CHAPTER 4:

OTHER THEORIES
OF
INTERNATIONAL
TRADE
HE OTHER THEORIES OF INTERNATIONAL TRADE

 The Specific Factor Model

 Ricardo-Viner Model

 Standard Model of Trade

 Paul Krugman-Maurice Obsfeld Model

 Leontief Paradox
 Disputed the Heckscher-Ohlin Theory
INTRODUCTION:

"Lowy Institute Data on Global Trade"

 US led global trade before 2000, with over 80% of countries trading more
with China.
 By 2018, it dropped to 30%, with China becoming the largest trading
partner for 128 out of 190 countries.
 In January 1998, French monthly Le Monde Diplomatique carried an
article titled "China holds world trade hostage." Set in the backdrop of
the 1997 Financial Crisis, the article by Stephen S. Cohen postulated that
China, "stripped of its old ideology," was bent on "asserting itself as a
world power in every domain."
 China's membership in the World Trade Organization (WTO) has led to
rapid growth and integration into the global economy, making it the world's
second-largest GDP-holder. However, China's economy remains opaque due to
opaque political and economic decisions and unreliable data provided by the
Communist Party of China (CCP).

 Chinese integration into the international economy has been criticized for its
opaque political and economic decision-making, and unreliable data. Despite
being a member of the WTO, China's internal factors and external trade
policies have led to concerns, with concerns being raised about mercantilist
and protectionist practices, which involve currency manipulation and tariff
barriers, affecting foreign commodities and companies' entry and survival.
 Chinese mercantile behavior also manifests in the form of "dumping“, i.e,
selling a commodity in another country at a price lower than its own
domestic market. The US and India have been perhaps the largest victims
of China's dumping policy, especially with regards to electric commodities,
aluminium, and steel.

 The US-China trade war, fuelled by US discontent over Chinese trade

policies and high deficits, highlighted China's influence on global supply
chains. The COVID-19 crisis further heightened scrutiny, prompting
countries to reassess their dependence on China, with India exemplified by
its overdependence.
ESSON 4.1: THE SPECIFIC FACTOR MODEL
Learning Objectives:
At the end of the lesson, the students should be able
to:

a) Explain the meaning of real income and gross national

income;
b) Discuss what factors of productions are;
c) Elaborate on the reasons why trade has an important
influence upon income distribution;
d) Elucidate on the Ricardian Model of Trade; and
e) Discuss the specific factor model of Jones and
Samueison.
ESSON 4.1: THE SPECIFIC FACTOR MODEL
 Trade - raises real income of trading countries.

 Real Income - is simply-adjusted income, measures the amount of disposable

income available to consumers (e.g., households and individuals). Also
represent purchasing power and closely linked to markets conditions as they
are an important factor that affects the market demand.

 National Income – represents the total amount of income accruing to a

country from economic activities in a year’s time.

 Gross National Income (GNI) - is the sum of the value added by all the
goods and services produced within a particular country.
ESSON 4.1: THE SPECIFIC FACTOR MODEL
 As the real income level (adjusted for inflation) rises, so does the
consumption of goods, thereby increasing the demand for such goods. An
increase demand means increased sales and increased profits. When the
national income goes down, demand for nonessential goods goes down as
well as sales and profit goes down. Therefore, national income affects
marketing.

 Ronald Jones and Paul Samuelson studied; countries rich in capital will
mean an increase in marginal productivity from the manufacturing
sector, while an increase in territory will increase the production of food.
ESSON 4.1: THE SPECIFIC FACTOR MODEL
 There are at least two reasons why trade has an important influence upon the
income distribution:

1. Resources cannot be transferred immediately and without cost from one

industry to another.

2. Industries use different factors and a change in the production mix a country
offers will reduce the demand for some of the production factors whereas
for others, it will increase the demand for such production factors.
ESSON 4.1: THE SPECIFIC FACTOR MODEL
 Goods - are produce using mix of the factors of production such as land,
labour, and capital.

 Factor of Production – is any resource that is used by firms to produce

goods and services.

 Jones and Samuelson were saying that firstly, it is hard to move resources
from one country to another without incurring any cost since the factor
of production are generally innate to a country. Secondly, production of
particular product requires different factors of production; hence, most
countries would produce those products for which it has abundant factors
production.
SSON 4.1: THE SPECIFIC FACTOR MODEL
 International business and trade has strong effects on the distribution of
income because different countries have different factors of production
available to them. If they are rich in particular resource needed for the
production of a certain product that is in high demand internationally, that
country will drive a higher income from trade by exporting such products.

