Table of Contents

GAINS AND LOSSES FROM TRADE IN THE SPECIFIC-FACTORS MODEL....................... 2

Trade and Resources: The Heckscher-Ohlin Model ....................................................................... 5
International Trade and Investment Theory .................................................................................... 6
Increasing Returns to Scale and Monopolistic Competition........................................................... 8
Offshoring ....................................................................................................................................... 9
GAINS AND LOSSES FROM TRADE IN THE SPECIFIC-
FACTORS MODEL
1. Ricardo-Viner model

In the Specific-Factors Model (also known as the Ricardo-Viner model), we analyze the short-
run effects of international trade on income distribution within a country. The model assumes:

• There are two goods.

• One factor (typically labor) is mobile between sectors.
• Other factors (e.g., land, capital) are specific to each sector — they cannot move between
industries in the short run.

Gains and Losses from Trade

1. Gains from Trade (at the national level):

• Overall Efficiency Increases: Trade allows a country to specialize in producing goods

where it has a comparative advantage, leading to more efficient allocation of resources.
• Consumption Possibilities Expand: The country can consume beyond its production
possibilities frontier (PPF).
• Aggregate Income Rises: The total value of output increases, so the country as a whole
is better off.

2. Distributional Effects (within the country):

Trade changes relative prices of goods, which affects the real incomes of factors differently:

Winners:

• Owners of the Specific Factor Used in the Export Sector benefit.

o The price of the export good rises due to trade.
o This increases returns to the factor specific to that sector (e.g., capital in the
manufacturing sector if the country exports manufactured goods).

Losers:

• Owners of the Specific Factor Used in the Import-Competing Sector lose.

o The price of the import-competing good falls.
o This reduces returns to the specific factor in that sector (e.g., land in agriculture if
the country starts importing agricultural products).

Ambiguous:

• Mobile Factor (Labor) faces uncertain outcomes.

o Labor moves between sectors in response to wage changes.
 o If trade leads to higher output and wages in the export sector, wages may rise.
o However, if the negative impact on the import-competing sector is large, real
wages (in terms of the consumption basket) might not improve for all workers.

2. Production Possibilities Frontier (PPF)

The Production Possibilities
Frontier (PPF) is an economic
model that illustrates the maximum
possible combinations of two
goods or services an economy can
produce using its resources
efficiently, given current
technology. It demonstrates the
concept of scarcity, as choices must
be made about how to allocate
limited resources. The curve is
typically concave (bowed
outward), reflecting the law of
increasing opportunity costs—meaning that producing more of one good requires giving up
increasingly larger amounts of the other. Points on the PPF represent efficient production, while
points inside indicate underutilized resources, and points outside are unattainable without trade or
technological advancement. In the context of international trade, the PPF shows how a country can
specialize in producing the good in which it has a comparative advantage and trade to consume
beyond its own production limits. Thus, the PPF is a powerful tool to explain efficiency, trade-
offs, and the benefits of economic cooperation between nations.
3. Earnings of Labor
Trade affects labor earnings
differently across sectors. When a
country opens to trade, the price of
the export good rises, attracting
more labor to that sector, while the
import-competing sector contracts.
Wages adjust to equalize across
industries, based on the value of
labor’s marginal product. Although
the economy as a whole gains,
workers may experience different
changes in real income depending
on the goods they consume and
which sector they work in.
4. Real wage
Higher wages do not always
mean higher real wages, which
measure purchasing power. In
the specific-factors model, if
the wage rises due to trade and
the price of the imported good
(e.g., agriculture/food) remains
constant, then W/PA (wage
divided by price of food)
increases. This means workers
can afford more food, so their
real wage in terms of food
rises. However, if the price of
the export good (e.g.,
manufactured goods) rises faster than wages, real wages in terms of that good may fall. Therefore,
the effect on real wages depends on what workers consume. If they spend more on the import
good, their real income likely increases.
Que ans :

In this case, the home country exports manufactured goods and imports agricultural
products. When trade opens:

• The price of manufactured goods (export) increases.

• The price of agricultural products (import) stays constant or decreases.
• Nominal wages (w) increase due to higher demand in the export sector.

Now let’s assess the real wage impact on each worker based on their spending patterns.

Worker A

Spending:

• 70% on agriculture (imported good)

• 30% on manufacturing (exported good)

Effect:

• Since the price of agricultural goods remains constant or falls, and nominal wages have
increased, Worker A’s real wage rises significantly.
• The majority of their consumption is cheaper or unaffected, while their income rises —
so Worker A is better off.

Worker B
Spending:

• 30% on agriculture
• 70% on manufacturing

Effect:

• The price of manufactured goods has increased, and although wages have also risen,
most of Worker B’s spending is on the now more expensive product.
• The rise in nominal wage might be offset by the rise in the price of manufactured goods,
leading to smaller or no real gain, and potentially even a loss in purchasing power.

