Chapter 2

Modern international trade

theory
M.s. Ngo Quynh Trang
International trade on
the basis of different
preferences.
 Y IC1’
IC1 Country 1
Country 1 and Country E
PA
2 have the same PPF
(Production Possibility A
PB=PB’
Frontier), produce and B≡B’
consume two products,
X and Y. Country 1 Country 2
prefers consuming Y E’
over X, while Country
IC2’
2 prefers X over Y. A’
IC2
PA’
0
X
 • Country 1: Production and consumption in A, IC1
intersects the PPF at A, the domestic price of is PA.
• Country 2: Production and consumption in A’, IC2
intersects the PPF at A', the domestic price is PA’.

Without trade • PA < PA’

èCountry 1 has a comparative advantage in X, so it exports
X and imports Y.
èCountry 2 has a comparative advantage in Y, so it exports
Y and imports X.
 • Country 1 specializes in the production of X and
shifts production down along the PPF curve.
• Country 2 specializes in the production of Y and
With trade shifts production up along the PPF curve.
• Both countries adjust their production until the
domestic equilibrium price of the products in the
two countries is equal
 • At point B ≡ B’, we have PB = PB’.
• Country 1 exports X to country 2 and imports Y from
Country 2.
• Country 1 consumes at point E on IC1’.
With trade • Country 2 consumes at point E’ on IC2’.
• According to comparative advantage: Both countries
benefit because IC1’ > IC1 and IC2’ > IC2.
• According to quantity: Both countries benefit because
E and E’ both have more X and Y than A and A’.
Heckscher-Ohlin Model
 • There are two countries exchanging two goods and two
factors of production.
• Both countries have the same level of technology.
• Factor allocation in production is the same in both countries.

Assumptions • Consumer preferences are identical.

• Labor and capital can freely move within each country but
not between countries.
• The markets are perfectly competitive.
• There is free international trade
 • Product X is labor-intensive compared to product Y if the
ratio of labor to capital used in the production of product X is
greater than in the production of product Y.
• Formula:
Lx Ly
Factor Intensity Kx
> Ky

èLx and Kx are the number of labor and capital units required
to produce one unit of X.
èLy and Ky are the number of labor and capital units required
to produce one unit of Y.
 • Product X is capital-intensive compared to product Y if the
ratio of capital to labor used in the production of product X is
greater than in the production of product Y.
• Formula:
Kx Ky
Factor Intensity Lx
> Ly

èIf product X is labor-intensive, then product Y will be capital-

intensive.
Lx Ly Kx Ky
Kx
> Ky Lx
< Ly
 Factor Labor (L) Capital (K)
Wheat 4 8
Cloth 6 2

Example
• Wheat is capital-intensive because: 8/4 > 2/6.
• Cotton is labor-intensive because: 6/2 > 4/8.
 • Indicating the abundance of a certain factor in production. It
could be K or L
• Country 1 has a labor surplus if the ratio of the total labor to
total capital in country 1 is greater than that of country 2
Factor • Formula:
Abundance L1
> L2 K1 K2
K1 K2 L1
< L2

èL1, K1: Total labor and capital in country 1

èL2, K2: Total labor and capital in country 2
 • Country 1 has a labor surplus if the ratio of labor cost to
capital cost in Country 1 is lower than that of Country 2.
• Formula:
w1 < w2 r1 > r2
r1 r2 w1 w2
Factor
W1, r1: Labor cost and capital cost in country 1
Abundance
W2, r2: Labor cost and capital cost in country 2
è A country with a labor surplus will experience a capital
shortage. The other country will face a labor shortage and a
surplus of capital.
 Factor Labor Capital Wage R
UK 100 200 30 2
USA 200 300 20 1

• UK has a surplus of capital because: 200/100 > 300/200

Example • USA has a surplus of labor because : 200/300 > 100/200

Identify the surplus factor using Wage and

Interest rate
 A country will export products that are intensive in
factors it has a relative surplus of, and import products
that are intensive in factors it has a relative shortage of,
which benefits all countries

ç Example:
Conclusion • Product X is labor-intensive, and product Y is capital-
intensive.
• Country 1 has a surplus of labor, and Country 2 has a
surplus of capital.
è Country 1 exports X and imports Y; Country 2 exports
Y and imports X
 Country 1 has a surplus of labor, and Country 2 has a surplus of
capital. X is labor-intensive, and Y is capital-intensive

Y
Co
un
try PA’
2

Analysis
A’
Count
ry 1

A
PA

0 X
 – The IC1 intersects the PPF of country 1 at point A, and the
PPF of country 2 at A’.

– Points A and A' represent the autarky equilibrium points of

country 1 and country 2.
Without trade – The tangents at A and A' determine the domestic
equilibrium prices in Country 1 and 2 as PA and PA',
respectively.

– Because PA < PA', country 1 has a comparative advantage

in product X, and country 2 in product Y.
 Y
Co
un
try
2
B’
IC2

With trade Count

ry 1
A’ E ≡ E’

A
B

0 X
 – Country 1 specializes in producing X, and Country 2
specializes in producing Y.

– Country 1 shifts production from A to B, with PA

increasing. Country 2 shifts production from A' to B',
With trade with PA' increasing.

– Specialization continues until the domestic price in

both countries is equal. At that point, Country 1
produces at B, Country 2 produces at B', and PB = PB
 – Country 1 exports X and imports Y, reaching
consumption at point E on the IC2 curve.

– Country 2 exports Y and imports X, reaching

consumption at point E' on the IC2 curve.
With trade
– E coincides with E' on IC2, satisfying the fact that the
consumption of both Country 1 and Country 2 is
higher than at A and A' on IC1.

Both countries gain