reading discussion
-According to Helpman, what were the successes and failures of the Hecksher-Ohlinframework?
-What is the “LeontiefParadox”, and what explanations have economists given to resolve it?
American Economic Association
The Structure of Foreign Trade
Author(s): Elhanan Helpman
Source: The Journal of Economic Perspectives, Vol. 13, No. 2 (Spring, 1999), pp. 121-144
Published by: American Economic Association
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Journal of Economic Perspectives-Volume 13, Number 2-Spring 1999-Pages 121-144
The Structure of Foreign Trade
Elhanan Helpman
W v r orld merchandise exports amounted to $5.3 trillion in 1997 and exports
of commercial services amounted to $1.3 trillion. These are unprece-
dented volumes that have expanded much faster than income in the
postwar period. Figure 1 presents long-term trends in the real volumes of merchan-
dise trade and output. While trade grew at an annual rate of 2.6 percent during this
period, output grew at only 1.5 percent. More than half of the volume of merchan-
dise trade flows amongst developed countries and less than 15 percent flows
amongst developing countries. The rest, about one third, represents North-South
trade between developed and developing countries.
What explains these large volumes of trade? Why do some countries export
computers while others export footwear? Can exports of airplanes be explained in
the same way as exports of paper products? Questions of this type have been
examined for many years. In attempting to answer them, economists have devel-
oped an elaborate analytical apparatus that has been greatly enriched in the last two
decades. They have used the insights from trade theory to examine ever richer data
sets in order to discover systematic patterns of trade flows and to evaluate how well
available theories match these data. Nevertheless, although we do have today better
answers to some of these questions than our predecessors had 40 years ago, the
evolving structure of world trade defies simple explanations. I describe in this paper
what we know about foreign trade and in what ways our understanding has
improved as a result of the last 20 years of research.
The paper is in five parts. In the next section I briefly review early insights:
David Ricardo’s theory of comparative advantage and a simplified version of the
m Elhanan Helpman is Professor of Economics, Harvard University, Cambridge, Massachu-
setts, and Tel Aviv University, Tel Aviv, Israel, and Fellow of the Canadian Institute for
Advanced Research, Toronto, Ontario.
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122 Journal of Economic Perspectives
Figure 1
Long-term Trends of World Merchandise Trade and Output, 1950-1994
2,000
Volume Indices, 1950 = 100
1,500
Merchandise trade
1,000
500 ,
0 ,-_ , ~~~~ tUc~rchandise output
1950 1960 1970 1980 1990
Source: WTO, Trends and Statistics 1995.
Heckscher-Ohlin theory. In the following section I discuss and evaluate further
developments of the Heckscher-Ohlin approach during the 1960s, 1970s and
1980s. While the first two decades provided mostly theoretical insights, major
empirical innovations appeared in the 1980s. The third part of the paper is devoted
to a discussion of the most recent developments on this front. Next, in part four,
comes a discussion and evaluation of research based on economies of scale and
product differentiation. This work was done mostly in the 1980s and 1990s. An
emphasis on the interplay between theoretical and empirical research characterizes
the entire presentation. Conclusions are provided in the closing section.
Early Insights
David Ricardo’s theory of comparative advantage, developed at the beginning
of the 19th century, has played a major role in modern thinking about trade.
Ricardian trade models assume that only labor is used to produce goods and
services, with a given fixed coefficient between labor and output of a particular
product in each country. The theory predicts that a country will export products in
which it has a comparative advantage; that is, products where its labor productivity
is high relative to its labor productivity in other products. The simple Ricardo
model remains useful for thinking about a host of issues, such as the effects of
technological progress on patterns of specialization and the distribution of gains
from trade.
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Elhanan Helpman 123
However, there are hardly any empirical studies of trade flows that build strictly
on Ricardo’s insights. A few appeared in the 1950s and ’60s (McDougall, 1951,
1952; Stern, 1962), but it quickly became apparent that such models are of limited
use in employing data to analyze the overall structure of foreign trade. The main
difficulty is that Ricardo’s theory is mute on a key ingredient: what causes labor
productivity to differ across countries?’ Differences in the use of capital comprise
an important source of variation in labor productivity. Capital-rich countries are
able to allocate more capital per worker to all economic activities than capital-poor
countries, but they may do so to a different degree in various lines of business. This
raises the question: what determines the allocation of capital to industries and
thereby labor productivity? But once the role of capital is taken seriously, it may be
best to abandon the exclusive focus on labor productivity and think about what
determines trade flows amongst countries that have additional inputs besides labor.
