November, 2019

International Economics

Instructor: Girma Estiphanos, Ph. D.

The Neoclassical Trade Theory

Economists in the Classical school developed the basic propositions regarding the
nature and impact of international trade in the late eighteenth and nineteenth
centuries. However, their analyses were limited considerably by the labor theory of
value and the assumption of constant costs. The development of neoclassical
economic theory in the late nineteenth and early twentieth centuries provided tools
for analyzing the impact of international trade in a more rigorous and less
restrictive manner. The term neoclassical derives from the view that writers were
extending and improving on the basic foundations of the classical economists.

In Ricardo’s model, it has been shown that mutually beneficial trade can be
achieved through the principle of comparative advantage (or comparative cost). In
addition to understanding the principle of comparative advantage, one also needs
to understand why each country has a comparative advantage or disadvantage in
the production of various goods. What determines a country’s comparative
advantage is of considerable significance since the location of international
production facilities and the pattern of trade throughout the world is not random.
The next discussion addresses the following two major questions:

a) What determines a country’s comparative advantage?

b) How does international trade affect the payments or returns to the factors
of production such as labor and capital?
The Heckscher – Ohlin (H – O) Model

Eli F. Heckscher (1879 – 1952) was a Swedish economist and economic historian.
In 1919, he published a brief article that contained the core idea of what determines
nations’ trade patterns. A clear overall explanation was developed and publicized
in the 1930s by Heckscher’s student, Bertil Ohlin (1899 – 1979). Many
elaborations (in terms of mathematical derivations) of the H – O model were
provided by Paul Samuelson, an American economist and a Noble price winner in
economics in 1976, after the 1930s and thus sometimes the model is refereed to as
the Heckscher – Ohlin – Samuelson (HOS) model. Eli Heckscher and Bertil Ohlin
accepted the fact that international trade is based on differences in comparative
costs, but attempted to explain the factors, which make for the differences in
comparative costs.

The H – O model is based on the following simplifying assumptions:

a) A two-country, two – good, and two – factor model,

b) The supply of the two factors of production is given,
c) The factors of production are mobile domestically, but immobile
internationally,
d) The technology available to produce the two goods is the same in both
countries and each good is produced under constant returns to scale,
e) The trading partners have the same tastes and preferences (or demand
conditions),
f) Perfect competition in both the product and factor markets, and
g) Absence of transportation costs, tariffs, and other obstructions to trade.
The H – O model (or neoclassical model) is the dominant model of comparative
advantage in modern economics. According to David Ricardo and Adam Smith,
trade between nations takes place because of the difference in the productivity of
labor, the only factor of production. The H – O model, on the other hand, goes
further to explain the basis for trade as factor endowment and factor intensity.
Specifically, the theory argues that relative price levels differ among nations
because they have different relative endowments of factors (that is, supplies of
factor of production) of production and that different commodities require differing
intensities (that is, degree of factor use) of factor inputs in their production.

There are four main theorems in the H – O model: the Hekscher – Ohlin theorem,
the Stolper – Samuelson theorem, the Rybczynski theorem, and the factor – price
equalization theorem. The Stolper – Samuelson and Rybczynski theorems describe
relationships between variables in the model while the H – O and factor – price
equalization theorems present some of the key results of the model. Applications of
these theorems also allow one to derive some other important implications of the
model

The Heckscher – Ohlin Theorem

Assuming two factors of production, labor and capital, in two countries, the H – O
theorem postulates that a labor – abundant (or capital – scarce) country will have a
comparative advantage in the production of and export of labor – intensive goods,
while a capital – abundant (or labor – scarce) country will have a comparative
advantage in the production of and export of capital – intensive goods. Thus,
through trade, a labor – abundant country will export labor – intensive goods
(because labor is cheap or wages are low) and import capital -intensive goods,
while a capital – abundant country will export capital – intensive goods (because
capital is cheap or rental costs are low) and import labor-intensive goods.

