation 1 and 2 in Figure 3.1 is due to the fact
that two nations have different factor
endowments or resources at their disposal
and/or use different technologies in
production.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Reasons for increasing opportunity costs and
different production frontiers

◼ In the real world, the production frontiers of

different nations will usually differ, since
practically no two nations have identical
factor endowments (even if they could have
access to the same technology).
◼ As the supply or availability of factors and/or
technology changes over time, a nation’s
production frontier shifts.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Community Indifference Curves

◼ A community indifference curve shows

combinations of two commodities that yield
equal satisfaction to the community or nation.
◼ Represent measure of taste and preference.
◼ Characteristics of community indifference
curves:
◼ The higher the curve, the greater the utility.
◼ Negative slope, convex to the origin.
◼ The curves do not cross.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
Community Indifference Curves

A point of intersection
would refer to equal
satisfaction on two different
community indifference
curves, which is inconsistent
with their definition.
 Community Indifference Curves

◼ However, a particular set or map of community

indifference curves refers to a particular income
distribution within the nation.
◼ A different income distribution would result in a
completely new set of indifference curves, which
might intersect previous indifference curves.
◼ This is what may happen as a nation opens trade or
expands its level of trade.
◼ Exports will benefit, while domestic producers
competing with imports will suffer.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Community Indifference Curves

◼ There is also a differential impact on consumers,

depending on whether an individual’s consumption
pattern is oriented more toward the X or the Y
commodity.
◼ Thus, trade will change the distribution of real
income in the nation and may cause indifference
curves to intersect.
◼ In this case, we could not use CICs to determine
whether the opening or the expansion of trade
increased the nation’s welfare.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Community Indifference Curves

◼ One way out of this impasse is through compensation

principle.
◼ The nation benefits from trade if the gainers would
be better off even after fully compensating losers for
their losses.
◼ i.e., Government to tax enough of the gain to fully
compensate the losers with subsidies or tax relief.
◼ Although compensation principle does not
completely eliminate all of the conceptual difficulties
inherent in using community indifference curves, it
allows to draw them as non-intersecting.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 FIGURE 3.2 Community Indifference Curves for Nation 1 and
Nation 2.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Community Indifference Curves

◼ Figure 3.2 shows three hypothetical

indifference curves for Nation 1 and 2.
◼ They differ on the assumption that tastes, or
demand preferences, are different in two
nations.
◼ Points N and A give equal satisfaction to
Nation 1, since they are both on indifference
curve I.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Community Indifference Curves

◼ Points T and H refer to a higher level of

satisfaction, since they are on a higher
indifference curve (II).
◼ Even though T involves more of Y but less of
X than A, satisfaction is greater at T as it is on
indifference curve II.
◼ Point E refers to still greater satisfaction, since
it is on indifference curve III.
◼ For Nation 2, A’=R’<H’<E’

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Community Indifference Curves

◼ A negative slope
◼ As a nation consumes more of X, it must
consume less of Y if the nation is to have the
same level of satisfaction (i.e., remain on the
same level of satisfaction).
◼ As Nation 1 moves from N to A on indifference
curve I, it consumes more of X but less of Y.
◼ Similarly, as Nation 2 moves from A’ to R’ on
indifference curve I’, it consumes more of X but
less of Y.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Community Indifference Curves

◼ If a nation continued to consume the same amount of Y

as it increased its consumption of X, the nation would
necessarily move to a higher indifference curve.
◼ The marginal rate of substitution (MRS) falls as more of
good X is consumed.
The MRS of X for Y in consumption is the amount of Y
◼
that a nation could give up for one extra unit of X and
still remain on the same indifference curve.
◼ The slope, or MRS, of indifference curve I is greater at
point N than point A. (A’>R’ in Nation 2).

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Community Indifference Curves

◼ The decline in MRS is an reflection of the fact

that the more of X and the less of Y a nation
consumes, the more valuable to the nation is
a unit of Y at the margin compared with a
unit of X.
◼ Therefore, the nation can give up less and less
of Y for each additional unit of X it wants.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Community Indifference Curves

◼ Declining MRS means that community

indifference curves are convex from the
origin.
◼ Thus, while increasing OC in production is
reflected in concave production frontiers, a
declining marginal rate of substitution in
consumption is reflected in convex
indifference curves.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Equilibrium in Isolation

◼ Interaction of forces of demand (community

indifference curves) and supply (production
possibilities frontier) determine equilibrium
for a nation in the absence of trade (autarky).
◼ Equilibrium point = Point of maximum social
welfare in a nation in isolation
◼ In the absence of trade, a nation is in
equilibrium when it reaches the highest
indifference curve possible given its
production frontier.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Equilibrium in Isolation

◼ This occurs at the point where a CIC is

tangent to the nation’s production frontier.
◼ The common slope of the two curves at the
tangency point gives the internal equilibrium-
relative commodity price in the nation and
reflects the nation’s comparative advantage.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 FIGURE 3.3 Equilibrium in Isolation.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Equilibrium in Isolation

◼ Indifference curve I is the highest indifference

curve that Nation 1 can reach with its
production frontier.
◼ Nation 1 is in equilibrium, or maximizes its
welfare when it produces and consumes at
point A in the absence of trade, or autarky.
◼ Nation 2 is in equilibrium at point A’, where
its production frontier is tangent to
indifference curve I’.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Equilibrium in Isolation

◼ Since CICs are convex from the origin and

drawn as non-intersecting, there is only one
such point of tangency, or equilibrium.
◼ One such equilibrium exists since there are an
infinite number of curves are possible but
would not maximize the nation’s welfare.
◼ On the other hand, the nation cannot reach
higher indifference curves with the current
available resources and technology.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Equilibrium in Isolation

◼ The equilibrium-relative commodity price in

isolation = slope of tangency between PPF and
indifference curve at autarky point of
production and consumption.
◼ Equilibrium-relative commodity price of X in
𝑃 1
isolation is 𝑃𝐴 = 𝑋 = in Nation 1
𝑃𝑌 4
𝑃𝑋
and 𝑃𝐴′ = = 4 in Nation 2.
𝑃𝑌
◼ Relative prices are different in Nation 1 and
Nation 2 because of different shape and location
of PPF’s and indifference curves.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Equilibrium in Isolation

◼ Since in isolation 𝑃𝐴 < 𝑃𝐴′ Nation 1 has a CA in

commodity X and Nation 2 in Y.
◼ Both nations can gain if Nation 1 specializes in
the production and export of X in exchange for Y
from Nation 2.
◼ Figure 3.3 illustrates that the forces of supply (as
given by the nation’s production frontier) and
the forces of demand (as summarized by the
nation’s indifference map together determine
the equilibrium-relative commodity prices in
each nation in autarky.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Case Study 3.1 Comparative Advantage of the
Largest Advanced and Emerging Economies

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Basis for and Gains from Trade with
Increasing Costs

◼ Relative commodity price differentials

between two nations reflect comparative
advantages, and form basis for mutually
beneficial trade.

◼ Each nation should specialize in the

commodity they can produce at the lowest
relative price.
◼ Specialization will continue until relative
prices equalize between nations.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 FIGURE 3.4 The Gains from Trade with Increasing Costs.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Basis for and Gains from Trade with
Increasing Costs

◼ We’ve seen in Figure 3.3 that in the absence of the

trade, the equilibrium-relative price of X is ¼ in
Nation 1 and 4 in Nation 2.
◼ Thus, Nation 1 has a CA in X and 2 in Y.
◼ Suppose that trade between two nations becomes
possible (e.g., through elimination of government
obstacles to trade or drastic reduction in
transportation costs).
◼ Nation 1 should now specialize in production and
export of X in exchange for Y from Nation 2.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Basis for and Gains from Trade with
Increasing Costs
◼ Starting from point A (equilibrium in isolation), as Nation 1
specializes in the production of X and moves down its
production frontier, it incurs increasing OCs in the
production of X.
◼ This is reflected in the increasing slope of its production
frontier.
◼ Starting from A’, as Nation 2 specializes in the production
of Y and moves upward along its production frontier, it
experiences increasing OCs in the production of Y.
◼ This is reflected in the decline in the slope of its
production frontier (a reduction in the OC of X, meaning
a rise in the OC of Y).

