TU-E1160 International Economics
by
Hannele Wallenius
2. WHY DO WE TRADE?
- Part I
Aalto University School of Science
Department of Industrial Engineering and Management
Six Valuable Lessons of Trade Theory
1. Free trade can raise aggregate economic efficiency
and aggregate economic welfare.
2. Free trade will benefit a country even if it is less
efficient than all other countries in every industry.
3. Some people will suffer losses with free trade.
4. A domestic firm may lose out in international
competition even if it is the lowest cost producer in
the world.
5. Trade protection may, in some special cases, be
beneficial for a country.
6. Although trade protection can be beneficial, the
case for free trade remains strong.
International Economics
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Index of Openness*
Country Name
Hong Kong
Estonia
High income: no OECD
Switzerland
Iceland
Sweden
Germany
Finland
Greece
Low Income
Turkey
France
United Kingdom
OECD Members
Middle Income
India
China
Japan
United States
* 2014
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1960
0,00
25,99
54,52
86,84
46,44
0,00
43,35
24,67
5,73
26,97
41,80
23,65
19,74
11,10
8,73
21,01
9,17
1980
178,38
42,71
85,46
69,41
56,90
41,99
62,90
44,59
17,09
43,24
49,89
37,37
28,45
15,12
12,42
27,79
20,07
2000
279,12
126,51
51,75
98,25
71,95
82,33
61,39
74,99
58,42
46,82
43,19
55,26
51,83
47,51
51,04
26,44
39,75
20,31
24,98
2015
400,87
154,42
61,56
114,09
100,99*
86,45
85,99
73,69
63,69
59,68
58,80
61,43
56,46
56,71
50,00
42,41
40,67
36,78
28,00
Some countries trade
extensively, others
very little.
In some countries the
index is very high,
other rather low.
How can this be
understood and
explained?
The higher the index
the larger the
influence of trade on
domestic activities.
Source: World Bank open data
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2. Why Do We Trade? - 2.1 The Law of Comparative Advantage
Exports of goods and services in EU
(% of GDP in 2015)
Luxembourg
Ireland
Slovak Republic
Hungary
Czech Republic
Belgium
Netherlands
Estonia
Slovenia
Bulgaria
Denmark
Austria
Poland
Croatia
Germany
Sweden
Romania
Portugal
Finland
Spain
Greece
Italy
France
United Kingdom
213.8
124.0
93.5
90.7
83.0
82.9
82.5
79.3
77.9
64.1
53.4
53.1
49.6
49.4
46.8
45.6
41.1
40.3
36.6
33.1
31.9
30.1
30.0
27.2
0.0
50.0
100.0
An other measure of
openness is also used:
Exports/GDP; see your
text book tables.
150.0
200.0
250.0
Source: World Bank open data
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2. Why Do We Trade? - 2.1 The Law of Comparative Advantage
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

NOTE! Openness index value greater than 100 means
that the country's exports are bigger than its overall
level of production (GDP or GNP). Such a situation
could occur if much of the economic activity of the
country in question involves the assembly and export of
final products made from imported raw or partially
assembled materials.
The value in excess of 100 comes about from the fact
that output is (always) measured in terms of value
added -- the value of capital and labor services devoted
in this case to the assembly of goods -- while exports
are measured in terms of the total value of goods -including the value of the imported parts. Clearly, in
such circumstances it is quite likely for exports to be
greater than value added.
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2. Why Do We Trade? - 2.1 The Law of Comparative Advantage
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Major Topics of Trade Theory?
The classical theory of international trade is
concerned with the following three
questions:
1. What are the gains from trade?
 In other words, if countries benefit from
international trade, where do the gains
come from, and how are they divided
among the trading countries?
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2. Why Do We Trade?
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Major Concerns of Trade Theory? continued
2. What is the structure/pattern of trade?
In other words, which goods/services are
exported, and which are imported?
What are the fundamental laws that govern
international allocation of resources and the
flow of trade?
