Chapter 4
Comparative Advantage and Factor Endowments
◼ Outline
Introduction: The Determinants of Comparative Advantage
Modern Trade Theory
The HO Trade Model
Gains from Trade in the HO Model
Trade and Income Distribution
The Stolper-Samuelson Theorem
The Specific Factors Model
Case Study: Comparative Advantage in a Single Natural Resource
Empirical Tests of the Theory of Comparative Advantage
Extension of the Heckscher-Ohlin Model
The Product Cycle
Case Study: United States-China Trade
Foreign Trade versus Foreign Investment
Off-Shoring and Outsourcing
Case Study: Off-Shoring by U.S. Multinational Corporations
Migration and Trade
The Impact of Trade on Wages and Jobs
Case Study: Do Trade Statistics Give a Distorted Picture of Trade Relations? The Case of the iPhone
3G
24 Gerber • International Economics, Seventh Edition
◼ Learning Objectives
After studying this chapter, students will be able to:
4.1 Use the Heckscher-Ohlin Trade Model to analyze trade patterns between two
countries with two inputs and two outputs.
4.2 Predict the impacts on different factors of production of trade-opening.
4.3 Discuss the limits of the HO model.
4.4 Explain the trade-offs for firms between trading and investing internationally.
4.5 Give examples of the determinants of international migration and its impact on
comparative advantage.
4.6 Describe the controversies surrounding the impact of international trade on
wages and jobs.
◼ What Students Should Know after Reading Chapter 4
Chapter 4 introduces the Heckscher-Ohlin and related models. The primary goal is to present the factor
proportions theory of the determinants of comparative advantage. A secondary goal is to understand the
effects of trade on the owners of factors of production. The Stolper-Samuelson and the specific factors
models allow students to consider the income distribution effects of trade. Students are walked through a
simple application that synthesizes the debates surrounding NAFTA and shows how these models can be
used to think about the distributional impacts of the agreement.
Product cycle theory is presented not as an alternative to comparative advantage but as an extension
of how comparative advantage might change over the life cycle of a product. This extension applies to
intra-firm trade as well, although the focus is on why a firm would choose foreign investment rather than
foreign trade. The goal in presenting both models is to put them into the context of traditional trade theory.
The discussion of intra-firm trade focuses on Dunning’s OLI (ownership-location-internalization) theory.
Ownership gives firms an asset that leads to a competitive advantage. Location refers to the fact that firms
will seek a production location that gives them advantages. Internalization is the firm’s attempt to capture
all the advantages of owning the asset. Firms decide whether to invest abroad or whether to trade from
Chapter 4 Comparative Advantage and Factor Endowments 25
Copyright © 2018 Pearson Education, Inc.
Outsourcing and off-shoring are both discussed in this chapter. Outsourcing and off-shoring are often
confused in popular discussion. It is useful to emphasize the differences in class so students can correctly
use the terms. Note that firms can practice any combination of off-shoring and outsourcing: outsource but
not off-shore, or vice versa, or do both or neither. Off-shoring has grown as global production chains have
expanded and with advances in communications technology. Both concepts are controversial in the
public’s opinion, but less so for economists. The final case study that ends the chapter tries to make clear
that off-shoring and the development of global production chains are calling into question many of our
assumptions about bilateral trade balances.
Migration is also discussed, including the simple model of the factors that influence the decision to
migrate: social networks, demand-pull factors, and supply-push factors. HO theory assumes labor cannot
migrate so immigration suggests the possibility that comparative advantage may shift due to migration.
The text concludes that in most circumstances immigrant labor either flows into non-tradeable production
or supplements what was already in place in the economy, so migration has not caused shifts in long-run
comparative advantage. This discussion on migration introduces terms that will be used later in the text.
Finally, the chapter tackles the issue of manufacturing job losses in the United States and Europe. Two key
points about jobs and wages are stated here and throughout the remainder of the book. First, for a given
population size, the number of jobs in our economy is dependent on macro policies and labor market
policies; the impact of trade is miniscule by comparison and affects the composition rather than the
number of jobs. A majority of the reduction in manufacturing jobs in all industrial countries appears to
have resulted from increasing productivity, not trade, although in recent years the consensus among
economists seems less firm. Second, wages depend on productivity. While trade may have caused some of
the decline in wages for the less-skilled workers, the primary culprit is technological change, which has
reduced the role of unskilled and semi-skilled workers in manufacturing.