A labor – abundant country is one that is well endowed with labor relative to the
other country. This gives the country a propensity for producing the good which
use relatively more labor in the production process, that is, the labor – intensive
good. As a result, if these two countries were not trading initially, that is, they were
in autarky, the price of the labor- intensive good in the labor – abundant country
would be bid down (due to extra supply) relative to the price of the good in the
other country. Similarly, in the capital – abundant country, the price of the capital –
intensive good would be bid down relative to the price of that good in the labor –
abundant country. Thus, the H – O theorem demonstrates that a difference in
resource endowments as defined by national abundances is one reason that
international trade may occur.

The Stolper – Samuelson Theorem

The Stolper – Samuelson theorem describes the relationship between changes in

output, or goods, prices and changes in factor prices such as wage rates and rental
rates within the context of the H – O model. The theorem states that if the price of
the labor-intensive good rises, then the price of labor (that is, wage rate), the factor
used intensively in that industry, will rise, while the price of capital (that is, rental
rate) will fall. Similarly, if the price of the capital-intensive good were to rise, then
the rental rate would rise while the wage rate would fall. Since prices change in a
country when trade liberalization occurs, the magnification effect can be applied to
yield an interesting and important result. Thus, a movement to free trade will cause
the real return of a country’s relatively abundant factor to rise, while the real return
of the country’s relatively scarce factor will fall.
The Factor – Price Equalization Theorem

The factor – price equalization theorem postulates that international trade will
bring about equalization (or convergence) in the relative and absolute returns to
homogeneous factors across nations. In other words, international trade will cause
the return labor (that is, wage rate) to be the same in all the trading nations.
Similarly, international trade will cause the returns to capital (rental rates) to be the
same in all the trading nations. The theorem derives from the assumptions of the
model, that the two countries share the same production technology and that
markets are perfectly competitive. In a perfectly competitive market, factors are
paid on the basis of the value of their marginal productivity, which in turn depends
upon the output prices of the goods. Thus, when prices differ between countries, so
will their marginal productivities and hence so will their wages and rents.
However, once goods prices are equalized, as they are in free trade, the values of
marginal products are also equalized between countries and hence the countries
must also share the same wage rates and rental rates. As such, international trade is
a substitute for the international mobility of factors. One should note, however, that
factor-price equalization is unlikely because it assumes the same technology
between countries, which is unlikely in the real world.

The Rybczynski Theorem

The Rybczynski theorem demonstrates the relationship between changes in

national factor endowments and changes in the outputs of the final goods within
the context of the H – O model. It states that an increase in a country’s endowment
of a factor will cause an increase in output of the good which uses that factor
intensively, and a decrease in the output of the other good. For example, if the U.S.
experiences an increase in capital equipment, then that would cause an increase in
output of the capital – intensive good, steel, and a decrease in the output of the
labor – intensive good, clothing. The theorem is useful in addressing issues such as
investment, population growth and hence labor force growth, immigration and
emigration, all within the context of the H – O model

An Evaluation of the H – O Model

The gist of the H – O model (or factor – endowment and factor-intensity theory) is
that comparative advantage and international trade occur because countries are
endowed with different factors and the production of goods requires different
proportions of these factors. There are mixed views among economists regarding
the validity of this theory. Some economists are of the view that certain
refinements are required on the H – O theory in order to explain the current trade
patterns. Others are seeking to replace the theory with a different approach. In what
follows, attempts are made to present two opposing views on the H – O theory of
comparative advantage.

The first view holds that the trade patterns of the 1980s do fit into the H – O
theory. For example, Japan had an export advantage in technology – intensive
products such as transport equipment, machinery, chemicals, and computers
because it had abundant supply of scientific personnel. On the other hand, Japan
depended on imports of natural resource – intensive primary products because it
had scarce resources for the production of such products. The second view reflects
the challenges to the H – O theory of comparative advantage. It argues that, even
with identical endowments, technology, tastes, and income distribution, trade can
take place owing to increasing returns to the firm. The typical example in this
regard is intra - industry trade (or trade in differentiated products). The advocates
of these views utilize models of imperfect competition and economies of scale to
substantiate their arguments.