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Basis for and Gains from Trade with
Increasing Costs

◼ This process of specialization in production

continues until relative commodity prices (the
slope of production frontiers) become equal
in two nations.
◼ The common relative price (slope) with trade
will be somewhere between the pre-trade
relative prices of ¼ and 4, at the level at
which trade is balanced.
◼ In Figure 3.4, this is 𝑷𝑩 = 𝑷𝑩′ = 𝟏

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Basis for and Gains from Trade with
Increasing Costs

◼ With trade, Nation 1 moves from point A

down to B in production.
◼ By then exchanging 60X for 60Y with Nation
2 (trade triangle BCE), Nation 1 ends up
consuming at point E (70X and 80Y) on its
indifference curve III.
◼ This is the highest level of satisfaction that
Nation 1 can reach with trade at Px/Py=1.
◼ Thus, Nation 1 gains 20X and 20Y from its no-
trade equilibrium point.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Basis for and Gains from Trade with
Increasing Costs

◼ Compare point E on indifference curve III

with A on indifference curve I.
◼ Line BE is called "trade possibilities line" or
simply "trade line" because trade takes along
this line.
◼ Similarly, Nation 2 moves from point A' up to
B' in production, and by exchanging 60Y for
60X with Nation 1 (trade triangle B'C'E'), it
ends up consuming at E' (100X, 60Y) on its
indifference curve III'.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Basis for and Gains from Trade with
Increasing Costs

◼ Thus, Nation 2 also gains 20X and 20Y from

specialization in production and trade.
◼ Note that with specialization in production
and trade, each nation can consume outside
its production frontier (also representing its
no-trade consumption frontier).

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Basis for and Gains from Trade with
Increasing Costs

◼ Equilibrium-relative commodity price with

trade = common relative price at which trade
is balanced. (𝑃𝐵 = 𝑃𝐵′ = 1)

◼ Balanced trade: quantity of X (Y) Nation 1(2)

wants to export = quantity of X(Y) Nation 2(1)
wants to import.
◼ Nation 1 wants to export 60X equals the
amount of X that Nation 2 wants to import.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Basis for and Gains from Trade with
Increasing Costs

◼ Any other relative price could not persist because trade

would be unbalanced.
◼ At Px/Py=2, Nation 1 would want to export more of X
than Nation 2 would be willing to import at this high
price.
◼ Then, the relative price of X would fall toward the
equilibrium level of 1.
◼ At a relative price of X lower than 1, Nation 2 would
want to import more of X than Nation 1 would be
willing to export at this low price.
◼ Then, the relative price of X would rise and gravitate
toward the equilibrium price of 1.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Basis for and Gains from Trade with
Increasing Costs

◼ One basic difference between trade model

under increasing costs and constant OCs case
◼ Under constant cost conditions, specialization
is complete.
◼ Production of commodity of their CA (only
producing that commodity)
◼ U.S. specialized completely in wheat
production, and UK in cloth production.

U.S. specialized completely in wheat production, and UK in cloth production.

 Basis for and Gains from Trade with
Increasing Costs

◼ Under increasing cost conditions,

specialization is incomplete.
◼ While Nation 1 produces more of X (the
commodity of CA) with trade, it continues to
produce some Y (see Point B in Figure 3.4).
◼ Nation 1 specializes in production of X, so it
incurs increasing OC in producing X; as
Nation 2 produces more Y, it incurs OC in Y
(declining OC of X).

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Basis for and Gains from Trade with
Increasing Costs

◼ As each nation specializes in producing the

commodity of its CA, relative commodity
prices move toward each other until they are
identical in both nations.
◼ As production moves along PPF toward
comparative advantage good, relative costs
change, thus changing basis and gains from
trade.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Case Study 3.2 Specialization and Export
Concentration in Selected Countries

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Case Study 3.2 Specialization and Export
Concentration in Selected Countries

◼ Due to increasing costs, no nation specializes

completely in production of only one product
in the real world.
◼ The closest to complete specialization in
production and trade that any nation comes is
Kuwait, where petroleum exports
represented 92.1% of total value of its exports
in 2010.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Small-country case with increasing costs

◼ Only small nation specialized completely in

production of the commodity of its CA.
◼ The large nation continued to produce both
commodities even with trade since the small
nation could not satisfy all of the demand for
imports of the large nation.
◼ In increasing costs case, however, we find
incomplete specialization even in the small
nation.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Small-country case with increasing costs

◼ Figure 3.4 - Suppose that Nation 1 is a very

small country while Nation 2 is a large
country.
◼ Suppose that equilibrium-relative price of X
on the world market is 1 (𝑃𝑊 =1), and it is not
affected by trade with small Nation 1.
◼ Since in the absence of trade, the relative price
1
of X in Nation 1 (𝑃𝐴 = ) is lower than the
4
world market price, Nation 1 has a CA in X.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Small-country case with increasing costs

◼ With opening trade, Nation 1 specializes in

production X until it reaches Point B on its
production frontier, where 𝑃𝐵 = 1 = 𝑃𝑊 .
◼ Even though Nation 1 is now considered to be a
small country, it still does not specialize completely
in production of X.
◼ By exchanging 60X for 60Y, Nation 1 reaches Point E
on indifference curve III and gains 20X and 20Y.
◼ Now Nation 1 does not affect relative prices in
Nation 2 (or rest of the world), and Nation 1 captures
all of the benefits from trade (which now amount to
only 20X and 20Y).
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 FIGURE 3.5 The Gains from Exchange and from Specialization.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 The Gains from Exchange and from
Specialization

◼ A nation’s gains from trade can be divided into 1)

gains from exchange and 2) gains from specialization.
◼ Figure 3.5 illustrates this breakdown for small Nation
1 (for simplicity, the autarky price line, 𝑃𝐴 =1/4, and
indifference curve I are omitted).
◼ Suppose that Nation 1 could not specialize in the
production of X with opening of trade but continued
to produce at Point A where MRT=1/4.
◼ Starting from Point A, Nation 1 could export 20X in
exchange for 20Y at the prevailing world relative
price of 𝑃𝑊 =1 and end up consuming at Point T on
indifference curve II.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 The Gains from Exchange and from
Specialization

◼ Even though Nation 1 consumes less of X and more

of Y at T in relation to A, it is better off than it was in
autarky since T is on higher indifference curve II.
◼ The movement from A to T in consumption measures
the gains from exchange.
◼ If subsequently Nation 1 also specialized in
production of X and produced at point B, it could
then exchange 60X for 60Y with the rest of the world
and consume at Point E on indifference curve III
(thereby gaining even more).
◼ The movement from T to E in consumption measures
the gains from specialization in production.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 The Gains from Exchange and from
Specialization

◼ In sum, the movement from A to T is possible by

exchange alone, and this takes place even if Nation
1 remains at Point A (autarky) in production.
◼ The movement from T to E shows the gains from
specialization in production.
◼ Note that Nation 1 is not in equilibrium in
production at Point A with trade since MRT<Pw.
◼ To be in equilibrium in production, Nation 1
should expand its production of X until it
reaches Point B, where 𝑃𝐵 = 𝑃𝑊 = 1.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Case Study 3.3 International Trade and
Deindustrialization in the United States, the
European Union, and Japan

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Case Study 3.3 International Trade and
Deindustrialization in the United States, the
European Union, and Japan
◼ Deindustrialization in the industrial countries
as a group, in the U.S., EU and Japan, was
due to increases in labor productivity or
internal causes rather than foreign trade.
◼ Deindustrialization as reflected in declining
share of manufacturing employment
◼ Table 3.4 about the relative importance of
different factors accounting for
deindustrialization in all advanced countries
(1970-1994)

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Case Study 3.3 International Trade and
Deindustrialization in the United States, the
European Union, and Japan
◼ Most of this decline resulted from growth of labor
productivity (which made possible higher levels of
output with less labor) and less as a result of decline
in rate of investments or other domestic forces.
◼ International trade actually resulted an increase in
industrial employment (negative signs indicate the
opposite of deindustrialization except in the U.S.
where it led to a 9.6 pp decline in manufacturing
employment).
◼ During the past decade, however, the huge trade
deficits and electronic revolution have led to many
more job losses than gains in U.S.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Trade Based on Differences in Taste

◼ The difference between pretrade-relative

commodity prices between Nation 1 and 2 in
Figures 3.3 and 3.4 was based on difference in
the production frontiers and indifference
curves in two nations.
◼ This determined the CA of each nation and
set the stage for specialization in production
and mutually beneficial trade.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Trade Based on Differences in Taste

◼ With increasing costs, even if two nations

have identical PPFs, basis for mutually
beneficial trade will still exist if tastes, or
demand preferences differ.
◼ The nation with relatively smaller demand
for X will have a lower autarky relative price
for, and comparative advantage, in X.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 FIGURE 3.6 Trade Based on Differences in Tastes.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Trade Based on Differences in Taste

◼ Since the production frontiers of two nations

are assumed to be identical, they are
represented by a single curve.
◼ With indifference curve I tangent to the
production frontier at point A for Nation 1
and indifference curve I’ tangent at point A’
for Nation 2, the pretrade-relative price of X
is lower in Nation 1.
◼ Nation 1 has a CA in commodity X and
Nation 2 in Y.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Trade Based on Differences in Taste

◼ With the opening of trade, Nation 1

specializes in production of X (and moves
down its production frontier), while Nation 2
specializes in Y (and moves up its own
production frontier).
◼ Specialization continues until Px/Py is the
same in both nations and trade is balanced.
◼ This occurs at Point B (which coincides with
B’), where 𝑃𝐵 = 𝑃𝐵′ = 1.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Trade Based on Differences in Taste

◼ Nation 1 then exchanges 60X for 60Y with

Nation 2 (trade triangle BCE) and ends up
consuming at point E on its indifference curve
III.
◼ Nation 1 thus gains 20X and 20Y as compared
with Point A.
◼ Nation 2 exchanges 60Y for 60X with Nation 1
(B’C’E’ triangle) and ends up consuming at
Point E’ on its indifference curve III’ (also
gaining 20X and 20Y from Point A’).
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Trade Based on Differences in Taste

◼ Note that when trade is based solely on taste

differences, the patterns of production become more
similar as both nations depart from autarky.
◼ Thus mutually beneficial trade can be based
exclusively on a difference in tastes between two
nations.
◼ Only if production frontier and indifference curves
are identical in both nations will the pretrade-relative
commodity prices be equal in both nations, ruling
out the possibility of mutually beneficial trade.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 ◼ Copyright 2013 John Wiley & Sons, Inc.