Eli Heckscher (1919) and Bertil Ohlin (1924) provided a framework for
thinking about trade in this situation. They emphasized the roles of labor, capital
and land in agriculture and industry, trying to explain how their availability shapes
a country’s pattern of specialization and trade. Paul Samuelson and his followers
elaborated a two-factor two-sector version that became the cornerstone of modern
trade theory (Samuelson, 1948; Jones, 1956-57, 1965). Samuelson’s version is crisp
and elegant. By focusing on labor and capital as inputs and on export- and
import-competing sectors, it cuts to the heart of the matter. The model was widely
adopted as the workhorse of the profession. According to the two-factor, two-sector
version of the Heckscher-Ohlin theory, a country should export the product that is
relatively intensive in using the factor with which the country is relatively well-
endowed. Thinking about labor and capital as the two inputs, it means that a
capital-rich country-a country that has more capital per worker than its trade
partners-should export the capital-intensive product.
The argument can be made in two parts. First, if factor prices are not equal-
ized, then the rental rate on capital relative to the wage rate is lower in the
capital-rich country.2 As a result, it uses in all product lines more capital per worker
than the capital-poor country. But, as shown by Lerner (1952), under these
circumstances the capital-rich country has a cost advantage in the capital-intensive
products, which it ends up exporting. This implies that its exports are more
capital-intensive than its imports. That is, if we were to calculate how much capital
and labor are embodied in the country’s exports and how much capital and labor
are embodied in its imports, we should find that for the capital-rich country the
1 Eaton and Kortum (1997) provide the first study of a Ricardian model that contains an explanation of
labor productivity based on a country’s technology level. Using extreme value distributions for labor
productivity they derive an equation for bilateral trade flows. They estimate this equiation for a sample
of OECD countries, using cumulative investment in R&D and the number of scientists and engineers as
proxies for technology levels. The fit appears to be good.
2 Capital accumulation in conjunction with international (financial) capital mobility tend to reduce
divergent rental rates on capital. Nevertheless, differences can persist for long periods of time.
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124 Journal of Economic Perspectives
ratio of capital to labor is larger in exports than in imports. Second, if factor prices
are equalized, then the capital-rich and capital-poor countries use the same ratios
of capital to labor to produce identical products. But because the capital-rich
country has a disproportionately large amount of capital relative to labor, it ends up
producing a disproportionately large amount of capital-intensive products. Other-
wise it cannot maintain full employment of labor and capital. It then follows that
with a similar composition of demand (that results, for example, from identical
homothetic preferences in all countries), the capital-rich country exports capital-
intensive products in this case too. So we find again that in the capital-rich country
the ratio of capital to labor embodied in exports is larger than the ratio of capital
to labor embodied in imports.
There are two concepts of trade in this theory: trade in goods and trade in
factor content. Trade in goods is standard; wheat and airplanes are goods, and they
can be imported or exported. Trade in factor content is different. It refers to the
inputs that are embodied in exports or imports. For example, if a unit of imported
wheat is produced with half a unit of land, three units of labor and five units of
water, then the factor content of the imported wheat is half a unit of land, three
units of labor and five units of water. Using this approach one can calculate the
factor content of exports, the factor content of imports, and the factor content of
net exports, which is the difference between the two.
Leontief (1954) put the prediction that a capital-rich country should export
capital-intensive products to a test. He calculated labor-output and capital-output
ratios for various sectors of the U.S. economy, and then-with the aid of these
coefficients- calculated how much labor and capital are embodied in exports and
how much in imports. Surprisingly, Leontief found that in 1947 the capital-labor
ratio embodied in imports exceeded the ratio embodied in exports by 60 percent!
The surprise emanated from the fact that after the war, the United States was
considered to be the most capital-rich country in the world and the Heckscher-
Ohlin theory predicts for such a country a higher capital intensity of exports than
imports. His finding became known as the “Leontief paradox.”
There were attempts to examine additional data sets, but while the paradox is
less pronounced in later data sets, it does not disappear. Leontief proposed his own
resolution for the paradox. He had used the assumption that the U.S. input-output
coefficients also apply to imports, which is the case when foreign suppliers use the
same techniques of production as domestic producers. When countries have access
to the same technologies and factor prices are equalized, this assumption is
justified. But, pointed out Leontief, if a U.S. worker is much more productive than
a foreign worker, then the U.S. should export relatively labor-intensive products.
Why would, however, U.S. workers be so much more productive, especially after
controlling for capital availability? This explanation seems to resolve one paradox
by introducing another.