Another challenge to the H – O theory was an empirical testing that was done by
Wassily W. Leontief in 1954. Leontief received the Nobel in 1973 for his
contribution on input – output table. He applied input – output technique to
examine the structure of US foreign trade. He examined the factor composition of
US exports and US imports. He considered that the US is capital abundant and thus
should export capital – intensive products. His surprising conclusion was that US
exports were labor - intensive, and US import substitutes were capital – intensive.
Thus, his finding appeared to refute the H-O model, resulting in what is now
referred to as the “Leontief Paradox.” Leontief’s findings caused considerable
dismay among economists, leading to the conclusion that something was either
wrong with the empirical test or with the basic theory. It turned out to be both,
resulting in a better understanding of how factor abundance influences
international trade. The next discussions highlight some of the explanations of the
Leontief paradox.

The most important explanation for the Leontief paradox has to do with the skill
level of the US workforce and its high technology. Leontief’s test, which found
that US exports were labor intensive, was based on the simple two - factor version
of the factor - proportions model. This simple model assumes that labor is
homogeneous. However, much of the US labor force is highly skilled or possesses
human capital (knowledge and skills) compared to other countries. Therefore, what
needs to be considered is what constitutes a factor of production? Physical capital
can be used as a factor as it was described in the simple version of the H – O
theory, but the same cannot be said for labor. In other words, the knowledge and
skills that the labor force (human capital) possesses should be treated as a separate
factor of production. Thus, it is reasonable to argue that the basic logic embodied
in the factor-proportions theory is correct. What is required is to broaden the
concept of factors of production in order to include factors other than labor and
capital.

The New Trade Theories

The point of departure in discussing the new trade theories is relaxing some of the
major assumptions of the H – O theory. In other words, relaxing most of the
assumptions of the theory only modifies but does not invalidate the theory.
However, relaxing the assumptions of constant economies of scale and perfect
competition requires the introduction of new trade theories which explain the
significant portion of international trade that have not been explained by the H – O
theory. The next discussion focuses on these new trade theories.

Trade Based on Differentiated Products (or Intra – Industry Trade)

There is a substantial portion of trade that the H – O model does not explain.
Countries can trade similar goods with one another, known as intra - industry trade
or trade in differentiated products. Differentiated products refer to similar, but not
identical products such as automobiles, cigarettes, television sets, and typewriters.
For example, Canada and the US have a large trading relationship based on
exporting and importing automobiles to and from each another. This implies that a
country simultaneously has a comparative advantage and a comparative
disadvantage in the same good.

There are at least three major reasons for product differentiation. First, Many
varieties of a product exist because produces attempt to distinguish their products
in the minds of consumers in order to achieve brand loyalty. In addition,
consumers themselves want a broad range of characteristics in a product from
which to choose. Since consumer tastes differ in innumerable way, some intra –
industry trade emerges because of product differentiation. Secondly, in a
physically large country, such as the US, transport costs for a product may play a
role in causing intra – industry trade, especially if the product has large bulk
relative to its value. For example, if a given product is manufactured both in the
eastern part of Canada and in California, a buyer in Maine (US’s state which is
closer to Canada) may buy the Canadian product rather the California product
because the transport costs are lower. At the same time, a buyer in Mexico may
purchase the California product. Thus, the US is both exporting and importing the
good. Finally, differing distributions of income can lead to intra – industry trade.
For instance, producers may cater to “majority” tastes (in terms of income) within
their nation, leaving “minority” tastes to be satisfied by imports

Trade Based on Economies of Scale

One of the assumptions of the H – O model was that both commodities were
produced under conditions of constant returns to scale in the two nations.
However, with increasing returns to scale, mutually beneficial trade can take place
even if the two nations are identical in every respect. Increasing returns to scale
refers to the production situation where output grows proportionately more than the
increase in the use of inputs or factors of production. For example, if all inputs are
doubled, output is more than doubled; and if all inputs are tripled, then output is
more than tripled. Increasing returns to scale may occur because at a larger scale of
operation, a greater division of labor and specialization become possible. In other
words, each worker can specialize in performing a simple repetitive task, resulting
in increased productivity. Furthermore, a larger scale of operation may permit the
introduction of more specialized and productive machinery than would be feasible
at a smaller – scale of operation. Thus, mutually beneficial trade is possible based
on increasing returns to scale.