◼ All rights reserved. Reproduction or translation of this work beyond

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Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 CHAPTER F O U R

4 International Economics
Tenth Edition

Demand and Supply, Offer Curves,

and the Terms of Trade
Dominick Salvatore
John Wiley & Sons, Inc.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Learning Goals:
◼ Show how the equilibrium price at which
trade takes place is determined by demand
and supply.
◼ Show how the equilibrium price at which
trade takes place is determined with offer
curves.
◼ Explain the meaning of the terms of trade and
how they have changed over time for the
United States.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Introduction

◼ Relative commodity price differences between two

nations in isolation reflect comparative advantage,
and forms basis for mutually beneficial trade.
◼ Can use partial and general equilibrium analysis to
determine equilibrium-relative commodity price at
which trade will take place.
◼ Partial equilibrium analysis (by utilizing
demand and supply curves)
◼ General equilibrium analysis (by using offer
curves)

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 FIGURE 4-1 The Equilibrium-Relative Commodity Price with Trade
with Partial Equilibrium Analysis.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 The Equilibrium-Relative Commodity Price
with Trade-Partial Equilibrium Analysis

◼ Figure 4.1 shows how the equilibrium-

relative commodity price with trade is
determined by partial equilibrium analysis.
◼ Curves Dx and Sx in panels A and C of
Figure 4.1 refer to the demand and supply
curves for commodity X in Nation 1 and 2.
◼ The vertical axes in all three panels measure
the relative price of commodity X.
◼ Px/Py, or the amount of commodity Y that a nation must
give up to produce one additional unit of X.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 The Equilibrium-Relative Commodity Price
with Trade-Partial Equilibrium Analysis

◼ The horizontal axes measure the quantity of

commodity X.
◼ Panel A shows that in the absence of trade,
Nation 1 produces and consumes at point A
at the relative price of X of 𝑃1 .
◼ Nation 2 produces and consumes at point A’
at 𝑃3 .
◼ With the opening of trade, the relative price
of X will be between 𝑃1 and 𝑃3 if both nations
are large.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 The Equilibrium-Relative Commodity Price
with Trade-Partial Equilibrium Analysis

◼ At prices above 𝑃1, Nation 1 will supply

(produce) more than it will demand
(consume) of commodity X and will export
the difference or excess supply (Panel A).
◼ Alternatively, at prices below 𝑃3 , Nation 2
will demand a greater quantity of X than it
produces or supplies domestically and import
the difference or excess demand (Panel C).

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 The Equilibrium-Relative Commodity Price
with Trade-Partial Equilibrium Analysis

◼ Panel A shows that at 𝑃1 , the quantity supplied

of X (QSx) = quantity demanded of X (QDx) in
Nation 1, so Nation 1 exports nothing of X.
◼ This gives point A* on curve S (Nation 1’s
supply curve of exports) in Panel B.
◼ Panel A also shows that 𝑃2 , the excess of BE of
QSx over QDx represents the quantity of
commodity X that Nation 1 would export at 𝑃2 .
◼ This is equal to B*E* in Panel B and defines point
E* on Nation 1’s S curve of exports of X.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 The Equilibrium-Relative Commodity Price
with Trade-Partial Equilibrium Analysis

◼ Panel C shows that at 𝑃3 , QDx = QSx (point

A’), so Nation 2 doesn’t demand any imports
of X.
◼ This defines point A’’ on Nation 2’s demand
curve for imports of X (D) in panel B.
◼ Panel C shows that at 𝑃2 , the excess B’E’ of
QDx over QSx represents the quantity of X
that Nation 2would import at 𝑃2 .
◼ This is equal to B*E* in panel B and defines
point E* on Nation 2’s D curve of imports of X.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 The Equilibrium-Relative Commodity Price
with Trade-Partial Equilibrium Analysis

◼ At 𝑃2 , the quantity of imports of X demanded

by Nation 2 (B’E’ in panel C) equals the
quantity of exports of X supplied by Nation 1
(BE in panel A).
◼ This is shown by the intersection of D and S
curves for trade in X in panel B.
◼ 𝑃2 is the equilibrium-relative price of X with
trade.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 The Equilibrium-Relative Commodity Price
with Trade-Partial Equilibrium Analysis

◼ From panel B, at Px/Py > 𝑃2 , the quantity of

exports of X supplied exceeds the quantity of
imports demanded, so the relative price of X
(Px/Py) will fall to 𝑃2 .
◼ At Px/Py < 𝑃2 , the quantity of imports of X
demanded exceeds the quantity of exports
supplied, so Px/Py will rise to 𝑃2 .

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 The Equilibrium-Relative Commodity Price
with Trade-Partial Equilibrium Analysis

◼ The same could be shown with Y commodity,

which is exported by Nation 2 and imported
by Nation 1.
◼ At any relative price of Y higher than
equilibrium, the quantity of Y exports
supplied by Nation 2 would exceed the
quantity of Y imports demanded by Nation 1.
◼ The relative price of Y would fall to
equilibrium level.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 The Equilibrium-Relative Commodity Price
with Trade-Partial Equilibrium Analysis

◼ At any Px/Py below equilibrium, the import

quantity of Y demanded would exceed the
export quantity of Y supplied, and Px/Py will
rise to the equilibrium level.

◼ Case study 4-1: International price of

petroleum in nominal and real (inflation-
adjusted) terms from 1972 to 2010.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Case Study 4-1 Demand, Supply, and the
International Price of Petroleum

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Case Study 4-1 Demand, Supply, and the
International Price of Petroleum

◼ Price of petroleum fluctuated widely from 1972

to 2011
◼ Due to supply shocks during Arab-Israeli War in
fall 1973 and Iranian revolution in 1979-1980,
OPEC (Organization of Petroleum Exporting
Countries) could increase the price of petroleum
from an average of $2.89 per barrel in 1972 to
$11.60 in 1974 and to $36.68 per barrel in 1980.
◼ These increases stimulated energy conservation
and expanded exploration and petroleum
production by non-OPEC countries.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Case Study 4-1 Demand, Supply, and the
International Price of Petroleum

◼ In the face of excess supply during 1980s and

1990s, OPEC could not prevent the price from
falling to a low of $14.17 in 1986 and $13.07 in
1998.
◼ The price then rose to $28.23 in 2000 and $104 in 2011
(all-time monthly high was $132.60 in July 2008).
◼ If we consider that all prices have risen over
time, we can see that the real (inflation-adjusted)
price rose from $2.89 in 1972 to $9.51 in 1974 and
$17.14 in 1980.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Case Study 4-1 Demand, Supply, and the
International Price of Petroleum

◼ It then fell to $4.69 in 1986 and $2.90 in 1998,

but it subsequently rose to $5.73 in 2000 and
$14.83 in 2008, and it was $15.80 in 2011.
◼ Therefore, the real price of petroleum was
5.47 times higher (15.80/2.89) in 2011 than in
1972, rather than 35.99 times in nominal
prices.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 FIGURE 4-1 The Equilibrium-Relative Commodity Price with Trade
with Partial Equilibrium Analysis.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 The Equilibrium-Relative Commodity Price
with Trade-Partial Equilibrium Analysis

◼ Figure 4-1 (Summary)

◼ At a relative price greater than P1, Nation 1’s excess
supply of X (Panel A) gives rise to Nation 1’s
international supply curve of X (S in Panel B).
◼ At a relative price lower than P3, Nation 2’s excess
demand for X (Panel C) gives rise to Nation 2’s
demand for imports of X (D in Panel B).
◼ Only at P2 (Panel B) does quantity of imports
demanded equal quantity of exports supplied.
◼ Thus P2 is equilibrium-relative commodity price
with trade.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Offer Curves

◼ Offer curves (sometimes called reciprocal

demand curves) introduced to international
economics by Marshall and Edgeworth, two
British economists, at the turn of the 20th
century.
◼ An offer curve of a nation show how much of
its import commodity a nation demands for it
to be willing to supply various amounts of its
export commodity.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Offer Curves

◼ Incorporating factors of both demand and

supply
◼ An offer curve shows the nation’s willingness
to import and export at various relative
commodity prices.
◼ An offer curve of a nation can be derived
from production possibilities frontier,
indifference map and various hypothetical
relative commodity prices at which trade
could take place.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 FIGURE 4-2 Derivation of the Offer Curve of Nation 1.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Offer Curves

◼ Nation 1 starts at no-trade (autarky) point A.