Conclusion:

• Worker A, who spends more on the imported good, gains more in real wage terms.
• Worker B, who spends more on the exported (and now more expensive) good, may see
little or no improvement, or even a decline in real wages.

Trade and Resources: The Heckscher-Ohlin Model

1. The Heckscher-Ohlin
The Heckscher-Ohlin (H-O) Model explains international trade based on a country's factor
endowments, such as labor, capital, and land. Unlike the Ricardian model, which focuses on labor
productivity differences, the H-O model suggests that countries will export goods that use their
abundant factors of production and import goods that use their scarce factors. For instance, a
capital-abundant country will export capital-intensive goods, while a labor-abundant country will
export labor-intensive goods. The model also predicts that trade will lead to factor price
equalization, where wages and returns to capital tend to converge across countries over time.
However, the model has limitations, such as assuming identical technology across countries, which
is not always the case. It also overlooks factors like transportation costs and preferences. Moreover,
real-world evidence, such as the Leontief Paradox, sometimes contradicts the model's predictions,
highlighting its empirical challenges.
2. Leontief’s Paradox
Leontief’s Paradox refers to the unexpected results from a study conducted by economist Wassily
Leontief in 1953, which challenged the predictions of the Heckscher-Ohlin (H-O) Model.
According to the H-O model, a country that is capital-abundant should export capital-intensive
goods and import labor-intensive goods, given that trade is driven by factor endowments.

Leontief, assuming the United States in 1947 was capital-abundant relative to other countries,
hypothesized that the U.S. would follow this pattern. However, his findings were the opposite. He
discovered that the capital-labor ratio for U.S. imports was actually higher than the capital-labor
ratio for U.S. exports. This meant that the U.S. was importing more capital-intensive goods and
exporting more labor-intensive goods, contrary to the predictions of the H-O model.
This discrepancy became known as Leontief’s Paradox, and it raised questions about the validity
of the Heckscher-Ohlin theorem, suggesting that factors beyond capital and labor, such as
technology or human capital, might play a more significant role in determining trade patterns.

International Trade and Investment Theory

1. Foreign Portfolio Investment (FPI)
Foreign Portfolio Investment (FPI) refers to investments in financial assets, such as stocks or
bonds, made by foreign investors in a country. Unlike Foreign Direct Investment (FDI), FPI
involves minority stakes and is typically short-term and more liquid, meaning it can be easily
bought or sold. FPI allows investors to diversify their portfolios by accessing foreign markets, but
it exposes them to exchange rate and market volatility risks. While FPI provides capital for
economies, it can be less stable than FDI, as investors may quickly withdraw during periods of
uncertainty.
2. Foreign Direct Investment (FDI)
Foreign Direct Investment (FDI) involves a long-term investment by a foreign entity or
individual in a business or assets in another country. Unlike Foreign Portfolio Investment (FPI),
FDI usually entails acquiring at least 10% of a company’s shares, establishing new operations, or
forming joint ventures, granting investors control or influence. FDI helps stimulate economic
growth by creating jobs, transferring technology, and improving infrastructure. While it involves
higher risks due to direct involvement in operations, it is typically considered more stable than
FPI. FDI plays a key role in integrating countries into the global economy and fostering
development.
3. Why does FDI occur?
Foreign Direct Investment (FDI) occurs for several reasons, including economic and strategic
factors. Companies invest abroad to gain market access, expanding their customer base,
particularly in saturated or slow-growth domestic markets. Resource-seeking FDI allows access to
cheaper labor, raw materials, or technology not available in the home country. Cost efficiency is
another driver, as firms relocate production to areas with lower costs, such as cheaper labor or
favorable tax policies. Firms also seek to acquire strategic assets, like valuable technologies or
intellectual property. Diversification helps reduce risk by spreading investments across regions.
Lastly, FDI enables firms to gain a competitive advantage by strengthening global presence or
establishing barriers to entry. Overall, FDI is a long-term strategy for growth, profitability, and risk
management.
4. International Investment Theories:
Ownership Advantages:
Ownership advantages refer to the unique assets or capabilities that a firm possesses, which give
it a competitive edge in foreign markets. These advantages could include technology, brand
reputation, management expertise, or proprietary knowledge. Firms with these ownership
advantages are more likely to engage in Foreign Direct Investment (FDI), as they can leverage
their unique strengths to overcome the costs and risks of entering a foreign market. Ownership
advantages help firms achieve superior performance abroad compared to local competitors.
Internalization Theory:
Internalization theory focuses on how firms choose to control their foreign operations rather than
relying on market transactions, such as licensing or franchising. The theory suggests that firms
prefer internalizing their operations abroad to avoid transaction costs associated with outsourcing
or licensing. By owning and controlling their foreign operations, firms can better protect their
intellectual property, ensure quality control, and reduce market uncertainties. This theory
emphasizes the importance of firms' desire to maintain control over their assets and reduce external
risks.
Dunning’s Eclectic Theory:
Dunning’s Eclectic Theory (also known as the OLI Framework) combines three factors—
Ownership advantages, Location advantages, and Internalization advantages—to explain
why firms engage in FDI. According to the theory:
1. Ownership advantages refer to a firm’s unique resources or capabilities.
2. Location advantages are the benefits that a particular country offers for foreign
investment, such as access to resources, favorable policies, or market potential.
3. Internalization advantages explain why firms prefer to internalize operations instead of
using external markets, as it helps reduce transaction costs and protects proprietary assets.