Trade Based on Technological Gaps and Product Cycles

According to the technological gap model, trade among industrialized countries is

based on the introduction of new products and new production processes. The
innovating nation shall have a temporary monopoly in terms of patents and
copyrights, which are granted to stimulate the flow of inventions. For example, the
US exports a large number of new high - technology products. However, as other
countries acquire the new technology, they will be in a position to produce the
products at lower labor costs. In the meantime, the US producers may have
introduced still newer products and newer production processes and may be able to
export these products based on the new technological gap established. One
shortcoming of the technological gap model is that it does not explain the reasons
for and the size of the gap.

A generalization and extension of the technological gap model is what is refereed

to as the product cycle model. According to this model, changes in technology and
the subsequent introduction of new products can change the pattern of exports and
imports. The basic idea behind the product cycle model is that certain countries,
primarily industrialized countries, specialize in the production of new goods based
on technological innovations, while other countries, mostly developing countries,
specialize in the production of the already well – established goods. Furthermore,
the model postulates that the introduction of new products usually requires highly
skilled labor in the production process. As the product matures and acquires mass
acceptance, its production becomes standardized, requiring less skilled labor. In
this process, the comparative advantage shifts from the advanced nation that
originally introduced the product to the less advanced nation with relatively
cheaper labor. This may be accompanied by foreign direct investment from the
innovating nation to the nation with cheaper labor. It should be pointed out that,
while the technological gap model emphasizes the time lag in the imitation
process, the product cycle model stresses the standardization process.

Summary

1. This chapter examined the development of trade theory from the

mercantilists to Adam Smith, David Ricardo, Heckscher – Ohlin, and the
new trade theories. It tried to answer three basic questions: a) what is the
basis for trade? b) what are the gains from trade? and c) what is the pattern
of trade?

2. The mercantilists emphasized the desirability of an export surplus in

international trade as a means of acquiring specie (primarily, gold and silver)
to add to the wealth of a country. They believed that a nation could gain in
international trade only at the expense of other nations. This implied that
international trade was a zero – sum game where exports were positive and
imports were negative. Thus, they advocated incentives for exports,
restrictions on imports, and strict government regulation of all economic
activities. Over time, the concept of wealth and the role of trade, and the
whole Mercantilist system of economic thought, were challenged by writers
such as David Hume and Adam Smith. Mercantilism broke down because it
lost intellectual respectability.

3. Adam Smith’s concept of absolute advantage was instrumental in altering

views on the nature of and the potential gains from trade. Assuming a two –
 nation, two – commodity, and the labor theory of value, Smith concluded
that mutually beneficial trade is possible based on absolute advantage.
According to Smith’s principle of absolute advantage, each country should
specialize in and export those commodities that it produces more efficiently
(i.e., with fewer labor input requirement) and should import those
commodities that it produces less efficiently (that is, with higher labor input
requirement). This implied that international trade was a positive – sum
game where both nations could mutually benefit from trade. Smith argued
that the role of the government was to see that markets function properly, by
removing barriers to effective operation of the “invisible hand” of the
market. However, there were few exceptions to Smith’s “laissez faire”
policy. For example, the protection of infant industries and industries that
are important for national defense were among the few exceptions.