3. What are the terms of trade?
In other words, at what prices are the
exported and imported goods exchanged?
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Why Do We Trade?
International difference in autarky* price of a product S in
two countries:
PS/PT
PS/PT
Finland
China
NSSA
With trade
prices start
to equalize.
P0
NSS/ NSD=
national
supply/demand
PS/PT =
relative price
of product S
When trade
starts the
demand for
Finish product
will decrease.
Country A
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NSSB
When trade
starts the
demand for
Chinese product
will increase.
P0
NDSA
NDSB
QS
Country B
2. Why Do We Trade? - 2.1 The Law of Comparative Advantage
QS
8
* Autarky = closed economy = no international trade allowed in a country
 Because country B has a lower autarky (relative)
price of S, it is said to have a comparative
advantage in S and a comparative disadvantage in
T and by same logic, country A has a comparative
advantage in T and comparative disadvantage in S.
 If trade would be allowed, consumers in country A
would like to buy product S from country B, and
prices would start to equalize.
Why Are the Autarky Prices Different?
1. Differences in technology or productivity
2. Difference in resource endowments
3. Difference in demand
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Understanding the Gains from
International Trade
Nations (or firms in different nations) trade with
each other because they benefit from it!
We can divide the different trade theories
in four categories...
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2. Why Do We Trade?
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Different Trade Theories
1. Early Trade Theory: Mercantilists
2. Classical Trade Theory: Ricardian Model
(section 2.1)
3. Modern Trade Theory: Heckscher-Ohlin
Model (section 2.2)
4. Alternative Approaches to Trade Theory
(section 2.3)
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2. Why Do We Trade?
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1. Early Trade Theory: Mercantilists
 Until mid-eighteenth century, it was believed
that the purpose of international trade was to
keep exports greater than imports and pile up
gold, and when/if deficits were created they
believed that imports had to be restricted.
 Mercantilists assumed trade to be a zero-sum
game since they assumed that fixed amounts
of goods and of gold existed in the world and
that trade merely determined their distribution
among the various nations.
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 But in the 1740s, David Hume explained that
as quantity of money (gold) changes, so also
does the price level, and the nation's real
wealth is unaffected.
 In 1770s, Adam Smith argued that
import restrictions would reduce the
gains from specialization and make
a nation poorer. He used absolute
advantage to explain the benefits of
trade.
Theories 2 - 4 will be now discussed in
more detail ...
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2. Why Do We Trade?
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2. Why Do We Trade?



2.1 The Law of Comparative
Advantage: Absolute vs.
Comparative Advantage
2.2 Modern Trade Theory:
Heckscher-Ohlin Model
2.3 Alternative Trade Theories:
Results from Practical Evidence
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continued
2. Why Do We Trade? - 2.1 The Law of Comparative Advantage
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Economic Basis for Trade
What are the factors that determine how
countries will specialize in international
trade?
David Ricardo (On the Principles of Political
Economy, 1819), developed the theory of
comparative advantage...
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Economic Basis for Trade continued
According to this theory,
Specialization and free trade will benefit
all trading partners (= real wages will
rise), even those who may be absolutely
less efficient producers.
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2. Why Do We Trade? - 2.1 The Law of Comparative Advantage
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Absolute vs. Comparative Advantage
Although comparative advantage is a
simple concept, experience shows that
it is a surprisingly hard concept for
many people to understand (or accept).
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2. Why Do We Trade? - 2.1 The Law of Comparative Advantage
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Absolute vs. Comparative Advantage
continued
Indeed, Paul Samuelson — the Nobel
laureate economist who did much to
develop the model of international trade
— has described comparative advantage
as the best example he knows of an
economic principle that is undeniably true
yet not obvious to intelligent people.
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Definition: Absolute Advantage
The advantage in the production of a
product enjoyed by one country over
another when it uses fewer resources to
produce that product than the other
country does.
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Absolute Advantage - an Illustration
Suppose country A and country B produce
wheat, but that A's climate is more suited to
wheat and its labor is more productive.
