Chapter 7
Growth and Trade
Overview
This chapter has two major purposes. First, it shows how the Heckscher-Ohlin model can be used
to analyze economic growth and its impact on international trade. Second, it examines additional
aspects of technological progress and its relationship to international trade.
Growth in a country’s production capabilities shifts the country’s production-possibility curve
out. Growth is balanced if the ppc shifts out proportionately. Balanced growth could occur
because all factors are growing at similar rates, or because production technology is improving at
the same rate in both sectors. Growth is biased if the outward shift in the ppc is skewed, so that
the growth favors producing more of one product than the other. Biased growth could occur if
one factor is growing more quickly than the other, or if production technology is improving more
in one sector than the other. (For instance, if only one product’s production technology is
improving, then the ppc intercept with the other product’s axis does not change—see footnote 1
in the text.)
One example of very biased growth is growth in only one factor, the other factor unchanged.
While the entire ppc shifts out, the growth is strongly biased in favor of the product that uses the
growing factor intensively. The Rybczynski theorem indicates that, if product prices are constant,
then the output quantity of the product that uses the growing factor intensively will increase,
while the output quantity of the other product must contract. The reason is that expanding
production of the intensive good also requires some of the other factor. This amount of the other
factor must be drawn from the other industry, so its output declines. A box applies this concept to
the “Dutch disease” of deindustrialization following discovery and development of production of
a natural resource.
The growth of the country’s production capabilities is likely to change the country’s willingness
to trade—the quantities that it wants to export and import—even if product prices do not change.
The change in the country’s willingness can be documented by examining the change in the
country’s trade triangle for the price ratio that held in the free-trade equilibrium before the
growth occurs. The change in the production point depends on whether growth is balanced or
biased. The change in the consumption point depends on tastes in the country. At the same price
ratio the quantities consumed of both products will increase if both goods are normal. Growth
that is balanced or biased toward producing the exportable product is likely to increase the
country’s willingness to trade. Growth that is sufficiently biased toward producing more of the
importable product will reduce the country’s willingness to trade.
If the country is small, then changes in its trade have essentially no impact on the world
equilibrium price ratio. In this case the analysis just presented using the initial price ratio is the
complete picture.
If instead this is a large country, then changes in its willingness to trade change the equilibrium
international price ratio. If the growth reduces the country’s willingness to trade, then the reduced
supply of exports and the reduced demand for imports results in an increase in the equilibrium
relative price of the country’s exportable product. The well-being of the country increases for two
reasons—the country’s production capabilities increase, and its terms of trade improve.
If growth of a large country increases its willingness to trade, then the increased supply of
exports and the increased demand for imports results in a decrease in the equilibrium relative
price of the country’s exportable product. If the price does not change by too much, then the
country’s well-being is higher—but the increase in well-being is less than it would be if the
country’s terms of trade did not deteriorate. If the price ratio changes by a lot then immiserizing
growth is possible—growth that expands the country’s willingness to trade causes such a large
decline in the country’s terms of trade that the well-being of the country declines. The loss from
the decline in the terms of trade is larger than the gain from the larger production capabilities.
This is more likely if the growth is strongly biased toward producing more of the exportable
product, foreign demand for the country’s exports is price inelastic, and the country is heavily
engaged in international trade.
The discussion of technology and trade focuses on several main points. First, differences in
production technologies available in different countries can be the source of comparative
advantage, because technology differences result in production possibility curves that are skewed
differently in different countries. Second, much new technology is the result of organized
research and development (R&D). The location of the production of new technology through
R&D follows the Heckscher-Ohlin theory. R&D is intensive in the use of highly skilled labor
(especially scientists and engineers) and also in capital that is willing to take large risks (for
instance, venture capital). Consistent with H-O theory, most new technology is created by R&D
located in the industrialized countries, which are well-endowed with these factors. Third,
although production using the new technology may first occur in the country that creates the new
technology, the technology is also likely to diffuse internationally. The product cycle hypothesis
suggest that there is a regular pattern as new technology diffuses, with developing countries often
becoming the exporters of many products after the products become standardized or mature.
Although the product cycle describes the evolution of production and trade for a number of
products, it is also subject to a number of limitations.
Openness to international trade can also increase a country’s growth rate. Imports can speed
diffusion of new production technology into a country, through imports of advanced capital
goods and, more generally, through greater awareness of new foreign technology. Openness to
trade can also place additional competitive pressure on domestic firms to develop and adopt new
technology, and export sales can increase the returns to their R&D activities. According to the
“new growth theory,” these increases in the country’s current technology base can enhance
ongoing innovation, resulting in a higher ongoing growth rate.
Finally, the box “Trade, Technology, and U.S. Wages” (another Focus on Labor) confronts an
important issue—why has the difference in wages between skilled and less skilled workers been
widening since the 1970s, in the United States and other countries. This could be the
Stolper-Samuelson theorem at work, if expanding trade with developing countries placed
downward pressure on the prices of products intensive in less skilled labor. But several studies
conclude that this effect is smaller than another—biases in technological change. Technological
change seems to have created rising demand for skilled labor for two reasons. First,
technological progress has been faster in industries that are intensive in skilled labor, resulting in
their faster growth. Second, technological progress is biased in favor of using more skilled labor.
Tips
This chapter is written to take the reader through the analysis of growth step-by-step—the
change in the production possibility curve, the change in the willingness to trade, the change in
the international equilibrium price ratio, and the overall effects of growth on the country,
including both the production growth and the change in the country’s terms of trade. It provides a
major application of the key tools from Chapter 4—the production-possibility curve, the
community indifference curves, and trade triangles. It attempts to cover the range of major cases
that can arise, without becoming overly taxonomic.
In class presentation of this material, we have found that it is useful for the instructor, after
briefly summarizing the generic process of the analysis, to present the entire analysis of each of
several specific examples. For instance, the example of growth of the scarce factor of production
can be used to introduce the Rybczynski theorem and to bring out the terms-of-trade effects of
growth that reduces a large country’s willingness to trade. The example can include discussion of
comparison of the country’s well-being and its production and consumption points before the
growth and after the growth (inclusive of the change in the price ratio). In addition, the
implication for factor incomes can be noted by referring back to the general Stolper-Samuelson
theorem. It is also possible to draw out the implications for the other (the non-growing) country.
Then, a second example can be examined from start to finish, such as technological improvement
only in the country’s export sector (with no diffusion to the other country). This example can be
used to bring out the terms-of-trade effects of growth that increases a large country’s willingness
to trade, and this can lead into a discussion of the possibility of immiserizing growth.
The table shown with Chapter 2 of this Manual could be used as a summary device at the
conclusion of the classroom presentation of the material in Chapter 7.