◼ Assignment Ideas
1. With the ratification and implementation of CAFTA in 2005, the Dominican Republic and a number
of small Central American countries now have a free trade agreement with the United States. Have
students look at the patterns of trade between the United States and these countries and write a short
paper using the Heckscher-Ohlin Theorem to predict the winners and losers in a more open trade
relationship. They might also look at the potential impact on Mexican trade from this agreement.
2. A more general assignment would be to ask students to pick a country, to identify its key resources
and its major exports and imports, and to decide whether the country’s trade pattern supports the
Heckscher-Ohlin Theorem. You can vary the nations over the class or let students pick a country
based on personal interests. They can report their findings in an oral presentation or a paper. For
26 Gerber • International Economics, Seventh Edition
◼ Answers to End-of–Chapter Questions
1. According to the following table, which country is relatively more labor-abundant? Explain your
answer. Which is relatively more capital-abundant?
United States
Canada
Capital
40 machines
10 machines
Labor
200 workers
60 workers
Answer: The capital-labor ratios are 1/5 and 1/6 for the United States and Canada. Since 1/5 is
2. Suppose that the United States and Canada have the factor endowments given in the table in
Question 1. Suppose further that the production requirements for a unit of steel is 2 machines
and 8 workers, and the requirement for a unit of bread is 1 machine and 8 workers.
a. Which good, bread or steel, is relatively capital-intensive? Labor-intensive? Explain your answer.
b. Which country would export bread? Why?
Answers:
a. The capital-labor ratio to make steel is 1/4; to make bread it is 1/8. Hence steel is more capital
3. Suppose that before trade takes place, the United States is at a point on its PPC where it produces
20 loaves of bread and 20 units of steel. Once trade becomes possible, the price of a unit of steel is 2
units of bread. In response, the United States moves along its PPC to a new point where it is
producing 30 units of steel and 10 loaves of bread. Is the country better off? How do you know?
Answer: The United States is definitely better off because it can consume a greater quantity of both
4. Given the information in Questions 1 and 2, explain what happens to the returns to capital and labor
in each country after trade begins.
Answer: The changes in the returns to capital are different by country. In the United States, the
demand for capital increases because more steel will be produced; conversely, the
Chapter 4 Comparative Advantage and Factor Endowments 27
5. Suppose that there are three factors: capital, labor, and land. Bread requires inputs of land and labor,
and steel requires capital and labor.
a. Which factors are variable, and which are specific?
b. Suppose Canada’s endowments of land and capital are 10 capital and 100 land, and the
United States’ are 50 capital and 100 land. Which good does each country export?
c. How does trade affect the returns to land, labor, and capital in the United States and in Canada?
Answers:
a. Labor is the variable factor and capital and land are specific.
6. Describe the changes in production requirements and the location of production that take place over
the three phases of the product cycle.
Answer: In the first phase, all production is in high-income countries. The input requirements
include relatively large amounts of scientific and engineering skills, marketing expertise,
7. Does intrafirm trade contradict the theory of comparative advantage? Why or why not?
Answer: No, in general it does not, but it may in some cases. Most intrafirm trade can be
understood as a firm that cuts up its production process into several distinct stages,
28 Gerber • International Economics, Seventh Edition
Copyright © 2018 Pearson Education, Inc.
In this case, firms are taking advantage of the comparative advantage of different nations
in order to produce their goods at the lowest overall cost.
In some cases, however, there may be other motives for locating a production stage in
another country. These motives include the desire to avoid trade barriers by producing all
or part of a good inside the country where sales are anticipated, the desire to escape
taxation, the attempt to deter market entry by a rival firm, and as insurance against
unforeseen events (e.g., political instability).
8. General Motors is a U.S.-based multinational, but it is also one of the largest car manufacturers in
Europe and South America. How might Dunning’s OLI theory explain the trade-offs GM faced as it
decided whether to export to those two markets or to produce in them?
Answer: Transportation costs are significant in the auto sector, meaning that producing close to
the final market can have cost advantages. The European market may have design
9. Many domestically owned apparel manufacturers buy their garments overseas, sew their labels into
them, and then sell them abroad or back into the home market. What are some of the considerations
that a clothing manufacturer might go through to choose this strategy instead of producing at home
and exporting?
Answer: These firms perceive their asset to be their brand. This may involve some elements of
design (ordering specific output from foreign suppliers) but also could involve quality. It
can be based strictly on marketing and advertising, creating an image from something that
10. Suppose Spain were to open its doors to a large number of unskilled Africans seeking to immigrate.
In general, what effects would you expect to see in Spain’s trade patterns and its comparative
advantage?
Answer: In theory, labor becomes more abundant and Spain’s comparative advantage could shift to