4. Today, Smith’s principle of absolute advantage explains only a small portion

of international trade such as those between developed and developing
countries. Most of world trade such as those among developed countries
could not be explained by absolute advantage. David Ricardo expanded on
the concept of absolute advantage by introducing the concept of comparative
advantage. According to Ricardo’s principle of comparative advantage, even
when one country is more efficient (or has an absolute advantage) than the
other nation in the production of both goods, mutually beneficial trade could
still take place. He argued that the more efficient nation should specialize in
and export the good in which its absolute advantage is greater, and import
the good in which its absolute advantage is smaller. Similarly, the less
efficient nation should specialize in and export of the good in which its
absolute disadvantage is smaller, and import the good in which its absolute
 disadvantage is greater. Ricardo introduced the concept of opportunity cost
to illustrate this case as applied to his popular examples of two goods, wine
and cloth, in two countries, Portugal and the England.

5. The Classical economists (for example, Adam Smith and David Ricardo)
developed the basic propositions regarding the nature and impact of
international trade. However, they were limited considerably in their
analyses by the assumptions of the labor theory of value and constant costs.
The development of the neoclassical economic theory in the late nineteenth
and early twentieth centuries provided tools for analyzing the impact of
international trade in a more rigorous and less restrictive manner. The
application of neoclassical theory to international trade issues and later
refinements of these ides constitute the basic contemporary theory of trade.

6. The Neoclassical model goes one step further (as compared to the Classical)
to extend the analyses in two directions. First, it tries to explain the reasons
for the difference in relative commodity prices and comparative advantage
between the two nations. Secondly, it attempts to analyze the effect of
international trade on the earnings of the factors of production in the two
trading nations. According to classical economists, comparative advantage
was based on the difference in the productivity of labor (the only factor of
production they considered) among nations, but they did not provide
explanation for such a difference. Two Swedish economists, Eli F.
Heckscher and Bertil Ohlin (H – O), undertook the task of providing those
explanations. Many elaborations of the model were provided by Paul
Samuelson, an American economist and a Nobel price winner in economics
 in 1976, after the 1930s and thus sometimes the model is refereed to as the
Heckscher – Ohlin – Samuelson (H – O- S) model.

7. There are four main theorems in the H – O model: the Heckscher – Ohlin
theorem, the Stolper – Samuelson theorem, the Rybczynski theorem, and the
factor – price equalization theorem. The Stolper – Samuelson and
Rybczynski theorems describe relationships between variables in the model
while the H – O and factor – price equalization theorems present some of the
key results of the model. Applications of these theorems also allow one to
derive some other important implications of the model.

8. On the basis of the simplifying assumptions that have been stated in the text,
the Heckscher – Ohlin (H – O) theorem may be stated as follows. A nation
will export the commodity whose production requires the intensive use of
the nation’s relatively abundant and cheap factor of production and import
the commodity whose production requires the intensive use of the nation’s
relatively scarce and expensive factor of production. For example, assuming
two factors of production, labor and capital, the theorem states that the
relatively labor – rich nation exports the relatively labor – intensive
commodity (because wage is lower), and imports the relatively capital –
intensive commodity (because rental cot of capital is higher). Similarly, the
relatively capital – rich nation exports the relatively capital – intensive
commodity (because rental cost of capital is lower), and imports labor –
intensive commodity (because wage is higher). Thus, the H – O theorem
emphasizes factor endowments and factor intensities as the bases for
international trade. For this reason, the theorem is often refereed to as factor
– endowment and factor proportion theory.
9. There were mixed view on the theoretical and empirical validities of the H –
O theorem of international trade. Some writers hold the view that the trade
patterns of the 1980s do fit into the H – O model, by citing the examples of
Japan and the U. S. Others argued that the H – O theory should be refined
and / or replaced, especially because of its restrictive assumptions such as
similar tastes and preferences, and constant returns to scale production
function. The major challenge to the H – O theory was the empirical testing
that was done by Wassily W. Leontief in 1954. Leontief’s findings refuted
the H – O theorem, resulting in what is now refereed to as the “Leontief
Paradox.” Consequently, refinements were made to the H – O theory of
international trade, leading to the new trade theories, which are based on
differentiated products, economies of scale, technological gap, and product
cycles.

10.Trade based on differentiated products (or intra – industry trade) is a

proposition that argues that countries can trade similar (but not identical)
products with one another. In other words, countries can simultaneously
export and import similar goods. For example, the US both exports and
imports automobiles, cigarettes, chemicals, and many other industrial
products.