5. Factors Influencing FDI

Supply Factors:

1. Production Cost: Firms may choose foreign locations over domestic sites due to lower
costs such as cheaper land, tax rates, commercial rents, or skilled/unskilled labor.
o Example: Nokia built a mobile phone plant in Vietnam to leverage low labor
costs.
2. Logistics: If transportation costs are significant, firms may prefer to produce locally in
the foreign market rather than exporting from domestic factories.
o Example: Heineken invested in local production to avoid the high cost of
shipping beer, which is primarily water.
3. Availability of Natural Resources: Companies may invest abroad to access natural
resources critical to their operations.
 o Example: U.S. oil companies invested worldwide to secure new oil reserves as
domestic production declined.
4. Access to Key Technology: Some firms find it more efficient to acquire technology via
FDI than to develop it internally.
o Example: Swiss pharmaceutical companies invested in U.S. biogenetics firms to
access emerging biotechnology.

Demand Factors:

1. Customer Access: Firms often establish a physical presence in foreign markets to

directly serve customers.
o Example: IKEA expanded globally by opening stores worldwide.
2. Marketing Advantages: Having a factory in a foreign market can enhance visibility and
improve customer service.
3. Exploitation of Competitive Advantages: Firms may choose FDI to leverage their
trademarks, brands, or technology in foreign markets.
o Example: Procter & Gamble, Nestlé, and Unilever set up local factories to better
serve local markets.
4. Customer Mobility: If a customer builds a factory abroad, firms may follow them to
maintain close supply relationships.
o Example: Samsung’s factory in northeast England led six of its Korean suppliers
to establish nearby facilities.

Political Factors:

1. Avoidance of Trade Barriers: Firms establish facilities in foreign countries to avoid

trade restrictions.
o Example: Microsoft set up a software development center in Canada to bypass
U.S. visa limitations for skilled workers.
2. Economic Development Incentives: Governments often provide incentives like tax
reductions, infrastructure improvements, or training programs to attract FDI.

Increasing Returns to Scale and Monopolistic Competition

1. Monopolistic Competition
Monopolistic Competition is a market structure characterized by many firms selling similar but
slightly differentiated products. In this structure, each firm has some control over its pricing due
to the differentiation in their offerings. Despite the product differences, firms face significant
competition, as many companies operate within the same market. Each firm experiences a
downward-sloping demand curve, meaning it can influence the price of its product, unlike in
perfect competition. Firms also benefit from increasing returns to scale, where average costs
decrease as production rises. Additionally, the market allows for free entry and exit, meaning new
firms can enter the market when profits are high and exit when they fall, leading to zero economic
profits in the long run. Monopolistic competition combines features of both monopoly and perfect
competition, with firms having limited pricing power but still facing substantial competition.
2. Trade Under Monopolistic Competition: Key Assumptions

Assumption 1: Product Differentiation

• Each firm produces a good that is slightly differentiated from others in the industry.
• This differentiation gives each firm some control over its pricing, as it faces a
downward-sloping demand curve.

Assumption 2: Many Firms in the Industry

• The market has a large number of firms, and each firm faces a share of the demand
proportional to the total number of firms (denoted as N).
• When one firm reduces its price, it faces a flatter demand curve compared to others,
reflecting greater competition.

Assumption 3: Increasing Returns to Scale

• Firms operate with increasing returns to scale, meaning as they produce more, average
costs decrease.
• Marginal cost is typically lower than average cost, and firms experience falling average
costs as production increases.

Assumption 4: Free Entry and Exit

• In the long run, firms can enter or exit the market freely.
• As long as firms can earn monopoly profits, new firms will enter, reducing profits for
existing firms. In the long run, this competition leads to zero profits for each firm,
similar to perfect competition.

Offshoring
1. Offshoring

Offshoring refers to the business practice of relocating certain business processes or operations
to a foreign country, typically to take advantage of lower labor costs, tax benefits, or favorable
regulatory environments. This can involve shifting production, customer service, IT services, or
other business functions to locations where the cost of doing business is cheaper, allowing
companies to reduce expenses and improve efficiency.