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The Structure of Foreign Trade 125
Further Developments: 1960s, 1970s and 1980s
The two-factor two-sector version of the Heckscher-Ohlin theory was extended
in the 1960s and ’70s; Ethier (1984) offers a review of the literature at this time.
These studies had a variety of purposes, but what is central for this paper is the fact
that from these studies grew a surprisingly simple theoretical specification, in which
two types of relationships could provide the underpinning for an analysis of the
generalized Heckscher-Ohlin theory.
The first set of relationships involves production. Let ai, represent the quantity
of input i used in the manufacturing of one unit of output j. I ignore intermediate
inputs. Therefore these coefficients describe primary inputs only, which would
include various types of capital, such as machines and structures; various types of
labor, such as high school dropouts and college graduates; and various types of
land, such as pasture and arable land. Cost-minimizing manufacturers choose these
coefficients from the available technology, taking factor prices as given. As a result,
these coefficients depend in a particular country on its technology and factor
rewards. In the simplest version of this model, the technology is taken to be the
same everywhere and factor prices are assumed to be equalized across countries.3
In this case, the same coefficients are used in all countries. Then, if an economy
fully employs its resources, we can derive a factor-market clearing condition. (If a
resource is not fully employed, replace its quantity with the actually employed
value.) Let Vk represent the quantity of input i in country k. Similarly, let Xk
represent the output of good j in country k. Then full employment of resources
implies
E ai,X>= Vt
for all inputs i and all countries k.
The second set of relationships comes from consumption. Preferences are
assumed to be the same in all countries and homothetic; that is, a ray drawn from
the origin of an indifference map will intersect all indifference surfaces at points
with the same slopes. These assumptions are strong ones. They imply that the
composition of consumption (the share of spending going to a product) is the
same everywhere. Namely, if we denote by sk the share of country k in consumption,
then consumption of good j in country k is given by
C = skXj
3Factor prices are not the same in all countries, not even in the OECD countries. But as O’Rourke and
Williamson (1999) demonstrate, trade and migration are powerful forces that lead to convergence of
factor prices. See Williamson (1998) for a review.
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126 Journal of Economic Perspectives
for all goods j and all countries k, where X1 = k Xj is aggregate world output of
good j. When trade is balanced, the share Sk equals country k’s share in world
income.
These two sets of fundamental relationships imply empirical specifications.
Each country’s production of any good is determined by its primary factor endow-
ments, while each country’s consumption of goods is determined by overall spend-
ing.4 Exports will be those products where the country produces more than it
consumes, and imports will be those products where the country produces less than
it consumes. The model allows countries to run trade deficits or surpluses. The
model implies a linear set of relationships between net exports and factor endow-
ments. Each relationship, for petroleum products, forest products, machinery or
chemical products, can be estimated from cross-country data. We do not need data
on production coefficients or technology, because these are assumed to be the
same in all countries. We do need data on net exports, which are readily available,
and data on factor endowments, which are not readily available-at least not in
comparable form.
Ed Leamer has done more than anybody else to promote a research agenda
centered on the construction of such data sets. For example, Leamer (1984) started
a new line of empirical research by estimating this linear relationship using a newly
constructed data set. The simple linear specification performs very well in explain-
ing actual patterns of trade on a cross section of 60 countries in his data set, for
both 1958 and 1975. Examples of the type of effects that were estimated include the
availability of oil raising net exports of petroleum products, but also reducing net
exports of machinery in 1975; and the abundance of literate, non-professional
workers raising exports of labor-intensive manufactures, such as apparel and foot-
wear. Leamer’s estimation maintains the assumption of linearity, which works well
for most sectors. In some sectors, however, such as chemicals, the data favor a
non-linear specification.
While estimates of this type are interesting, they do not provide a test of the
generalized Heckscher-Ohlin theory. The reason is that the theory predicts a
relationship between endowments and trade mediated by technology. To test it
therefore requires independent information about all three objects: technology,
endowments, trade.
Two concepts of trade have surfaced so far: trade in goods and trade in factor
content. The former is a natural focus of trade theory, and was examined by
Leamer. The latter was examined by Leontief. Leontief’s procedure can be gener-
alized by constructing measures of the factor content of net exports, as suggested
by Vanek (1968). With identical technology coefficients in all countries, this
procedure is straightforward. Just convert net exports of goods into the factor
content of net exports, by multiplying the quantity of net exports of each good with
4Uniqueness of the production structure requires additional assumptions, such as the equality of the
number of inputs and outputs.