Country A will therefore produce more wheat
per acre than country B and use less labor in
growing it and bringing it to the market.
Country A thus enjoys an absolute advantage
over country B in the production of wheat.
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2. Why Do We Trade? - 2.1 The Law of Comparative Advantage
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Definition: Comparative Advantage
The advantage in the production of a
product enjoyed by one country over
another when that product can be
produced at lower cost in terms of other
products than it could be in the other
country.
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Comparative Advantage an Illustration
• Suppose that countries C and D both produce
wheat and corn and that C enjoys an absolute
advantage in the production of both - that is,
C's climate is better than D's, and fewer of C's
resources are needed to produce a given
quantity of both wheat and corn.
• C and D each need to choose between planting
land with wheat and corn.
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2. Why Do We Trade? - 2.1 The Law of Comparative Advantage
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Comparative Advantage - an Illustration
continued
• To produce more wheat, either country must
transfer land from corn production and vice
versa.
• Suppose that in country C, a bushel of wheat
has an opportunity cost of two bushels of corn.
At the same time, suppose that producing a
bushel of wheat in country D requires to give
up only one bushel of corn
D enjoys a
comparative advantage in producing wheat.
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Example 1: Gains from Mutual Absolute Advantage
Assume
a) two countries with fixed amount of land (100 acres)
and land yields given in the table below,
b) only two products produced (wheat and cotton),
c) preferences for food and clothing are such that both
countries consume equal amounts of wheat and
cotton.
Production Possibilities Frontiers (PPF) before trade:
New Zealand Australia
Wheat 600 (6 x 100) 200 (2 x 100)
Cotton 200 (2 x 100) 600 (6 x 100)
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PPF in Each Country:
New Zealand Australia
Example 1: Continued
Wheat 600 (6 x 100) 200 (2 x 100)
Cotton 200 (2 x 100) 600 (6 x 100)
When there is no trade, the allocation of resources
will be such that both countries will produce 150
bushels of wheat and 150 bales of cotton.
Australia
New Zealand
Wheat
600
Both countries
would produce
and consume
at 150, 150.
Wheat
W: 25 acres x 6 bu/acre
W: 75 acres x 2 bu/acre
C: 75 acres x 2 bales/acre
C: 25 acres x 6 bales/acre
200
(150, 150)
(150, 150)
PPF
200
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Cotton
600
2. Why Do We Trade? - 2.1 The Law of Comparative Advantage
Cotton
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Example 1: Continued
 Expanded possibilities after trade:
If countries realize that they should specialize
(Australia in cotton and New Zealand in wheat)
and trade, both countries could gain.
 Both are now specializing:
Production
Wheat
Cotton
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New
Zealand Australia
600
0
0
600
Consumption
New
Zealand Australia
300
300
300
300
2. Why Do We Trade? - 2.1 The Law of Comparative Advantage
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Example 1: Continued
In this situation 300 bushels of wheat is traded for
300 bales of cotton:
New Zealand
Australia
Wheat
Wheat
600
(300, 300)
(300, 300)
200
200
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Cotton
2. Why Do We Trade? - 2.1 The Law of Comparative Advantage
600 Cotton
27
Example 1: Continued
Trade enables both countries to move
beyond their previous resource and
productivity constraints.
 Both countries (after trade) can consume
beyond their production possibilities (PPFs)!
This is the beauty
of trade!
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Example 2: Gains from trade when one country
has a double absolute advantage
New Zealand
Wheat 6 bushels
Cotton 6 bales
Australia
1 bushels
3 bales
• Production Possibilities and Consumption in a
Closed Economy (same assumptions as before):
NZ: 50 x 6 = 300 both
wheat and cotton.