◼ If trade takes place at 𝑃𝐵 = 𝑃𝑋 /𝑃𝑌 =1, Nation 1
moves to point B in production, trades 60X
for 60Y with Nation 2, and reaches point E on
its indifference curve III.
◼ This gives point E in the right panel.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Offer Curves

◼ At 𝑃𝐹 = 𝑃𝑋 /𝑃𝑌 =1/2, Nation 1 would move

instead from point A to F in production,
exchange 40X and 20Y with Nation 2, and
reach point H on its indifference curve II.
◼ This gives point H in the right panel.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Offer Curves

◼ Joining the origin with points H and E and

other points similarly obtained, we generate
Nation 1’s offer curve in the right panel.
◼ The offer curve of Nation 1 shows how many
imports of Y Nation 1 requires to be willing to
export various quantities of X.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Offer Curves

◼ To keep the left panel simple, we omitted the

autarky price line 𝑃𝐴 = 1/4 and indifference
curve I tangent to the production frontier and
𝑃𝐴 at point A.
◼ Note that 𝑃𝐴 , 𝑃𝐹 and 𝑃𝐵 in the right panel
refers to the same Px/Py as 𝑃𝐴 , 𝑃𝐹 and 𝑃𝐵 in
the left panel since they refer to the same
absolute slope.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Offer Curves

◼ The offer curve of Nation 1 in the right panel

lies above the autarky price line of 𝑃𝐴 =1/4 and
bulges toward the X-axis, which measures the
commodity of its comparative advantage and
export.
◼ To induce Nation 1 to export more of X,
Px/Py must rise.
◼ Thus, at 𝑃𝐹 = 1/2, Nation 1 would export 40X,
and at 𝑃𝐵 = 1, it would export 60X.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Offer Curves

◼ Two reasons for this:

◼ (1) Nation 1 incurs increasing OC in
producing more of X (for export).
◼ (2) The more of Y and less of X that Nation 1
consumes with trade, the more valuable to the
nation is a unit of X at the margin compared
with a unit of Y.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 FIGURE 4-3 Derivation of the Offer Curve of Nation 2.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Derivation and Shape of Offer Curve of Nation 1

◼ Nation 2 starts at the autarky equilibrium

point A’.
◼ If trade takes place at 𝑃𝐵′ = 𝑃𝑥/𝑃𝑦=1, Nation
2 moves to point B’ in production, exchanges
60Y for 60X with Nation 1, and reaches point
E’ on its indifference curve III’.
◼ Trade triangle B’C’E’ in the left panel
corresponds to O’C’E’ in the right panel, and
we get point E’ on Nation 2’s offer curve.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Derivation and Shape of Offer Curve of Nation 1

◼ At 𝑃𝐹′ = 𝑃𝑥/𝑃𝑦=2 in the left panel, Nation 2

would move instead to point F’ in
production, exchange 40Y for 20X with
Nation 2’s offer curve.
◼ Joining the origin with points H’ and E’ and
other points similarly obtained, we make
Nation 2’s offer curve in the right panel.
◼ The offer curve of Nation 2 shows how many
imports of X Nation 2 demands to be willing
to export various quantities of Y.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Derivation and Shape of Offer Curve of Nation 1

◼ Likewise, we omitted the autarky price line

𝑃𝐴′ =4 and indifference curve I’ tangent to the
production frontier and 𝑃𝐴′ at point A’.
◼ Note that 𝑃𝐴′ , 𝑃𝐹′ and 𝑃𝐵′ in the right panel
refers to the same Px/Py as 𝑃𝐴′ , 𝑃𝐹′ and 𝑃𝐵′ in
the left panel since they refer to the same
absolute slope.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Derivation and Shape of Offer Curve of Nation 1

◼ The offer curve of Nation 2 in the right panel

lies below the autarky price line of 𝑃𝐴′ =4 and
bulges toward the Y-axis, measuring the
commodity of its CA and export.
◼ To induce Nation 2 to export more of Y, the
relative price of Y must rise.
◼ Its Px/Py must fall.
◼ At 𝑃𝐹′ =2, Nation 2 would export 40Y, and at
𝑃𝐵′ =1, it would export 60Y.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Derivation and Shape of Offer Curve of Nation 1

◼ Nation 2 requires a higher relative price of Y

to be induced to export more Y since:
◼ (1) Nation 2 incurs increasing OC in
producing more Y (for export).
◼ (2) The more of X and the less of Y that Nation
2 consumes with trade, the more valuable to
the nation is a unit of Y at the margin
compared with a unit of X.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 The Equilibrium-Relative Commodity Price
with Trade-General Equilibrium Analysis

◼ The intersection of offer curves of two nations

defines the equilibrium-relative commodity price
at which trade takes place between them.
◼ Only at this equilibrium price will trade be
balanced between two nations.
◼ At any other relative commodity price, the
desired quantities of imports and exports of two
commodities would not be equal.
◼ This would pressure on the relative commodity
price to move toward its equilibrium level.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 FIGURE 4-4 Equilibrium-Relative Commodity Price with Trade.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 The Equilibrium-Relative Commodity Price
with Trade-General Equilibrium Analysis

◼ The offer curves of Nation 1 and 2 in Figure

4.4 are those derived in Figures 4.2 and 4.3.
◼ These two offer curves intersect at E=E’.
◼ Defining equilibrium Px/Py= 𝑃𝐵 = 𝑃𝐵′ =1.
◼ At 𝑃𝐵 , Nation 1 offers 60X for 60Y (point E on
Nation 1’s offer curve), and Nation 2 offers
exactly 60Y for 60X (point E’ on Nation 2’s
offer curve).
◼ Thus, trade is in equilibrium at 𝑃𝐵 .

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 The Equilibrium-Relative Commodity Price
with Trade-General Equilibrium Analysis

◼ At any other Px/Py, trade would not be in

equilibrium.
◼ At 𝑃𝐹 = 1/2, the 40X that Nation 1 would
export (see point H) would fall short of the
imports of X demanded by Nation 2 at this
relatively low price of X.
◼ This is given by a point, not shown in this
figure, where the extended price line 𝑃𝐹
intersects the extended offer curve of Nation 2.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 The Equilibrium-Relative Commodity Price
with Trade-General Equilibrium Analysis

◼ The excess import demand for X at 𝑃𝐹 = 1/2

by Nation 2 tends to drive Px/Py up.
◼ As this occurs, Nation 1 will supply more X
for export (i.e., Nation 1 will move up its offer
curve), while Nation 2 will reduce its import
demand for X (i.e., Nation 2 will move down
its offer curve).
◼ This will continue until supply and demand
become equal at 𝑃𝐵 .

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 The Equilibrium-Relative Commodity Price
with Trade-General Equilibrium Analysis

◼ The pressure for 𝑃𝐹 to move toward 𝑃𝐵 can

also be explained in terms of Y and arises at
any other Px/Py, such as 𝑃𝐹 ≠ 𝑃𝐵 .
◼ Note that equilibrium-relative commodity
price of 𝑃𝐵 =1 with trade (determined in
Figure 4.4 by the intersection of the offer
curves of Nation 1 and 2) is identical to that
found by trial and error.
◼ At 𝑃𝐵 =1, both nations happen to gain equally
from trade.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Relationship between General and Partial
Equilibrium Analyses

◼ Both partial equilibrium and general equilibrium

analysis use production frontiers and
indifference maps to find equilibrium trade price.
◼ Only general equilibrium analysis considers all
markets together, not just the market for
commodity X.
◼ Changes in the market for X affect other markets,
which possibly impact the market for X.
◼ General equilibrium analysis is therefore
required for more complete analysis.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 FIGURE 4-5 Equilibrium-Relative Commodity Price with Partial
Equilibrium Analysis.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Relationship between General and Partial
Equilibrium Analyses

◼ In Figure 4.5, S is Nation 1’s supply curve of

exports of X and is derived from Nation 1’s
production frontier and indifference map in
the left panel of Figure 4.2.
◼ (The same information from which Nation 1’s
offer curve in the right panel of Figure 4.2 is
derived).

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Relationship between General and Partial
Equilibrium Analyses

◼ S shows that the quantity supplied of exports

of X by Nation 1 is zero (point A) at
Px/Py=1/4, 40 (H) at Px/Py=1/2, and 60 (E) at
Px/Py=1.
◼ The export of 70x by Nation 1 at Px/Py=1 ½ (R
on S curve) can be obtained from the left
panel of Figure 4.2.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Relationship between General and Partial
Equilibrium Analyses

◼ D refers to Nation 2’s demand for Nation 1’s

exports of X and derived from Nation 2’s
production frontier and indifference map in
the left panel of Figure 4.3.
◼ D in Figure 4.5 shows that the quantity
demanded of Nation 1’s exports of X by
Nation 2 is 60 (E) at Px/Py=1, 120 (H’) at
Px/Py=1/2, but 40 (R’) at Px/Py=1 ½ .