 Specific Factor (SF) model was originally advanced by Jacob Viner, and it
is a variant of the Ricardian model of trade was developed by English
political economist David Ricardo in his magnum opus “On the Principles
of Political Economy and Taxation (1817)”. Also it is the first formal model
of international trade.
ESSON 4.1: THE SPECIFIC FACTOR MODEL
 David Ricardo – developed the classical theory of comparative advantage
in 1817 to explain why countries engage in international trade even when
one country’s workers are more efficient at producing every single good
than workers in other countries.

 He also demonstrated that if two countries is capable of producing two

commodities engage in the free market, then each country will increase its
overall consumption by exporting the good for which it has a comparative
while importing the other good, provided that there exist difference in
labour productivity between both countries.
ESSON 4.1: THE SPECIFIC FACTOR MODEL
 Ricardos’s theory implies that comparative advantage rather than absolute
advantage is responsible for much of international trade (baripedia.org,
2021). In addition, Ricardian’s model assumes that owners (countries) of
factors of production for products that are in demand would receive an
increasing part of the world’s global income.

 The SF model is sometimes referred to as the Ricardo-Viner Model. It was

later developed and formalized mathematically by Ronald Jones and Paul
Samuelson. They elaborated the SF model based on the specific factors such
as “territory or terrain (T), labour (L), and capital (K)”.
ESSON 4.1: THE SPECIFIC FACTOR MODEL
 They said that products like food (X) are made by using territory (T) and
labour (L), while manufactured products (Y) uses capital (K) and labor
(L).

 Mobile factor – refers to one that can be used in both food and
manufactured products, while territory and capital are specific factors,
territory (T) are used only for food and capital used only for manufactured
products:

Food (X) = (T + L)
Manufactured Products (Y) = (K + L)
ESSON 4.1: THE SPECIFIC FACTOR MODEL
 Therefore, the production for food gives the quantity of food that can be
produced by given any input of territory/terrain and labor:

QF = QF (T, L)

Where:

QF = Output of Food
T = Territory/terrain (Land)
L = Labor Employed
ESSON 4.1: THE SPECIFIC FACTOR MODEL
 The production function for a manufactured product gives the quantity of
the product that can be produced given any input of capital and labor:

QMP = QMP (K, L)

Where:

Q = Output of the manufactured

product
K = Capital Stock
L = Labor Employed
ESSON 4.1: THE SPECIFIC FACTOR MODEL
 When labor moves from food to manufactured product, food production
falls while output of the manufactured product rises. The shape of the
production function reflects the law of diminishing marginal returns.

 Law of Diminishing Marginal Returns – is a theory in economics that

predicts that after some optional level of capacity is reached; adding an
additional factor of production will actually result in smaller increase in
output.
ESSON 4.1: THE SPECIFIC FACTOR MODEL
 For the economy as a whole, the total labor employed in producing a
manufactured good and producing food must equal the total labor supply:

LMP + LF = L

Where:

LM = Labor used for production

P of manufactured product
LF = Labor used for production
of food
SSON 4.1: THE SPECIFIC FACTOR MODEL
 Therefore, a country rich in capital and poor in land tends to produce
more manufactured products than food products, whatever the price. A
country rich in land (territory), like most agricultural countries, tends to
produce more food. Other factors held constant, an increase in capital will
mean an increase in marginal productivity from the manufactured
sector, while an increase in territory will increased in food production.

 When two countries decide to trade, they create an integrated global

economy whose manufacture and food production is equal to the sum of the
production of the two countries. If they do not trade, the production for a
good is equal to the consumption.
ESSON 4.2: STANDARD MODEL OF TRADE
Learning Objectives:
At the end of the lesson, the students should be able
to:

a) Explain the meaning of the global demand curve and

the global supply curve;
b) Discuss market equilibrium;
c) Elaborate on the relationship between global demand
and the level of prices; and
d) Elucidate on the meaning of terms of trade.
ESSON 4.2: STANDARD MODEL OF TRADE
 Standard Model of Trade by Paul Krugman- Maurice Obsfeld Model
- It implies the existence of the relative global demand curve resulting from the
different preferences for a certain good and relative global supply curve
resulting from different production possibilities.