11.Trade based on economies of scale emanates from the fact that trade can
take place between two countries because of scale economies, regardless of
the same endowments, technology, and tastes. Economies of scale arise
because division of labor and specialization become possible when the scale
 of operation is sufficiently great. In other words, efficiency and productivity
increase with a large scale of operation.

12.Technological gap model postulates that a great deal of the exports of

industrial nations is based on the introduction of new products and new
production processes. Product cycle model is a generalization and extension
of the technological gap model. It postulates that the comparative advantage
in introducing new products lies in the high – technology nations but
ultimately shifts to cheap- labor nations once the product acquires mass
acceptance. Technological gap model emphasizes the time lag in the
imitation process, while the product cycle model stresses the standardization
process.

Glossary of Key Concepts and Terms

1. History of Economic Thought: The study of the heritage left by writers on

economic subjects over many years

2. Mercantilism: A philosophy that was popular in countries such as Britain,

Spain, France, and the Netherlands during the seventeenth and eighteenth
centuries. The essence of mercantilism was statecraft. It is based on the
premise that a country can promote its self – interest by discouraging
imports and encouraging exports in order to increase its wealth.
Furthermore, a country’s wealth was based on its holdings of precious
metals, primarily gold and silver. The doctrine of mercantilism had many
features: it was highly nationalistic, it favored the regulation and planning of
 economic activity as an effective means of fostering the goals of the nation,
and it favored positive trade balance.

3. Favorable Trade Balance: The excess of exports over imports or favorable

balance of trade.

4. Zero – Sum Game: A game in which one person’s winnings are matched by
the losses of the other player. In the context of international trade, it is a
situation in which one country’s economic gain is achieved at the expense of
the other.

5. Price – Specie – Flow Mechanism: A proposition forwarded by David

Hume to challenge the mercantilists’ view on international trade regarding the
maintenance of favorable trade balance. Hume argued that the accumulation of
gold by means of a trade surplus would lead to an increase in the money supply
and therefore to an increase in prices and wages. This would reduce the
competitiveness of the country with a surplus. On the other hand, the loss of
gold in the deficit country would reduce its money supply, prices, and wages
and therefore increases its competitiveness. Thus, it is not possible for a nation
to continue to maintain a positive trade balance indefinitely.

6. Physiocrats: A doctrine which developed in France in the eighteenth century as

a reaction against mercantilism. The founder and leader of the physiocratic school
was Francois Quesnay (1694 – 1774). The physiocrats developed the idea of
natural order. They argued that governments should never extend their interference
in economic affairs beyond the minimum essentials of protecting life and property.
They were opposed to almost all feudal, mercantilist, and government restrictions.
This is the basis for the famous phrase “laissez faire, laissez passer” – let it be, let
it go. The physiocrats thought that only agriculture was productive, for it produces
a surplus a net product above the cost of production. They looked at the economy
as a whole and analyzed the circular flow of wealth.

7. Laissez – Faire: A doctrine that advocated that the economic affairs of society
are best guided by the decisions of individuals to the virtual exclusion of collective
authority. The idea has its basis in the writings of the Physiocrats, but its analytic
foundations of the idea lie in the work of Adam Smith and the classical school.
Smith argued that individuals acting purely out of self-interest would be a
progressive force for the maximization of the total wealth of a nation. The role of
the authorities, given this aim, should be permissive, creating a legal defensive
apparatus sufficient to allow individual action. Interference with the free working
of this natural order will reduce the growth of wealth and misdirect resources.

8. Positive – Sum Game: A game in which all players can receive a positive
payoff in the game. In the context of international trade, it is a situation in which
all the trading partners can mutually benefit from trade.

