International Economy
Week 3
Prepared by
Shi Young Lee* (Chung-Ang University)
[email protected]
2010-1
1
Contents: Global Trade Models
Trade Models Based on Comparative Advantage
I. Labor Productivity and Trade: Ricardian Model
II. Factor Endowments and Trade: Heckscher-Ohlin
Model
Keywords: Absolute vs comparative advantage,
specialization, autarky, input-output coefficients,
opportunity costs, gains from trade, & Ricardo,
Heckscher-Ohlin, Dutch disease
References: Krugman and Obstfeld Chs 2 and 4

On David Ricardo (1772-1823)
David Ricardo was born in 1772. His parents were very successful and
his father was a wealthy merchant banker. They lived at first in the
Netherlands and then moved to London. David himself had little
formal education (obviously not a modern role model!) and went to
work for his father at the age of 14. However, when, at the age of
21, he married a Quaker (against his parents wishes) he was
disinherited and so set up on his own as a stockbroker. He was
phenomenally successful at this and was able to retire at 42 and
concentrate on his writings and politics. He developed many
important areas of economic theory and was great friends with
other classical economists - Thomas Malthus and Jean-Baptiste
Say. However, much of the theory he developed is still used and
taught today.
Key Claims of Ricardian Model
1. Comparative rather than absolute advantage
determines trade pattern & volume
2. International trade makes countries to
specialize
3. Gains from trade may be larger for relatively
small countries than large countries
Ricardian Model
2. Framework:
(1) Basic Ingredients of Ricardian model: 2*2*1
2 Countries (North and South) world
2 Outputs (X and Y)
1 factor of production: labor (as a key
determinant)
Assumptions: identical (similar) taste
perfect competition
free mobility of labor
Input-Output Coefficients Table
Input-output
Coefficients
North
South
Input-output
Coefficients
aLX
1
4
a*LX
aLY
1
2
a*LY
Total Labor
Force
200
100
Ricardian Model
aLi
input-output coefficient that describes production
technology (labor productivity), i.e., no of
hours/days to produce 1 unit of good i  labor
efficiency
Ricardian Model
3. Production possibility frontiers for the North
and South.
- Describe the opportunity cost of producing Y in
terms of X.
- Compute the autarky relative prices for each
region.
- Describe autarky equilibrium.
- Determine absolute and comparative advantages
for the two regions.
Ricardian Model
Both regions decide to open up.
- Suppose that the international price can be
determined as follows: PW=aP+(1-a)P*
where “a” is the relative weight assigned to the
South's autarky price. Assume further that
=(3/4).
- Compute the international price and determine
pattern of trade and gains from trade for each
region.
Applications
1. Suppose, due to famine, that the labor force of
the North suddenly has contracted from 100 to
50. Determine new trade pattern.
2. Suppose that the South experiences
technological progress. How does the inputoutput coefficient change? And why?
Determine new trade pattern and gains from
trade?
Problems associated with a simple
Ricardian Model
1. Extreme specialization
2. Ignores the income distribution effects
3. No adjustment cost
4. No effect of labor force expansion
5. Ignores the role of institution & trade
On Competitiveness from Krugman
(1994)
"Countries do not compete with each other the way corporations do.
Coke and Pepsi are almost pure rivals: only a negligible fraction of
Coke's sales go to Pepsi workers and so on. So if Coke is
successful, then it tends to be at Pepsi's expense. However, major
industrial countries, while they sell products that compete with each
other, are also each other's main export markets and each other's
main suppliers of useful imports. If the EC does well, then EC is
likely to help the U.S. economy by providing it with larger markets
and selling it goods of superior quality at lower prices. International
trade is not a zero-sum game. When productivity rises in Japan, the
main result is a rise in Japanese real wage. At the same time, EC
and U.S.'s wages are likely to rise if not stay the same."
Discussion Questions
(1) How do we define competitiveness of nations?
(2) Discuss the difference. Do you think that his
claim is valid? Why? Or why not?
(3) Can you think of any other difference?
Factor Endowments and Trade
Key Facts of Heckscher-Ohlin Model:
1. Countries tend to export goods that are intensive in
factors with which they are abundantly supplied
Comparative advantage determined by factor
abundance
2. International trade changes relative prices of goods and
thus brings about changes in the relative returns to
capitalists and workers: income redistribution effects
from trade
3. The empirical evidence on the H-O proposition may be
weak : Leontief Paradox

Basic Ingredients of H-O proposition
- 2 Countries (North and South) world
- 2 Outputs (X and Y)
- 2 factors of production: capital and labor
Assumptions:
- identical (similar) taste
- perfect competition
- free mobility of factors: labor and capital
Outline of Heckscher-Ohlin Model
(1) Describe Autarky equilibrium
(2) Trade equilibrium when Home country is a
price-taker or partial price-taker
- Suppose that (K/L)>(K/L)*
- (K/L)x >(K/L)y Then Home country has
comparative advantage in X and Foreign Y
- Trade pattern determined
(3) A Graphical description of Heckscher-Ohlin
proposition
Stolper-Samuelson Result
- Trade liberalization changes the relative prices faced by
Home country
- Suppose that X is a capital-intensive
- Opening up increases the relative price of X in terms of Y in
comparison to the autarky relative prices. This implies that
the price of capital intensive good X increases
– Then outflow of capital and labor out of Y  outflow of
capital from Y < demand for capital in X and outflow of
labor from Y > demand for labor in X
- The returns to capitalist rise while the returns to workers
fall: Stolper-Samuelson result Capitalists become better
off while workers become worse off in Home country
Stolper-Samuelson result leads to
political economy approach
Political Economy Approach
– In this case, workers may oppose such trade
liberalization policy
– Trade liberalization policy almost always
brings social frictions between classes and
industries
– Compensation schemes always discussed but
may not be credible resistance level may
be related to compensation

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Ungenerous Endowments from
Economist (1996)
- Evidence of natural resource abundance and
economic growth: abundance of natural
resources often does not lead to high economic
growth
- Explain Dutch Disease via main symptom:
discovery (or abundance) of natural resource
often leads to a shrinkage of the traded sector
(often manufacturing capacity) and dampens
economic growth
Reasons
- Natural resources do not come for free: considerable investment
required to acquire natural resources and the investment diverts
capital and labor away from productive investment (manufacturing
sector)
- Commodity price volatility: If an economy relies on one or two
commodities, then due to volatility, the economy is unable to
prosper due to huge adjustment cost
- Discovery of natural resource (a commodity) often leads to the
expansion of public sector (via nationalization) Once the public
sector expands, it is hard to stop (related to habit formations)
- The discovery fosters rent-seeking activities related to the industry
and spread of corruption Distort work incentives
Business Strategy: Korea-US FTA

Suppose that you are the managing director for
Hyundai Auto
- Your job is to devise business strategy plan in
response to the ratification of Korea-US FTA
- Domestic market and US market