A: 75 x 1 = 75 wheat
25 x 3 = 75 cotton
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Wheat
Cotton
New Zealand
600/300
600/300
Australia
100/75
300/75
2. Why Do We Trade? - 2.1 The Law of Comparative Advantage
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Example 2: Continued
• When countries realize that they can benefit
from specialization and trade:
Production
Stage 1
Wheat
Cotton
New
Zealand Australia
300
0
300
300
Stage 2
New
Zealand Australia
450
0
150
300
Only partial specialization:
75 x 6 = 450 and 25 x 6 = 150
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Example 2: Continued
If 100 bu of wheat from NZ is traded
to 200 bales of cotton from Australia
• Consumption after trade: Stage 3
New Zealand
Wheat
350
Cotton
350
Australia
100
100
• When countries specialize they will maximize their
combined output and use resources more
efficiently: both countries are better off than they
were before the trade (closed economy consumptions
were 300, 300 and 75,75).
 Both have moved beyond their own production
possibilities.
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
By exposing firms and products to
international competition, economies
are encouraged to focus on areas of
comparative advantage. This helps
ensure that scarce skills and
resources are deployed where they
are most productive.
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International Equilibrium with Increasing
Costs
• Next we will extend the classical model of trade to
the more general case of increasing opportunity costs
and introduce demand by means of social indifference
curves.
Increasing Opportunity Cost
Clothing
a) Product specific
factors.
Indifference Map and
Consumer Equilibrium
Clothing
b) Different industries
use factors in
different proportions.
I’’
I’
PPF
Food
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I’’’
2. Why Do We Trade? - 2.1 The Law of Comparative Advantage
Food
33
General Equilibrium
in a Small Open Economy
Clothing
CPF
S'T'
ST
P0
Consumption Possibility Frontier
domestic price ratio
international price ratio
original "closed" economy
production and consumption
P1
= new production point, after trade
C
= consumption after trade
I’, I’’ = social indifference curves
S
CPF
U PPF
S'
I'
I''
P1
P0
C
O
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=
=
=
=
T
T'
Food
2. Why Do We Trade? - 2.1 The Law of Comparative Advantage
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Specialization Based on Comparative Advantage
(countries PPF are different) and the Resulting Gains
from Trade
1. Assume such a
domestic price ratios
that E (in US) and
E* (in UK) are
consumption and
production in autarky
(= no trade).
2. After trade production takes
place in Q and Q* and consumption
at S and S*, respectively.
America
Figure 1 (a)
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Britain
Figure 1 (b)
2. Why Do We Trade? - 2.1 The Law of Comparative Advantage
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Specialization Based on Comparative Advantage
and the Resulting Gains from Trade continued
• Figure 1: In autarky, America produces and
consumes at E, and Britain at E*. With trade,
America shifts production from E to Q and
consumes at S by exporting VQ units of food to
Britain in exchange for VS units of British clothing.
America is better off with trade because S lies on a
higher indifference curve than E. Indeed, in our
illustration, America consumes more food and
more clothing at S than at E. Britain shifts
production from E* to Q* and consumption from
E* to S*. Britain’s welfare increases also. Trade
triangles SVQ and Q*V*S* are identical.
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Different set of
indifference
curves!
Same Production Technique in Both
Countries, Trade Based on Different Taste
Figure 2
Clothing
America
In autarky US produces
and consumes at A and
UK at B. After free trade
both will produce at Q
but consume at A’ and
B’, respectively.
Britain
Again both countries
can consume beyond
their production
possibilities.
Food
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Trade Based on Different Taste continued
• Figure 2: Trade based on different tastes. America
and Britain share the same production frontier MN
(= same technology in both countries). In autarky,
America produces and consumes at A, and Britain
at B. With free trade, both countries produce at Q,
but America consumes at A’ and Britain at B’.
Trade triangles A’VQ and QSB’ are identical.
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2. WHY DO WE TRADE?



2.1 The Law of Comparative
Advantage: Absolute vs.
Comparative Advantage
2.2 Modern Trade Theory:
Heckscher-Ohlin Model
2.3 Alternative Trade Theories:
Results from Practical Evidence
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2. Why Do We Trade? - 2.2 Modern Trade Theory: HeckscherOhlin Model
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What are the ultimate determinants of
comparative advantage?