9. Absolute Advantage: Is the basis for trade according to Adam smith. Smith
argued that each nation should specialize in the production of those commodities
that it could produce more efficiently than other nations, and should import those
commodities that it could produce less efficiently. According to Smith, this
international specialization of factors of production would result in an increase in
world output, which would be shared by the trading partners.
10. Efficiency: A concept that was developed at the turn of the twentieth century
by the Italian – French economist Vilfredo Pareto and is sometimes known as
Pareto – efficiency or Pareto – optimality. The term can be described in two ways:
efficiency of production and efficiency of an economic system. In the former case,
a plant may be said to be efficient if all its resources (for example, land, labor,
capital, and entrepreneurial skills) are used well. This would imply that a given
level of output is being produced with the least resource cost. In other words, the
given productive resources are being used to produce output with a maximum
value. In the later case, an economic system is said to be efficient if the resources
are being used and goods and services are being distributed in such a way that it is
impossible to make anyone in the system better off without making someone else
worse off.

11. Comparative Advantage: Is the basis for trade according to David Ricardo.
Ricardo began by extending Smith’s idea of absolute advantage to his principle of
comparative advantage. Assuming two – nations, two-commodities, and one factor
of production (labor), a comparative advantage exists whenever the relative labor
requirements differ between the two nations. In other words, when the relative
labor requirements are different, the internal opportunity cost (that is, the next best
alternative forgone) of the two commodities is different in the two countries. Thus,
Ricardo argued that, even if one nation is less efficient than (has an absolute
disadvantage with respect to) the other nation in the production of both
commodities, there is still a basis for mutually beneficial trade. The less efficient
nation should specialize in the production of and export the commodity in which
its absolute disadvantage is smaller (or comparative advantage is greater), and
import the commodity in which its absolute disadvantage is greater (or
comparative advantage is lower). Ricardo demonstrated his case by using his
popular example of two countries, England and Portugal, and two goods, cloth and
wine.

12. Opportunity Cost: It is the most fundamental concept in economics. The

opportunity cost of an action is the value of the forgone alternative action.
Opportunity cost can only arise in a world where the resources available to meet
wants are limited so that all wants cannot be satisfied. If resources were limitless,
no action would be at the expense of any other and thus, the opportunity cost
would be zero. Clearly, in a real world of scarcity, opportunity cost is positive. For
example, in the theory of production, the opportunity cost of one commodity (say,
cloth) is the amount of another commodity (say, wine) that must be given up or
sacrificed in order to release just enough factors of production or resources to
enable the production of one additional unit of cloth.

13. The Production Possibility Schedule: The tabular presentation of alternative

combinations of the two commodities that a nation can produce by fully utilizing
all of its resources with the best technology available to it.

14. The Production Possibility Frontier (PPF): The graphical translation of the
production possibility schedule. It is also refereed to as the production possibility
curve or transformation curve. The PPF reflects all combinations of two products
that a country can produce at a given point in time given its resource base, level of
technology, full utilization of resources, and economically efficient production.

15. Labor Theory of value: A theory employed by the classical economists (for
example, David Ricardo and especially Karl Marx) to explain the determination of
relative prices on the basis of the quantities of labor embodied in the production of
the commodities. According to this theory, the cost or price of a commodity is
determined by or can be inferred exclusively from its labor content.

16. Factor Endowment: The supplies (or quantities) of factors of production. In

other words, it is the levels of availability of factors in an area or country. These
are usually defined as land, labor, capital, and entrepreneurial skills. The different
relative abundance of factors of production is the basis for explaining comparative
advantage in the H – O approach to international trade.

17. Factor Proportion: The degree of factor use or the ratio in which factors of
production are combined. In the case of two factors, labor and capital, it is the ratio
of labor to capital or capital to labor.

18. Labor – Intensive Commodity: The commodity with the higher labor –
capital ratio (L/K) at all relative factor prices.

19. Capital – Intensive Commodity: The commodity with the higher capital –
labor ratio (K/L) at all relative factor prices.

20. Leontief Paradox: The empirical findings that US import substitutes were
more capital intensive than US exports. This is contrary to the H – O model of
international trade, which predicts that, as the most capital – abundant nation, the
US should export capital – intensive products and import labor – intensive
products.