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Relationship between General and Partial
Equilibrium Analyses

◼ D and S intersect at point E, determining the

equilibrium Px/Py=1 and the equilibrium quantity of
exports of 60X.
◼ At Px/Py=1 ½, excess supply of exports of R’R=30X,
and Px/Py falls toward equilibrium Px/Py=1.
◼ At Px/Py=1/2, excess demand of exports of HH’=80X,
and Px/Py rises toward equilibrium Px/Py=1, given
by point E.
◼ The same conclusion would be reached in terms of Y.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 The Terms of Trade

◼ Terms of trade = the ratio of the price of a

nation’s export commodity to the price of its
import commodity.
◼ In a two-nation world, the terms of trade of
Nation 1 are equal to the reciprocal of the terms
of trade of Nation 2.
◼ Nation 1’s exports are the imports of its trade
partner in a two-nation world.
◼ If Nation 1 exports X and imports Y, its terms of
trade are given by PX/PY, where P = price index.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 The Terms of Trade

◼ In a world of many traded goods, the terms of

trade is the ratio of the export price index to
the import price index, also called commodity
or net barter terms of trade.
◼ As supply and demand considerations change
over time, offer curves will shift, changing the
volume and TOT.
◼ An improvement in a nation’s TOT is regarded
as beneficial to the nation in that the prices that
the nation receives for exports rise relative to
prices that it pays for imports.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 The Terms of Trade

◼ Since Nation 1 exports X and imports Y, TOT

of Nation 1 are given by Px/Py.
◼ In Figure 4.4, these are Px/Py=𝑃𝐵 = 1 or 100 (in
percentages).
◼ If Nation 1 exported and imported many
commodities, Px would be the index of its
export prices, and Py would be the index of
import prices.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 The Terms of Trade

◼ Since Nation 2 exports Y and imports X, TOT

of Nation 2 are given by Py/Px.
◼ Note that this is the inverse, or reciprocal, of
Nation 1’s TOT and also equals 1 or 100 (in
percentages) in this case.
◼ If through time the TOT of Nation 1 rose, say
from 100 to 120, this would mean that Nation
1’s export prices rose 20% in relation to its
import prices.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 The Terms of Trade

◼ This would also mean that Nation 2’s TOT

have worsened off from 100 to
(100/120)100=83.
◼ Note that we can always set a nation's TOT
equal to 100 in the base period, so that
changes in TOT over time can be measured in
percentages.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 The Terms of Trade

◼ Even if Nation 1’s TOT improve over time,

we cannot conclude that Nation 1 is
necessarily better off due to this, or that
Nation 2 is necessarily worse off due to the
deterioration of its TOT.
◼ Chapter 11 will cover this part in details.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Case Study 4-2 The Terms of Trade of the G-7
Countries

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Case Study 4-2 The Terms of Trade of the G-7
Countries

◼ Table 4.2 shows TOT of G7 countries from

1972 to 2011.
◼ ToTs were measured by dividing index of
export unit value by index of import unit
value, taking 2000 as 100.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Case Study 4-2 The Terms of Trade of the G-7
Countries

◼ ToTs of G7 countries fluctuated very widely

over the years and were much lower in 2011
than in 1972 for U.S., Germany, and
especially Japan.
◼ Much higher for Canada (due to a sharp
increase in price of petroleum and primary
commodities of which Canada is a major
exporter).

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Case Study 4-3 The Terms of Advanced and
Developing Countries

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Case Study 4-3 The Terms of Advanced and
Developing Countries

◼ Table 4.3 gives TOT of advanced and

developing countries from 1972 to 2010.
◼ ToTs were measured by dividing the index of
export unit value by index of import unit
value with 2000 as 100.
◼ Table 4.3 shows that ToTs of advanced
countries declined from 1972 to 1985 but then
rose until 1995, and they were 98 in 2010, as
compared with 110 in 1972.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Case Study 4-3 The Terms of Advanced and
Developing Countries

◼ Fore developing countries, the ToTs rose

sharply from 1972 to 1980 as a result of a
rapid growth in ToTs of Western
Hemispheric countries, but they then
declined until 1985 and were 102 in 2010, as
compared with 61 in 1972.
◼ From 1972 to 2010, ToTs rose for Asia and
declined for European developing countries.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Case Study 4-3 The Terms of Advanced and
Developing Countries

◼ Although ToTs of industrial and developing

countries reflected to a large extend the large
fluctuations in price of petroleum over the period
examined, other forces were also clearly at work.
◼ For example, the largest fluctuation was in the
ToTs of Western Hemispheric countries, whose
exports were mostly non-petroleum.
◼ ToTs of Middle East as a whole declined between
1972 and 1974 since many Middle Eastern
countries didn’t export petroleum.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 ◼ Copyright 2013 John Wiley & Sons, Inc.

◼ All rights reserved. Reproduction or translation of this work beyond

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Request for further information should be addressed to the
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information herein.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Chapter 4 – Problem #8

Problem #8
◼ From the left panel of Figure 4.3, derive Nation
2’s supply curve of exports of commodity Y.
◼ From the left panel of Figure 4.2, derive Nation
1’s demand curve for Nation 2’s exports of
commodity Y.
◼ Use the demand and supply curves that you
derived to show how the equilibrium-relative
commodity price of commodity Y with trade is
determined.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Chapter 4 – Problem #8

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Chapter 4 – Problem #8

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 CHAPTER F I V E

5 International Economics
Tenth Edition

Factor Endowments and the

Heckscher-Ohlin Theory
Dominick Salvatore
John Wiley & Sons, Inc.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Learning Goals:
◼ Explain how comparative advantage is based on
differences in factor endowments across nations
◼ Explain how trade affects relative factor prices
within and across nations
◼ Explain why trade is likely to be only a small
reason for higher skilled-unskilled wage
inequalities

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Introduction

◼ Extending trade model to include:

◼ Basis of comparative advantage
◼ Effect of international trade on return to labor

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Introduction

◼ According to classical economists, comparative

advantage was based on the difference in
productivity of labor (the only factor of production
they considered) among nations, but they provided
no explanation for such a difference in productivity.

◼ Heckscher-Ohlin theory goes further that by

extending the trade model to examine basis for CA
and effect that trade has on factor earnings in two
nations.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Assumptions of the Theory

◼ Heckscher-Ohlin theory based on following

assumptions:
1. Two nations, two commodities, two factors of
production (labor and capital)
2. Technology is the same in both nations.
3. Commodity X is labor intensive, commodity Y is
capital intensive in both nations.
◼ Labor-capital ratio (L/K) is higher for commodity X than
for Y in both nations at the same relative factor prices.
◼ This is equivalent to saying that capital-labor ratio (K/L)
is lower for X than for Y.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Assumptions of the Theory

◼ Heckscher-Ohlin theory based on following

assumptions (continued):
4. Constant returns to scale for X and Y in both nations
◼ Increasing the amount of labor and capital used in
production of any commodity X or Y will increase the
output of that commodity in the same proportion.
5. Incomplete specialization in production in both
nations
◼ This implies that neither of two nations is very small.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Assumptions of the Theory

◼ Heckscher-Ohlin theory based on following

assumptions (continued):
6. Tastes are the same in both nations
7. Both commodities and factors are traded in perfectly
competitive markets.
8. Perfect factor mobility within each nation, but not
between nations
9. No transportation costs, tariffs or other barriers to
free trade.
10. All resources are fully employed in both nations.
11. International trade between the nations is balanced.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Assumptions of the Theory

◼ Perfect Competition:
1) Producers, consumers, and traders of X and Y
commodities in both nations are each too small to
affect the price of these commodities.
2) In the long run, commodity prices equal their costs
of production, leaving no economic profit after all
costs are taken into account.
3) All producers, consumers, and owners of factors of
production have perfect knowledge of commodity
prices and factor earnings in all parts of the nations
and in all industries.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Factor Intensity, Factor Abundance, and the
Shape of the Production Frontier

◼ Factor Intensity
◼ In a two-commodity, two factor world (labor and
capital), commodity Y is capital intensive if the
capital-labor ratio (K/L) used in the production of
Y is greater than K/L used in the production of X.

◼ It is not the absolute amount of capital and labor

used in production of X and Y, but the amount of
capital per unit of labor that determines capital
intensity.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 FIGURE 5-1 Factor Intensities for Commodities X and Y
in Nations 1 and 2.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Factor Intensity, Factor Abundance, and the
Shape of the Production Frontier

◼ Why does Nation 2 use more K-intensive

production techniques in both commodities than
Nation 1?
◼ Capital must be relatively cheaper in Nation 2
than in Nation 1.
◼ Thus, producers in Nation 2 use relatively more
capital in the production of both commodities to
minimize their costs of production.
◼ But why is capital relatively cheaper in Nation 2?
◼ To answer this, we must define factor abundance
and examine its relationship to factor prices.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Factor Intensity, Factor Abundance, and the
Shape of the Production Frontier

◼ In sum, commodity Y is unequivocally the K-

intensive commodity if K/L is higher for commodity
Y than for X at all possible relative factor prices.
◼ Nation 2 uses a higher K/L in the production of both
commodities since the relative price of capital is
lower in Nation 2 than Nation 1.
◼ If the relative price of capital declines, producers will
substitute K for L in the production of both
commodities to minimize their costs of production.
◼ Thus, K/L will rise for both commodities, but Y
continues to be the K-intensive commodity.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Factor Intensity, Factor Abundance, and the
Shape of the Production Frontier

◼ How to define factor abundance?

