Chapter 5 Tests of Trade Models: The Leontief Paradox and Its Aftermath 1
Chapter 5
Tests of Trade Models: The Leontief Paradox
and Its Aftermath
The aim in the first half of this chapter is to discuss in considerable detail both the methodology involved in tests of several theories of comparative advantage and the results of these tests. Several aspects of this chapter are relatively unique. First, the literature that is surveyed includes several very recent examinations of the HO model. Second, there is much more extensive discussion of methodology than is ordinarily found in texts at this level. We include this material because it is our belief that the Leontief Paradox represents a watershed in the development of the theory of international trade flows. On the one hand, some critics are rightfully concerned with the adequacy of the testsand we explain whywhile on the other, some economists have viewed Leontief’s findings as a signal to explore new avenues. We devote the second part of the chapter to these pursuits. Thus, precisely because the interplay between theoretical analysis and empirical verification is so strong in this instance, we feel it is important to explain very clearly how economists have conducted these tests and the problems they have encountered along the way.
Despite our enthusiasm for this material, there is no doubt that some students will find it difficult but, we hope, less dull than other textbook treatments. Two discussions remaining in the body of the chapter that may require special care in lectures are the treatment of recent tests of HO and the material on increasing returns to scale and trade flows. Both issues are at the forefront of current research and should be presented to the students as such.
Chapter Outline
Introduction
Tests of the Classical Model
Tests of the HO Model
Attempted Reconciliations of Leontief’s Findings
Other Tests of the HO Model
Recent Tests of the HO Model
Alternative Theories of Comparative Advantage
Human Skills Theory
Product Cycle Theory
Similarity of Preferences Theory
Intraindustry Trade
Increasing Returns and Imperfect Competition
Conclusions
Summary
Exercises
Suggested Answers for the EndofChapter Exercises
1.Why were Leontief’s findings considered to be paradoxical?
Leontief assumed that the US was the most capital abundant country in the world after World War II and expected his test of the HO model to confirm that US exports were relatively capital intensive while US imports were relatively labor intensive. Instead, he found that US imports were more capital intensive than its exports, hence Leontief’s Paradox.
2.Suppose that the information below represents the complete trade data for each country. Use this data to calculate values of IIT for each country.
Using the formula (5.1), we have:
Country A:
IIT 100 50{|10/18 5/18||8/18 1/18||0/18 12/18|}
100 50(24/18) 33.3
Country B:
IIT 100 50{|5/7 0||.4/7 6/7||1.6/7 1/7|}
100 50(11.2/7) 20
Country C:
IIT 100 50{|2/4.5 1.8/4.5||1/4.5 1.5/4.5||1.5/4.5 1.2/4.5|}
100 50(1/4.5) 88.9
3.Discuss various reasons why we might expect countries to engage in intraindustry trade.
First, transportation costs may be a factor. If two parts of a country are very far apart, it might be logical for one region to export a product while another distant region imports the same product. Second, the data may be misleading. Since import and export data tend to be aggregated across broad categories, a country might be simultaneously exporting and importing goods in the same category although they have very different characteristics. Finally, economies of scale may lead to specialization in narrow product lines (or varieties of a good), with countries exporting several varieties of a product in exchange for different varieties of the same product.
4.Explain carefully how Leontief went about testing the HO model. Why is this an incomplete test of the model?
Leontief compared the factor content of US exports to and imports from the rest of the world in order to test the HO theory. His principle tool was an inputoutput table constructed to represent the US economy. This table detailed the aggregate transactions between and within all sectors of the economy. Using the inputoutput table, he calculated the capital and labor requirements necessary to (a) decrease US exports by $1 million and (b) increase US imports by $1 million. Since he couldn’t measure the actual amounts of labor and capital used by the foreign producers, he calculated the amounts of factors that would be required to produce those same (imported) goods in the US. He then compared the capital and labor requirements necessary for this change in production. He was surprised to find that the amount of capital per worker idled by a reduction in US exports would be less than the amount of capital per worker needed to increase US importcompeting products.
The HO model explicitly links factor endowments to factor intensities in production, and subsequently links this to trade patterns. Leontief’s test was incomplete since it only tested the link between factor intensities and trade patterns, and ignored factor endowments. This was largely the result of inadequate data on endowments. (It is important to note that the incomplete nature of the test is distinct from the criticism of its basic assumption that US inputoutput tables could be used to describe the production technology in other countries.)
5.Discuss the merits of the alternative reconciliations of Leontief’s findings. Why do you think so much effort was expended in trying to reconcile Leontief’s findings with the HO model?
(a)Leontief’s explanation that American labor was more productive than labor in the rest of the world is logical, although his choice of a factor of three was arbitrary and unsupported by evidence.
(b)Vanek criticized Leontief’s omission of natural resources as a factor of production. If the US was relatively scarce in natural resources, then it could expect to import natural resourceintensive products, which also tended to be capital intensive in production. This is also logical, but why should we limit the analysis to just three factorswhy not more?
(c)Travis’s argument that the US tariff structure distorted trade is also logically intuitive, but impossible to prove since we can’t measure what imports would have been in the absence of tariffs.
(d)Comparisons of expenditure patterns across countries indicate that differences in tastes and preferences could be significant in overturning HO predictions, although no convincing demonstration has been presented.
An enormous amount of effort has been expended trying to reconcile Leontief’s findings with the HO model principally because the model is logical and intuitively appealing. Using a plausible set of assumptions, it is concise and complete, and offers reasonable explanations for observed economic behavior. Further, welfare implications are easily read, and the model offers clear policy prescriptions.
6.How else might the HO model be tested? (Hint: factor price equalization). What would you expect to find if you were to test this proposition with real world data? Would this necessarily refute the model?
The HO model could also be tested by questioning the conclusion that factor prices will be equal with free trade. We should expect to find that factor prices are not equal, for a variety of reasons. Free trade does not prevail, but is distorted by tariff and nontariff barriers. Moreover, labor productivity varies greatly across countries, as do production processes for identical goods. Instead, we might want to consider the effect of trade on factor pricesdo they tend to move toward equality?
7.Explain how each of the alternative models of comparative advantage explains the Leontief Paradox.
Human skills: Rather than comparing relative endowments of capital and labor, we should focus on endowments and intensities of skilled and unskilled labor. Since the US has a more highly trained and skilled work force relative to many other countries, US exports tend to be skilledlabor intensive.
Product cycle model: The stage where goods are invented and tested in the market place (where the US has comparative advantage) requires frequent modification of production techniques, and will therefore be relatively labor intensive. As production is standardized in later stages (and exported), the techniques will tend to become more capital intensive.
Similar preferences: Producers in a country try to satisfy consumers’ tastes. When that country opens to trade, the desire for a variety of products (though basically similar in nature) leads to trade between countries with similar production and consumption patterns. Thus, as a capital abundant country we should expect to import capital intensive products and export labor intensive goods.
8.Would the Linder hypothesis provide a convincing explanation for the pattern of international trade in wheat? In coal? Explain why or why not.
Linder’s hypothesis is that consumers prefer to choose from a variety of goods with slightly different characteristics, and that international trade allows us to obtain this variety. Since both wheat and coal are relatively homogeneous products, neither would seem to be a good candidate for Linder’s model.