• Ricardo did not bother to answer this
question.
• He just assumed that the differences in
comparative advantage depended on
comparative difference in labor productivity
(that is, differences in technology), but he
did not explain the basis for these
differences. Implicit reason in his example
was climate...
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2. Why Do We Trade? - 2.2 Modern Trade Theory: HeckscherOhlin Model
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What are the ultimate determinants of
comparative advantage? continued
 It remained to Heckscher and Ohlin to
offer an explanation for comparative
advantage.
 And this theory has become, since
1930s, the orthodox explanation of the
ultimate cause of international trade.
Eli Heckscher
(1879 - 1952)
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2. Why Do We Trade? - 2.2 Modern Trade Theory: HeckscherOhlin Model
Bertil Ohlin
(1899-1979)
41
What are the ultimate determinants of
comparative advantage? continued
Their basic idea is:
1. Commodities differ in their factor
requirements.
2. Countries differ in their factor
endowments.
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2. Why Do We Trade? - 2.2 Modern Trade Theory: HeckscherOhlin Model
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What are the ultimate determinants of
comparative advantage? continued
A country has comparative advantage in
those commodities that use its abundant
factors intensively.
• This is why labor-abundant countries, such as
India and China export footwear, rugs, textiles, and
other labor intensive commodities; and landabundant countries, such as Argentina, Australia,
and Canada, export meat, wheat, wool, and other
land-intensive commodities.
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The Basic Assumptions of the HeckscherOhlin Model:
1. Number of countries, factors, and
commodities are all two (often referred to
as the 2 x 2 x 2 model).
2. Technology is the same in both countries.
3. Constant returns to scale
4. Strong factor intensity
5. Incomplete specialization
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The Basic Assumptions of the HeckscherOhlin Model continued:
6. Perfect competition
7. Factors are perfectly mobile within each
country but perfectly immobile between
countries.
8. Tastes are largely similar between countries.
9. Free trade
10. Transportation costs are zero.
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2. Why Do We Trade? - 2.2 Modern Trade Theory: HeckscherOhlin Model
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Heckscher-Ohlin Theorem with a Single
Technique
• The structure of trade, in general, can be
traced back to differences in
factor endowments, technology, and
tastes.
• Since Heckscher-Ohlin theory assumes that
technology and tastes are similar between
countries, it attributes the comparative
advantage to differences in factor endowments.
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2. Why Do We Trade? - 2.2 Modern Trade Theory: HeckscherOhlin Model
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Heckscher-Ohlin Theorem with a Single
Technique continued
In summary, the capital-abundant
country exports the capital-intensive
commodity, and the labor-abundant
country exports the labor-intensive
commodity.
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Example 1: Factor Endowments and
Production-Possibilities


One country
Required inputs per unit of output:
Cloth, Y
Steel, X
Endowments
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Labor
4
2
900
Capital
1
3
600
2. Why Do We Trade? - 2.2 Modern Trade Theory: HeckscherOhlin Model
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Example 1: Continued
Cloth, Y
Steel, X
Endowments
Labor
4
2
900
Capital
1
3
600
Cloth
•M
600
Capital constraint
225 •
150
J
•
JEH is
the PPF
E
Labor constraint
•
0
150
G
H
•
200
450
Steel
Figure 3
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Example 1: Continued
• Figure 3: Derivation of the production-possibilities
frontier. If the economy had an unlimited supply of
capital (labor), it would be able to produce along
the labor constraint JG (capital constraint MH).
When the supplies of both factors are limited, both
constraints become binding and the production
frontier coincides with the heavy kinked line JEH.
Because steel is capital intensive relative to cloth,
the capital constraint is steeper than the labor
frontier.
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Heckscher-Ohlin Theorem
with a Single Technique
Cloth
Figure 4
Since same tastes in
both countries, only
one set of communal
indifference curves.