1) In terms of physical units
2) In terms of relative factor prices

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Factor Intensity, Factor Abundance, and the
Shape of the Production Frontier

◼ Factor Abundance
1) In terms of physical units:
◼ Nation 2 is capital abundant if the ratio of the
total amount of capital to the total amount of
labor (TK/TL) available in Nation 2 is greater
than that in Nation 1.

◼ It is not the absolute amount of capital and

labor available in each nation, but the ratio of
the total amount of capital to the total amount
of labor.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Factor Intensity, Factor Abundance, and the
Shape of the Production Frontier

◼ Factor Abundance
2) In terms of relative factor prices:
◼ Nation 2 is capital abundant if the ratio of the
rental price of capital to the price of labor time
(PK/PL) is lower in Nation 2 than in Nation 1.

◼ Rental price of capital is usually considered to

be the interest rate (r), while the price of labor
time is the wage rate (w), so PK/PL = r/w.
◼ It is not the absolute level of r that determines
whether a nation is K-abundant, but r/w.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Factor Intensity, Factor Abundance, and the
Shape of the Production Frontier

◼ The definition of factor abundance in terms of

physical units considers only the supply of
factors.
◼ The definition of factor abundance in terms of
relative factor prices considers both demand
and supply since demand for a factor of
production is a derived demand.
◼ Derived from demand for the final commodity
that requires the factor in its production.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Factor Intensity, Factor Abundance, and the
Shape of the Production Frontier

◼ Since we have assumed that tastes or demand

preferences are the same in both nations, the
two definitions of factor abundance give the
same conclusions.
◼ With TK/TL larger in Nation 2 than in Nation 1
in the face of equal demand conditions (and
technology), PK/PL will be smaller in Nation 2.
◼ Thus, Nation 2 is K-abundant nation in terms
of both definitions.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Nation 2 is K-abundant, and
commodity Y is K-intensive

Nation 1 is L-abundant, and

commodity X is L-intensive

FIGURE 5-2 Factor Abundance and the Shape of the Production

Frontiers of Nation 1 and Nation 2.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Factor Intensity, Factor Abundance, and the
Shape of the Production Frontier

◼ Since Nation 2 is the K-abundant nation and

commodity Y is K-intensive commodity, Nation 2 can
produce relatively more of Y than Nation 1.
◼ Since Nation 1 is the L-abundant nation and
commodity X is L-intensive commodity, Nation 1 can
produce relative more of X than Nation 2.
◼ This gives a production frontier for Nation 1 that is
relatively flatter and wider than the production
frontier of Nation 2 (if we measure X along the
horizontal axis).

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Case Study 5-1 Relative Resource
Endowments of Various Countries

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Factor Endowments and the Heckscher-Ohlin
Theory

◼ Heckscher-Ohlin (H-O) theory is based on

two theorems:
◼ 1. H-O theorem
◼ 2. Factor-price equalization theorem

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Factor Endowments and the Heckscher-Ohlin
Theory

1. The H-O theorem

◼ “A nation will export the commodity whose
production requires the intensive use of the
nation’s relatively abundant and cheap
factor and import the commodity whose
production requires the intensive use of the
nation’s relatively scarce and expensive
factor.”

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Factor Endowments and the Heckscher-Ohlin
Theory

1. The H-O theorem

◼ In short, the relatively labor-rich nation exports the
relatively labor-intensive commodity and imports
the relatively capital-intensive commodity!
◼ Nation 1 exports commodity X since X is L-
intensive commodity, and L is relatively abundant
and cheaper factor in Nation 1.
◼ Conversely, Nation 2 exports commodity Y since Y
is K-intensive commodity, and K is the relatively
abundant and cheaper factor in Nation 2.
◼ r/w is lower in Nation 2 than in Nation 1.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Factor Endowments and the Heckscher-Ohlin
Theory

1. The H-O theorem (Cont.)

◼ H-O theorem explains comparative advantage rather
than assuming it.
◼ In other words, H-O theorem postulates that the
difference in relative factor abundance and prices is the
cause of pre-trade difference in relative commodity
prices between two nations.
◼ This difference in relative factor and relative commodity
prices is then translated into a difference in absolute
factor and commodity prices between two nations.
◼ It is this difference in absolute commodity prices in two
nations that is the immediate cause of trade.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 FIGURE 5-3 General Equilibrium Framework of the
Heckscher-Ohlin Theory.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 General Equilibrium Framework of the
Heckscher–Ohlin Theory
◼ Starting at the lower right-hand corner of the diagram,
we see that tastes and the distribution in the ownership
of factors of production (i.e., the distribution of income)
together determine the demand for commodities.
◼ The demand for final commodities determines the
derived demand for the factors required to produce
them.
◼ The demand for factors of production, together with the
supply of the factors, determines the price of factors of
production under perfect competition.
◼ The factor prices, together with technology, determines
the commodity prices.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 General Equilibrium Framework of the
Heckscher–Ohlin Theory
◼ However, out of all these forces working together, the H–O
theorem isolates the difference in the physical availability or
supply of factors of production among nations (in the face of
equal tastes and technology) to explain the difference in
relative commodity prices and trade among nations.
◼ Specifically, Ohlin assumed equal tastes (and income
distribution) among nations. This gave rise to similar
demands for final commodities and factors of production in
different nations.
◼ Thus, it is the difference in the supply of the various factors
of production in different nations that is the cause of
different relative factor prices in different nations.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 General Equilibrium Framework of the
Heckscher–Ohlin Theory
◼ Finally, the same technology but different factor
prices lead to different relative commodity prices and
trade among nations.
◼ Thus, the difference in the relative supply of factors
leading to the difference in relative factor prices and
commodity prices is shown by the double lines in
Figure 5.3.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 FIGURE 5-4 The Heckscher-Ohlin Model.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Illustration of the Heckscher–Ohlin
Theory
◼ The left panel of the figure shows the production
frontiers of Nation 1 and Nation 2, as in Figure 5.2.
◼ Indifference curve I (which is common for both
nations) is tangent to Nation 1’s production frontier
at point A and to Nation 2’s production frontier at A.
◼ Indifference curve I is the highest indifference curve
that Nation 1 and Nation 2 can reach in isolation,
and points A and A’ represent their equilibrium
points of production and consumption in the
absence of trade.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Illustration of the Heckscher–Ohlin
Theory
◼ The tangency of indifference curve I at points
A and A’ defines the no-trade, or autarky,
equilibrium-relative commodity prices of 𝑃𝐴
in Nation 1 and 𝑃𝐴′ in Nation 2.
◼ Since 𝑃𝐴 < 𝑃𝐴′ , Nation 1 has a comparative
advantage in commodity X, and Nation 2 has
a comparative advantage in commodity Y.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Illustration of the Heckscher–Ohlin
Theory
◼ The right panel shows that with trade Nation 1
specializes in the production of commodity X,
and Nation 2 specializes in the production of
commodity Y (see the direction of the arrows
on the production frontiers of the two nations).
◼ Specialization in production proceeds until
Nation 1 has reached point B and Nation 2 has
reached point B’, where the transformation
curves of the two nations are tangent to the
common relative price line 𝑃𝐵 .
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Illustration of the Heckscher–Ohlin
Theory
◼ Nation 1 will then export commodity X in exchange
for commodity Y and consume at point E on
indifference curve II (see trade triangle BCE).
◼ On the contrary, Nation 2 will export Y for X and
consume at point E’, which coincides with point E
(see trade triangle B’C’E’).
◼ Nation 1’s exports of commodity X equal Nation 2’s
imports of commodity X (i.e., BC = C’E’)
◼ Nation 2’s exports of commodity Y equal Nation 1’s
imports of commodity Y (i.e., B’C’=CE).

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Illustration of the Heckscher–Ohlin
Theory
◼ At 𝑃𝑋 /𝑃𝑌 > 𝑃𝐵 , Nation 1 wants to export more
of commodity X than Nation 2 wants to
import at this high relative price of X, and
𝑃𝑋 /𝑃𝑌 falls toward 𝑃𝐵 .
◼ At 𝑃𝑋 /𝑃𝑌 < 𝑃𝐵 , Nation 1 wants to export less of
commodity X than Nation 2 wants to import
at this low relative price of X, and 𝑃𝑋 /𝑃𝑌 rises
toward 𝑃𝐵 .