21. Intra – Industry Trade: International trade in the differentiated products of

the same industry or broad product group. Product differentiation can take two
forms: horizontal and vertical. Horizontal differentiation is based on certain
characteristics such as, for example, color or taste of a wine. Vertical
differentiation is based on quality, appealing to consumer’s income.

22. Economies of Scale: The production situation where output grows

proportionately more than the increase in the use of inputs or factors of production.
Economies of scale arise because of division of labor and specialization, resulting
from a sufficiently large scale of operation. In other words, division of labor and
specialization increases efficiency and productivity.

23. Technological gap Model: The hypothesis that a portion of international trade
is based on the introduction of new products using new production processes.

24. Product Cycle Model: The hypothesis that new products introduced by
advanced nations and produced with skilled labor eventually become standardized
and can be produced in other nations with less skilled labor.

Review Questions and Practical Exercises

1. Why are the pure theory of international trade and the theory of commercial
policy referred to as the microeconomic aspects of international economics?
Explain.

2. Why are the studies of the balance of payments and of the process of
adjustment to the balance of payments disequilibria referred to as the
macroeconomic aspects of international economics?
3. What are the basic questions that one seeks to answer in international trade
theories?

4. a) What were the mercantilists’ views on international trade and what

policies did they advocate in international trade?
b) How does the concept of national wealth differ from today’s view?
c) What are the contributions of the mercantilists to international trade?
d) What were the major challenges to mercantilists’ views on international
trade?

5. a) What were the bases for and the pattern of trade according to Adam
Smith?
b) What policies did Adam Smith advocate in international trade?
c) What did Adam Smith think about the proper role of the government in
the economic life of the nation? What were some of the exceptions in his
analysis?
d) By using your own example, illustrate Adam Smith’s principle of
absolute advantage.
e) What are the major contributions of Adam Smith to international trade
theory and what are the major weaknesses in his analysis of international
trade?

6. a) What do you understand by the concept of the “invisible hand?” Explain.

b) What do you understand by the concept of “laissez faire” and who
originated the concept?
c) How do you evaluate the concept of “laissez faire” in today’s world?
 7. a) What were the bases for and the pattern of trade according to David
Ricardo?
b) State and explain David Ricardo’s principle of comparative advantage.
c) Illustrate the principle of comparative advantage by using the concept of
opportunity cost (you may use tables and/or graphs).
d) In what way was Ricardo’s principle of comparative advantage superior
to Adam Smith’s principle of absolute advantage?
e) What are the major contributions of David Ricardo to international trade
theory and what were the major weaknesses in his analysis of international
trade?

8. a) What do you understand by the “neoclassical trade theory?”

b) How does the neoclassical trade theory of international trade depart from
the classical trade theories? Explain.

9. a) State and explain the H – O theorem of international trade. What are the
assumptions of the theorem and what are the weaknesses of the theorem?
b) What are the basic determinants of comparative advantage in the H – O
approach to international trade?
c) What does the factor-price equalization theorem postulate? What is its
relationship to the international mobility of factors of production?

d) What is meant by the Leontief paradox? What are some of the possible
explanations for the paradox?

10. a) What is meant by “labor – abundance?” Give examples.

b) What is meant by “capital – abundance?” Give examples.
c) What is meant by “labor – intensive” commodity? Give examples.
d) What is meant by “capital – intensive” commodity? Give examples.
e) What is meant by “labor-capital ratio” or “capital – labor ratio?”

11. a) How do the new trade theories depart from the classical and the
neoclassical trade theories? Explain.
b) What are the bases for trade in intra – industry trade? Explain this
situation by providing practical examples.
c) What are the bases for trade in scale economies? Explain this situation
by providing practical examples.
d) What are the bases for trade in technological gap and product cycle
models? Explain this situation by providing practical examples.
12. Make your own critical evaluation of the following views (principles or
theories) of international trade:
a) Mercantilists’ views
b) Adam Smith’s principle of absolute advantage
c) David Ricardo’s principle of comparative advantage
d) The H – O theorem
e) The new trade theories