 According to Paul Krugman and Maurice Obsfeld, the exchange rate, the
rapport between the export prices and the import prices, is determined by the
intersection between the two curves, which is equilibrium. Relative prices
determine the economy’s output. Other factors being constant, the exchange
rate improvement for a country implies a substantial rise in the welfare of
that country.
ESSON 4.2: STANDARD MODEL OF TRADE
 Global demand or total demand – refers to amount of money, which
subjects (consumers) of an economy plan to spend on goods and services at
the different size of income or at given prices in a given period. Total
demand consists of:

Expenses by Type Symbolized by

Personal consumption of C – consumption
expenditure
Gross private domestic I – investment
investment
Gross government spending G – government
spending
Net export NX – net export
ESSON 4.2: STANDARD MODEL OF TRADE
 Net exports are a measure of nation’s total trade. The formula for net
exports is a simple one: the value of a nations total of export of goods and
services minus the value of all the goods and services it imports.

Net Exports = Total Exports – Total Imports

 The economy’s equilibrium level is established as a result of the game of

global demand and global supply in a market economy.

 Market equilibrium is the intersection of the global demand curve and the
global supply curve.
ESSON 4.2: STANDARD MODEL OF TRADE

 The aggregate demand curve shows how many goods and services
consumers can and are willing to buy at different total price levels, other
conditions remaining the same. The size of purchases made by consumers
influences prices. The size of global demand changes the level of prices
inversely. The crucial factor is the elasticity of global demand in relation to
interest rates or level of global wealth.
SSON 4.2: STANDARD MODEL OF TRADE
 The quantity of an item supplied by the subjects (consumers) of an economy
is determined by a number of different factors; the supply curve represents
the relationship between price and quantity supplied, with all the other
factors affecting supply held consultant. Quantity supplied (supply curve) is
a function or price:
Quantity supplied = supply curve = f (price)

 The standard trade model is a general model that includes the Ricardian
model, the Ronald Jones and Paul Samuelson specific factors model, and the
Hecksher – Ohlin (H-O) model as a special cases – two goods, food (F) and
cloth (C). Each country’s production possibility frontier (PPF) is a smooth
curve.
SSON 4.2: STANDARD MODEL OF TRADE
 The standard trade model assumes the following:
a. Each country produces two goods, food (F) and cloth (C).
b. Each country’s production possibility frontier (PPF) is a smooth curve (TT)
c. The point on it’s PPF, at which an economy actually produces, depends on
the price of cloth relative to food, PC/PF.
d. Isovalue lines are lines along which the market value output is constant.

 A country’s PPF determines its relative supply function because it shows

what the country is capable of producing, which should be maximized.

 Equilibrium is the intersection of demand and supply curves.

SSON 4.2: STANDARD MODEL OF TRADE

 An economy chooses its production of cloth QC and food QF to maximize the

value of its output (V) given the prices of cloth and food.
V = (PC) (QC) + (PF) (QF)
Where:
V = value of out put
PC = price of cloth
QC = quantity of cloth
PF = price of food
QF = quantity of food
ESSON 4.2: STANDARD MODEL OF TRADE
 The slope of an isovalue line (relative price of cloth to food) equals PC/PF.
The best point to produced is where PPF is tangent to the isovalue line, a line
of slope equal to the relative prices.

 The standard trade model is built on four key relationships:

a) The relationship between the PPF and the world relative supply (RS) curve;
b) The relationship between relative prices (RP) and relative demand (RD);
c) The word equilibrium as determined by world RS and RD; and
d) How changes in the terms of trade affect a nation’s welfare.

 The world relative supply curve (RS) is upward sloping because an increase
in the price of cloth/ price of food (PC/PF) leads both countries to produce
more cloth and less food.
ESSON 4.2: STANDARD MODEL OF TRADE
 The world relative demand curve (RD) is downward sloping because an
increase in PC/PF leads both countries to shift their consumption mix away
from cloth toward food.

 Terms of trade (TOT) means the price of a country’s imports.