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Illustration of the Heckscher–Ohlin
Theory
◼ Point E involves more of Y but less of X than point A;
nevertheless, Nation 1 gains from trade because point
E is on higher indifference curve II.
◼ Although point E’ involves more X but less Y than
point A’, Nation 2 is also better off because point E’ is
on higher indifference curve II.
◼ This pattern of specialization in production and trade
and consumption will remain the same until there is
a change in the underlying demand or supply
conditions in commodity and factor markets in either
or both nations.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Factor Endowments and the Heckscher-Ohlin
Theory

◼ Heckscher-Ohlin (H-O) theory is based on

two theorems:
◼ 1. H-O theorem
◼ 2. Factor-price equalization theorem

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Factor-Price Equalization and Income
Distribution

◼ Heckscher-Ohlin (H-O) theory is based on two theorems:

2. The factor price equalization theorem
◼ International trade will bring about equalization in

the relative and absolute returns to homogenous

factors across nations.
◼ In short, wages and other factor returns will be the

same after specialization and trade has occurred.

◼ Holds only if H-O theorem holds.

◼ Heckscher–Ohlin–Samuelson theorem

(H–O–S theorem, for short).

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Factor-Price Equalization and Income
Distribution

◼ Heckscher-Ohlin (H-O) theory is based on

two theorems:
2. The factor price equalization theorem
◼ International trade causes w to rise in Nation 1
(the low-wage nation) and fall in Nation 2. (the
high-wage nation), reducing the pretrade
difference in w between nations.
◼ Similarly, trade causes r to fall in Nation 1 (the
K-expensive nation) and rise in Nation 2 (the K-
cheap nation), reducing the pretrade difference
in r between nations.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Factor-Price Equalization and Income
Distribution

◼ Heckscher-Ohlin (H-O) theory is based on

two theorems:
2. The factor price equalization theorem
◼ Thus, international trade causes a
redistribution of income from the relatively
expensive (scarce) factor to the relatively cheap
(abundant) factor.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 FIGURE 5-5 Relative Factor–Price Equalization.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Relative and Absolute Factor–Price
Equalization

◼ Since each nation operates under perfect competition

and uses the same technology, there is a one-to-one
relationship between w/r and Px /Py.
◼ That is, each w/r ratio is associated with a specific
Px /Py ratio.
◼ Before trade, Nation 1 is at point A, with w/r = (w/r)1
and Px /Py = 𝑃𝐴 ; Nation 2 is at point A’,
with w/r = (w/r)2 and Px /Py = 𝑃𝐴′ .
◼ With w/r lower in Nation 1 than in Nation 2 in the
absence of trade, 𝑃𝐴 is lower than 𝑃𝐴′ so that Nation 1
has a comparative advantage in X.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Relative and Absolute Factor–Price
Equalization

◼ As Nation 1 (the relatively L-abundant nation) specializes

in the production of commodity X (the L-intensive
commodity) and reduces the production of commodity Y,
the demand for labor increases relative to the demand for
capital and w/r rises in Nation 1.
◼ This causes Px/Py to rise in Nation 1.
◼ On the other hand, as Nation 2 (the K-abundant nation)
specializes in the production of commodity Y (the K-
intensive commodity), its relative demand for capital
increases and r/w rises (i.e., w/r falls).
◼ This causes Py/Px to rise (i.e., Px/Py to fall) in Nation 2.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Relative and Absolute Factor–Price
Equalization

◼ The process will continue until point B=B’, at

which 𝑃𝐵 = 𝑃𝐵′ and w/r = (w/r)* in both nations.
◼ Note that 𝑃𝐵 = 𝑃𝐵′ only if w/r is identical in
two nations, since both nations operate under
perfect competition and use the same
technology (based on assumption!).
◼ 𝑃𝐵 = 𝑃𝐵′ lies between 𝑃𝐴 and 𝑃𝐴′ .
◼ (w/r)* lies between (w/r)1 and (w/r)2 .

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Relative and Absolute Factor–Price
Equalization

◼ To summarize, Px/Py will become equal as a

result of trade, and this will occur only when
w/r has also become equal in the two nations
(as long as both nations continue to produce
both commodities).

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Effect of Trade on the Distribution of Income

◼ We want to examine how international trade affects

real wages and the real income of labor in relation to
real interest rates and the real income of owners of
capital within each nation.
◼ Do the real wages and income of labor rise or fall in
relation to the real interest rates and earnings of
owners of capital in the same nation as a result of
international trade?
◼ Trade increases the price of the nation’s abundant
and cheap factor and reduces the price of its scarce
and expensive factor.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Effect of Trade on the Distribution of Income

◼ In terms of the example, w rises and r falls in Nation

1, while w falls and r rises in Nation 2.
◼ Since labor and capital are assumed to remain fully
employed before and after trade, the real income of
labor and the real income of owners of capital move
in the same direction as the movement in factor
prices.
◼ Thus, trade causes the real income of labor to rise and
the real income of owners of capital to fall in Nation 1
(the nation with cheap labor and expensive capital).

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Effect of Trade on the Distribution of Income

◼ On the other hand, international trade causes the real

income of labor to fall and the real income of owners
of capital to rise in Nation 2 (the nation with
expensive labor and cheap capital).
◼ This is the conclusion of the Stolper–Samuelson
theorem.
◼ Since in developed nations (e.g., the United States,
Germany, Japan, France, Britain, Italy, Canada)
capital is the relatively abundant factor (as in our
Nation 2), international trade tends to reduce the real
income of labor and increase the real income of
owners of capital.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Effect of Trade on the Distribution of Income

◼ This is why labor unions in developed nations

generally favor trade restrictions.
◼ In less developed nations (e.g., India, Egypt, Korea,
Mexico), however, labor is the relatively abundant
factor, and international trade will increase the real
income of labor and reduce the real income of
owners of capital.
◼ Since, according to the Heckscher–Ohlin theory,
international trade causes real wages and the real
income of labor to fall in a capital-abundant and
labor-scarce nation such as the United States,
shouldn’t the U.S. government restrict trade?
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Effect of Trade on the Distribution of Income

◼ The answer is almost invariably no.

◼ The reason is that the loss that trade causes to labor is
less than the gain received by owners of capital.
◼ With an appropriate redistribution policy of taxes on
owners of capital and subsidies to labor, both broad
classes of factors of production can benefit from
international trade.
◼ Such a redistribution policy can take not only the form
of retraining labor displaced by imports but also the
form of tax relief for labor and provision of some social
services.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 The Specific-Factors Model

◼ The effect of international trade on the distribution of

income discussed in the previous section is based on
the assumption that factors are perfectly mobile
among the nation’s industries or sectors.
◼ Although this is likely to be true in the long run, it
may not be true in the short run, when some factors
(say, capital) may be immobile or specific to some
industry or sector.
◼ In this case, the conclusions of the Heckscher–Ohlin
model on the effects of international trade on
distribution need to be modified as explained by the
specific-factors model.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 The Specific-Factors Model

◼ Under the specific-factors model, both commodities are

produced with labor and capital, but labor is mobile between
the two industries while capital is specific to each industry.
◼ That is, the capital used in the production of X (say, food)
cannot be used in the production of Y (say, cloth), and
vice versa.
◼ With the opening of trade, the nation will specialize in the
production of and will export commodity X (the labor-
intensive commodity) and import commodity Y (the specific
capital-intensive commodity).
◼ This will increase the relative price of X (i.e., Px /Py ) and
the demand and nominal wage rate of labor in the nation.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 The Specific-Factors Model

◼ Some labor will move from the production of Y to the

production of X.
◼ Since labor is mobile between the two industries, industry
Y will have to pay the higher going nominal wage rate for
labor even while facing a reduction in Py /Px and the
transfer of some its labor to the production of X.
◼ The effect of this on the real wage rate of labor in the nation is
ambiguous.
◼ The reason is that the increase in Px /Py and in the derived
demand for labor will be greater than the increase in the
nominal wage rate.
◼ Thus, the real wage rate of labor falls in terms of
commodity X.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 The Specific-Factors Model

◼ On the contrary, since the nominal wage rate increased

but the price of commodity Y (the import-competing
commodity) declined in the nation, the real wage rate
increased in terms of commodity Y.
◼ Thus, the real wage rate in the nation falls in terms of
X but rises in terms of Y.
◼ The effect on the real wage of labor is, therefore,
ambiguous.
◼ The real wage and income will fall for those workers
who consume mainly commodity X and will increase
for those workers who consume mainly commodity Y.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 The Specific-Factors Model

◼ The result for specific capital is not ambiguous.