Before trade, America
produces and consumes at
R, and Britain at Q*. With
free trade, America shifts
production to Q and
consumption to C. Britain
maintains production at Q*
but consumes at C*.
Steel
Figure 4
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Heckscher-Ohlin Theorem
with a Single Technique
• Figure 4: Production frontiers JQH and J*Q*H*
reflect the fact that America is endowed with
more capital than Britain, while Britain is
endowed with more labor than America. Before
trade, America produces and consumes at R,
and Britain at Q*. With free trade, America
shifts production to Q and consumption to C.
Britain maintains production at Q* but shifts
consumption to C*. Trade triangles CQV and
Q*C*V* are identical. America exports steel,
and Britain cloth.
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Heckscher-Ohlin Theorem
with Many Techniques
Cloth
Before trade, America
produces and consumes
at R, and Britain at R*.
With free trade, America
produces at Q and
consumes at C, and
Britain at Q* and C*,
respectively.
Figure 5
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2. Why Do We Trade? - 2.2 Modern Trade Theory: HeckscherOhlin Model
Steel
53
Heckcher-Ohlin Theorem
with Many Techniques
• Figure 5: Production frontier JH of America (the capitalabundant country) is skewed along the axis for steel
(the capital-intensive commodity); and the production
frontier J*H* of Britain (the labor-abundant country) is
skewed along the axis for cloth (the labor-intensive
commodity). Before trade, America produces and
consumes at R, and Britain at R*. With free trade,
America produces at Q and consumes at C, and Britain
at Q* and C*, respectively. Trade triangles CQV and
Q*C*V* are identical, America exports steel, and
Britain cloth.
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2. Why Do We Trade? - 2.2 Modern Trade Theory: HeckscherOhlin Model
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Derivation of Offer Curves and the
International Equilibrium
Figure 6 (b)
2. At p = 3, America
shifts production to Q
and consumption to S.
3. And at p = 4, R and
K, respectively.
1. In autarky (p = 2)
US produces and
consumes at E.
Food
America’s imports of clothing
Clothing
Figure 6 (a)
US offer curve
America’s exports of food
TOT = Terms of Trade = ratio of export and import prices
International Economics
Hannele Wallenius
2. Why Do We Trade? - 2.2 Modern Trade Theory: HeckscherOhlin Model
55
Derivation of Offer Curves and the International
Equilibrium continued
• Figure 6: Derivation of America’s offer curve. At the
Autarkic relative price of food (p), assumed to be equal
to 2, America produces and consumes at E in panel (a),
and trades at the origin of panel (b). At p=3, America
shifts production to Q and consumption to S in panel
(a), and trades at S in panel (b). Similarly, at p=4,
America produces at R and consumes at K in panel (a),
and trades at K in panel (b). Trade triangles SVQ and
KGR are identical to triangles SJO and KLO,
respectively. The locus of all trade points (such as S
and K) in panel (b) is America’s offer curve.
International Economics
Hannele Wallenius
2. Why Do We Trade? - 2.2 Modern Trade Theory: HeckscherOhlin Model
56
International Equilibrium
Clothing
America’s imports
Britain’s exports
Figure 7
Here the offer curves
of two trading
countries define the
international
equilibrium at K.
Food
America’s exports
Britain’s imports
International Economics
Hannele Wallenius
2. Why Do We Trade? - 2.2 Modern Trade Theory: HeckscherOhlin Model
57
Derivation of Offer Curves and the International
Equilibrium continued
• Figure 7: International equilibrium
International equilibrium occurs at K,
where the offer curves intersect.
America exports OL units of food to
Britain and imports OL* units of clothing
from Britain. The slope of terms-oftrade line TOT3 gives equilibrium terms
of trade OL*/OL.
International Economics
Hannele Wallenius
2. Why Do We Trade? - 2.2 Modern Trade Theory: HeckscherOhlin Model
58
End of Fun!
On next lecture:
2. WHY DO WE TRADE?
- Part II
International Economics
Hannele Wallenius
2. Why Do We Trade?
59