TOT = PE/ PI
Where
PE = price of exports
PI = price of imports
SSON 4.2: STANDARD MODEL OF TRADE
 If country A exports shoes only and country B exports garments only,

A’s term of trade is: TOTA = and

B’s term of trade is TOTB =

Where:
PS = Price of shoes
PG = Price of Garments
LESSON 4.2: STANDARD MODEL OF TRADE
 Generally, a rise in the TOT increases a country’s welfare, while a decline in
the TOT reduces its welfare. Intuitively, if TOT falls, price of what the
country consumes. Intuitively, if TOT rises, price of what a country produces
goes up relative to the price of what the country consumes.

 The relationship of TOT, total price of production, and country’s welfare is

direct:

TOT Total price of production country’s welfare

LESSON 4.3: LEONTIEF PARADOX
Learning Objectives:
At the end of the lesson, the students should be able
to:

a) Explain the Heckscher-Ohlin Theory;

b) Discuss the meaning of “paradox”; and
c) Elaborate on the Loentief paradox
LESSON 4.3: LEONTIEF PARADOX
♦ According to Heckscher-Ohlin theory (factors proportions theory) each
country exports commodity which intensively uses its abundant factor
meaning that a country rich in a particular resource should be exporting
products that will use that resource and import products made from resources
that the country lacks.

♦ Wassily W. Leontief was the one who made the first serious attempt theory
he was a Russian-born American economist. In 1953 he studied the US
economy closely.
LESSON 4.3: LEONTIEF PARADOX

♦ The H-O theory predicts that the US would export more capital-extensive
goods and import labor – extensive goods. However, Leontief was surprised
to discover that the US was actually exporting labor-extensive goods and
importing capital-extensive goods. His analysis became known as the
leontief paradox.

♦ In the international division of labor, the US specialized in labor intensive

rather than capital-intensive goods, which contradicted the widely accepted
view derived from the H-O theory. His analysis became known as the
Leontief paradox because it was the reverse of what was expected by the H-
O theory.
ESSON 4.3: LEONTIEF PARADOX
♦ A paradox is a seemingly absurd or self contradictory statement or
proposition that when investigated or explained may prove to be well-
founded or true.

♦ Iowa state university, department of economics, has done an interesting and

comprehensive account of Leontief paradox, including results for some other
countries than the US, something worth looking into:

♦ Wassily Leontief, received a noble prized in 1973 for his contribution to the
input-output analysis. Three of his students, Paul Samuelson (specific
factor model), Robert Solow, and Vernon Smith also received a noble prize.
ESSON 4.3: LEONTIEF PARADOX
♦ Leontief reached a paradoxical conclusion that the US – the most capital
abundant country in the world by any criterion- exported labor-intensive
commodities and imported capital-intensive commodities, which contradicts
the H-O theory; hence the result has come to be known as the Leontief
paradox (para= contra to, doxa= opinion).

♦ Boris Swerling (1953) complained that 1947 was not a typical year: the
postwar disorganization of production overseas was not corrected by that time.
Therefore, in 1956, Leontief repeated the test for US imports and exports
which prevailed in 1951.
ESSON 4.3: LEONTIEF PARADOX
♦ Professor Robert Baldwin (1971) used the 1962 US trade data and found that
US imports were 27% more capital intensive than US exports. The paradox
continued.

♦ In 1959, Tatemoto and Ichimura studied Japan’s trade pattern and discovered
another paradox. Japan was a labor-abundant country, but exported capital-
extensive goods and imported labor-intensive goods. Japan’s overall trade
pattern was inconsistent with the H-O theory. It agreed with the leontif
paradox.
ESSON 4.3: LEONTIEF PARADOX
♦ In 1961, Stolper and Roskamp applied leontief method to trade pattern of
East Germany (EG). EG’s exports were capital-intensive. About EG’s trade
was with the communist bloc, and EG was capital abundant relative to its
trading partners. Thus, the EG case was consistent with the H-O theory.

♦ Also in 1961, Wahl studied Canada’s trade pattern. Canadian exports were
capital intensive. Most of Canadian trade with the US. The result was
inconsistent with H-O, and therefore, consistent with the leontief paradox.
ESSON 4.3: LEONTIEF PARADOX

♦ In 1962, Bharawaj studied India’s trade pattern. India’s exports were labor
intensive, consistent with H-O theory. However, Indian trade with the US
was not in accordance with the H-O theory, but was not consistent with the
Leontief paradox. Indian exports to the US were capital-intensive.

♦ In 1975, Hong analyzed Korea's trade pattern (1966-1972), which was

consistent with the H-O theory.
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