There are two main types of offshoring:

1. Manufacturing Offshoring: Companies move their production facilities to countries

where labor and raw materials are less expensive.
2. Service Offshoring: Businesses may outsource services like customer support, software
development, or technical support to countries with skilled labor at lower wages.
While offshoring can result in cost savings and increased efficiency, it can also raise concerns
about job losses in the home country, quality control, and ethical implications regarding labor
practices in foreign locations.

2. Costs of Capital and Trade

In the value chain model of offshoring, the costs of capital and trade are assumed to be uniform
across all activities. This means that the cost of using equipment, infrastructure, or transporting
goods is the same regardless of which production task is being considered. This assumption
simplifies the analysis by allowing the offshoring decision to depend solely on labor costs and
skill intensity. Since Home has higher wages for skilled labor, firms offshore low-skill, labor-
intensive activities (like assembly) to Foreign, where wages are lower. In contrast, high-skill
tasks (like R&D and marketing) remain at Home. This leads to a clear cutoff point on the value
chain, known as Line A, where tasks to the left (low skill) are offshored, and those to the right
(high skill) are kept at Home. Without uniform capital and trade costs, this clear division would
not exist, and offshoring decisions would be more complex.

3. Slicing the Value Chain

Slicing the value chain refers to the process by which firms break down the production of a product
into distinct tasks and decide where each task should be performed—either at Home or in a Foreign
country. Instead of producing the entire product in one location, firms identify individual activities
such as design, component manufacturing, assembly, marketing, and research & development, and
choose to offshore only those segments that can be done more cost-effectively abroad. This is
especially relevant for low-skill, labor-intensive tasks, which are often moved to countries with
lower wages. On the other hand, high-skill, knowledge-intensive tasks are retained at Home, where
skilled labor is more available despite higher wages. Slicing the value chain allows firms to
maximize efficiency and reduce production costs by taking advantage of global differences in labor
skills and wages. It reflects how globalization and technological advances enable production to be
more flexible and geographically dispersed.
4. Relative Demand and Supply for Skilled Labor
Relative demand and supply for skilled labor play a central role in determining wage differences
between countries and influence offshoring decisions in the value chain model. Relative demand
refers to how much skilled labor is needed compared to unskilled labor, while relative supply
indicates how much skilled labor is available in relation to unskilled labor. In developed (Home)
countries, the supply of skilled labor is generally higher, but so is the demand—especially for high-
tech and knowledge-based tasks. This leads to higher relative wages for skilled labor in Home.
When firms offshore low-skill
tasks to Foreign (where wages are
lower), the demand for skilled
labor increases in both countries.
In Home, firms focus more on
high-skill activities like R&D and
innovation, increasing domestic
skilled labor demand. In Foreign,
offshoring creates new
opportunities that require
supervisory or technical skills, gradually raising demand for skilled labor there too. This global
shift can lead to wage inequality, favoring skilled over unskilled workers.
5. Changing the Costs of Trade
Change in Home Labor Demand and Relative Wage
When the costs of trade decrease, it
becomes easier and cheaper for
firms to offshore certain production
activities. This change affects both
the demand for labor at Home and
the relative wage of skilled labor.
As trade costs fall, firms can afford to offshore more low-skilled tasks to Foreign. This leads to a
decrease in demand for low-skilled labor at Home, since those jobs are now being done abroad. At
the same time, firms at Home increasingly focus on high-skilled activities such as design,
innovation, and R&D. As a result, the demand for skilled labor at Home increases.
Because demand for skilled labor rises while low-skilled labor demand falls, the relative wage of
skilled labor at Home increases. In simple terms, skilled workers earn more compared to unskilled
workers. This widening gap reflects growing wage inequality, a common side effect of increased
offshoring driven by lower trade costs.
Change in Foreign Labor Demand and Relative Wage
When trade costs decrease, firms in developed (Home)
countries offshore more low-skilled tasks to developing
(Foreign) countries, where labor is cheaper. This shift leads
to an increase in demand for low-skilled labor in Foreign, as
more assembly, packaging, and other labor-intensive tasks
are relocated there.
At the same time, the growing presence of multinational
firms and complex tasks can also gradually raise the demand
for skilled labor in Foreign, especially for managing
operations, quality control, and technical support. As a
result, both skilled and unskilled labor demand increase in Foreign, but the initial surge is stronger
for unskilled labor.
This causes the relative wage of unskilled labor to rise in Foreign, reducing the wage gap between
skilled and unskilled workers—the opposite of what happens in Home. Over time, as skill-
intensive activities expand in Foreign, the relative wage of skilled labor may also rise, reflecting
an overall upgrading of the labor force.