◼ Since capital is specific to each industry, opening trade
does not lead to any transfer of capital from the
production of commodity Y to the production of
commodity X in the nation.
◼ With more labor used with the given specific capital in the
production of X (the nation’s export commodity), the real
return on capital in the production of X rises.
◼ On the contrary, with less labor used with the same
amount of specific capital in the production of Y (the
nation’s import-competing commodity), the real return on
the specific capital used in the production of Y falls.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 The Specific-Factors Model

◼ Results of the Specific-Factors Model

◼ Trade will:
◼ have an ambiguous effect on a nation’s mobile
factors,
◼ benefit the immobile factors specific to a
nation’s export commodities or sectors, and
◼ harm the immobile factors specific to a nation’s
import-competing commodities or sectors.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Empirical Tests of the Heckscher-Ohlin Model

◼ The Leontief Paradox

◼ A 1951 test of the H-O theory
◼ The first empirical test of the Heckscher–Ohlin
model was conducted by Wassily Leontief in 1951
using U.S. data for the year 1947.
◼ Since the United States was the most K-abundant
nation in the world, Leontief expected to find that
it exported K-intensive commodities and
imported L-intensive commodities

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Empirical Tests of the Heckscher-Ohlin Model

◼ The Leontief Paradox

◼ Leontief estimated K/L for U.S. import
substitutes rather than for imports.
◼ Import substitutes are commodities, such as
automobiles, that the United States produces at
home but also imports from abroad (because of
incomplete specialization in production).
◼ Showed that the pattern of trade did not fit the
conclusions of the H-O theorem.
◼ Exports in the U.S. seemed to be labor intensive
when they should have been capital intensive.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Case Study 5-7 Capital and Labor Requirements
in U.S. Trade

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Empirical Tests of the Heckscher-Ohlin Model

◼ Table 5.6 gives the capital and labor requirements per

million dollars of U.S. exports and import substitutes, as
well as the capital/worker-year for imports relative to
exports.
◼ For example, dividing the capital/worker-year of $18,180
for U.S. import substitutes by the capital/worker-year of
$14,010 for exports using 1947 data (see the third row of
the table), Leontief obtained the capital/worker-year for
imports relative to exports of 1.30.
◼ Since the United States is a relatively capital-abundant
nation and U.S. import substitutes are more capital
intensive than U.S. exports, we have a paradox.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Empirical Tests of the Heckscher-Ohlin Model

◼ Using 1951 trade data, the K/L ratio for imports/exports

fell to 1.06, and, excluding natural resource industries, the
ratio fell to 0.88 (thus eliminating the paradox).
◼ Using 1958 input requirements and 1962 trade data,
Baldwin obtained the K/L ratio for imports/exports of 1.27.
◼ When natural resource industries were excluded, the ratio
fell to 1.04, and when human capital was included, it fell
to 0.92 (once again, eliminating the paradox)

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Empirical Tests of the Heckscher-Ohlin Model

◼ Source of the Leontief Paradox Bias

◼ A more general source of bias is that Leontief used a two-
factor model (L and K), thus abstracting from other factors
such as natural resources (soil, climate, mineral deposits,
forests, etc.).
◼ However, a commodity might be intensive in natural
resources so that classifying it as either K or L intensive
(with a two-factor model) would clearly be inappropriate.
◼ Furthermore, many production processes using natural
resources—such as coal mining, steel production, and
farming—also require large amounts of physical capital.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Empirical Tests of the Heckscher-Ohlin Model

◼ The U.S. dependence on imports of many natural resources,

therefore, might help explain the large capital intensity of U.S.
import-competing industries.
◼ U.S. tariff policy was another source of bias in the Leontief
study.
◼ A tariff is nothing else than a tax on imports. As such, it
reduces imports and stimulates the domestic production of
import substitutes.
◼ In a 1956 study, Kravis found that the most heavily protected
industries in the United States were the L-intensive industries.
◼ This biased the pattern of trade and reduced the labor
intensity of U.S. import substitutes, thus contributing to the
existence of the Leontief paradox.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Empirical Tests of the Heckscher-Ohlin Model

◼ Perhaps the most important source of bias was the fact that
Leontief included in his measure of capital only physical
capital (such as machinery, other equipment, buildings, and
so on) and completely ignored human capital.
◼ Human capital refers to the education, job training, and
health embodied in workers, which increase their
productivity.
◼ The implication is that since U.S. labor embodies more
human capital than foreign labor, adding the human capital
component to physical capital would make U.S. exports
more K intensive relative to U.S. import substitutes.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Empirical Tests of the Heckscher-Ohlin Model

◼ Source of the Leontief Paradox Bias

(Summary)
◼ Assumed a two factor world which required
assumptions about what is capital and what is
labor.
◼ Most heavily protected industries in U.S. were L-
intensive, reduced imports and increased
domestic production of L-intensive goods.
◼ Only physical capital included as capital, ignoring
human capital (education, job training, skills).

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Case Study 5-8 The H-O Model with Skills and
Land

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Case Study 5-8 The H-O Model with Skills
and Land

◼ Figure 5.6 shows that:

◼ Africa (1) with relatively more abundant land and
fewer skilled workers exports more primary
commodities,
◼ whereas industrial market economies (5) with
relatively more skilled workers export more
manufactured goods.
◼ Between Africa and industrial countries lie Latin
America (2), South Asia (3), and East Asia (4), which
have relatively less land and more skilled workers than
Africa and export relatively more manufactured goods
than Africa but fewer than industrial countries.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Case Study 5-8 The H-O Model with Skills
and Land

◼ The straight line in the figure is the regression line

showing the general relationship between relative factor
endowments and type of exports.
◼ It was estimated for the year 1985 from 126 data points
(not shown in the figure), each referring to a country, and
it shows a clear positive relationship between skill
availability and exports of manufactures.
◼ The numbered circles in the figure show regional
averages.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Summary

◼ The Heckscher–Ohlin theory presented in this

chapter extends our trade model of previous
chapters to explain the basis of (i.e., what
determines) comparative advantage and to
examine the effect of international trade on
the earnings of factors of production.
◼ These two important questions were left
largely unanswered by classical economists.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Summary

◼ The Heckscher–Ohlin theory is based on a number of

simplifying assumptions (some made only implicitly
by Heckscher and Ohlin).
◼ These are (1) two nations, two commodities, and two
factors of production; (2) both nations use the same
technology; (3) the same commodity is labor
intensive in both nations; (4) constant returns to
scale; (5) incomplete specialization in production; (6)
equal tastes in both nations;

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Summary

◼ (7) perfect competition in both commodities and

factor markets; (8) perfect internal but no
international mobility of factors; (9) no transportation
costs, tariffs, or other obstructions to the free flow of
international trade; (10) all resources are fully
employed; and (11) trade is balanced.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Summary

◼ In a world of two nations (Nation 1 and Nation 2),

two commodities (X and Y), and two factors (labor
and capital), we say that commodity Y is capital
intensive if the capital–labor ratio (K/L) used in the
production of Y is greater than K/L for X in both
nations.
◼ We also say that Nation 2 is the K-abundant nation if
the relative price of capital (r/w) is lower there than
in Nation 1.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Summary

◼ Thus, Nation 2’s production frontier is skewed toward

the Y-axis and Nation 1’s is skewed toward the X-axis.
◼ Since the relative price of capital is lower in Nation 2,
producers there will use more K-intensive techniques in
the production of both commodities in relation to
Nation 1.
◼ Producers would also substitute K for L (causing K/L to
rise) in the production of both commodities if the
relative price of capital declined. Commodity Y is
unequivocally the K-intensive commodity if K/L
remains higher for Y than for X in both nations at all
relative factor prices.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Summary

◼ The Heckscher–Ohlin, or factor-endowment, theory

can be expressed in terms of two theorems.
◼ According to the H–O theorem, a nation will export
the commodity intensive in its relatively abundant
and cheap factor and import the commodity
intensive in its relatively scarce and expensive factor.
◼ According to the factor–price equalization (H–O–S)
theorem, international trade will bring about
equalization of relative and absolute returns to
homogeneous factors across nations.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Summary

◼ If some factors are specific (i.e., can only be used in

some industries), the specific-factors model
postulates that trade will have an ambiguous effect
on the nation’s mobile factors.
◼ It will benefit the immobile factors that are specific to
the nation’s export commodities or sectors, and harm
the immobile factors that are specific to the nation’s
import-competing commodities or sectors.

Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Summary

◼ Out of all the possible forces that could cause a difference

in pretrade-relative commodity prices between nations,
Heckscher and Ohlin isolate the difference in factor
endowments (in the face of equal technology and tastes)
as the basic determinant or cause of comparative
advantage.
◼ International trade can also be a substitute for the
international mobility of factors in equalizing relative and
absolute returns to homogeneous factors across nations.
◼ The general equilibrium nature of the H–O theory arises
from the fact that all commodity and factor markets are
components of an overall unified system so that a change
in any part affects every other part.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 Summary

◼ The first empirical test of the H–O model was

conducted by Leontief using 1947 U.S. data.
◼ Leontief found that U.S. import substitutes were about
30 percent more K intensive than U.S. exports.
◼ Since the United States is the most K-abundant nation,
this result was the opposite of what the H–O model
predicted; this became known as the Leontief paradox.
◼ Empirical results seem to show that the traditional Heckscher–
Ohlin model can explain trade between developed and
developing countries (often referred to as North–South trade)
and a highly qualified or restricted version of the H–O can
model the much larger trade among developed countries (i.e.,
North–North trade).
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
 ◼ Copyright 2013 John Wiley & Sons, Inc.

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Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.