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Elhanan Helpman 127
the input coefficient aij and summing over all goods, using the common technology
matrix. What Vanek has shown, is that under the model’s assumptions this measure
of factor content should equal the economy’s measure of factor abundance. The latter
is constructed as follows. Begin with the total factor content of production, which
equals the economy’s factor endowment, and then subtract out the factor content
that goes into domestic consumption, where consumption of each input is propor-
tional to the country’s share of world spending. The result will be a measure of
factor abundance. On net, inputs that are relatively abundant are exported while
those that are relatively scarce are imported. Vanek’s key equation is
, = V- S Vi
for all inputs i and all countries k, where FP is the factor content of net exports of
input i in country k and Vi = SkVi is the aggregate endowment of input i in the
world economy.
Vanek’s (1968) equation was used by Leamer (1980) to point out a shortcom-
ing of Leontief’s procedure: whenever there are more than two inputs, that is, more
than just labor and capital, a comparison of the ratio of the embodied quantities of
just two of them in imports and exports does not provide the relevant metric for
rejecting the theory. This may sound like a possible neat resolution of the Leontief
paradox. It is not. As pointed out by Brecher and Chaudhri (1982), the fact that the
United States was a net exporter of labor services has an implication for consump-
tion per worker; that is, U.S. consumption per worker should fall short of world
consumption per worker, which is not born out by the data.
Bowen, Leamer and Sveikauskas (1987), who were the first to use independent
information about endowments, technology and trade, performed two types of tests
on Vanek’s (1968) key equation. They used the U.S. technology matrix to calculate
the factor content of net exports F k for all countries. Their tests involved compar-
ing these measures of factor content with the measures of factor abundance
i- s’Vi. They were done with data for 12 inputs and 27 countries (for 1967).
One test compared the signs of the two calculations-that is, whether a factor that
was predicted to be exported by the factor abundance measure was also exported
by the factor content measure (and similarly for imports)-and found disagree-
ment one-third of the time. Another test compared the rank order of the inputs in
the calculated measures of the factor content of net exports with the measures of
factor abundance and found disagreement about half the time. This appears to be
bad news for the expanded Heckscher-Ohlin theory. But how bad the news is is
hard to gauge, because in this exercise the theory is not tested against a well-
specified alternative. For this reason it is also possible to take a more positive
attitude and to argue that the theory explains a reasonably large fraction of the
variation-across factors and countries- of the factor content of net trade flows.
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128 Journal of Economic Perspectives
Recent Advances
Although Bowen, Leamer and Sveikauskas (1987) pointed out difficulties with
the Vanek equation, they did not investigate whether the data deviate systematically
from the theoretical predictions. This important task was undertaken by Trefler
(1995). He compiled a new data set, for 33 countries, that disaggregates endow-
ments into nine inputs. The countries in the sample accounted for three-quarters
of world exports and nearly 80 percent of world income in 1983. Again, Trefler first
calculated the factor content of net exports, using the U.S. technology matrix for
all countries, and then compared them to the factor abundance measures. Vanek’s
(1968) theoretical prediction is that the two measures should have a correlation
of 1. Trefler found instead a correlation of .28.5 A sign test of the Bowen, Leamer
and Sveikauskas (1987) type was successful in only about one-half of the cases. It
therefore appears that Trefler’s data fits the expanded Heckscher-Ohlin theory as
well or as badly as Bowen, Leamer and Sveikauskas’s data does.
Trefler (1995) showed clearly in what ways these data deviate from the theo-
retical predictions. First, the measures of the factor content of net exports are
compressed towards zero relative to the factor abundance measures. That is, even
in cases in which both variables have the same sign, the former is much smaller in
absolute value than the latter. This compression is striking. It is not unusual in these
data for the absolute value of the factor abundance measure to be 10 to 50 times
higher than the absolute value of the factor content of trade, as one can see in
Figure 2, which presents these measures for capital (every point represents a
country). Second, whenever a poor country exports an input on net, it exports less
than predicted by its factor abundance measure. And whenever it imports an input
on net, it imports more than predicted by its factor abundance measure. For rich
countries the opposite is true. If one takes the factor content measure of net
exports derived from trade flows and then subtracts from it the factor abundance
measure, derived by subtracting the factor content of domestic consumption from
the domestic factor endowment, that difference has a correlation of .87 with per
capita GDP. Third, poor countries tend to be abundant in more factors than rich
countries, in the sense that they have more inputs for which the domestic endow-
ment exceeds the quantity of the factor embodied in domestic consumption.
Indeed, the correlation between the factor abundance measure and per capita GDP
is -.89.6
5 All the reported calculations use normalized data, which is obtained from the original data by dividing
every input by the standard deviation across countries of the difference
PI _ ( Vk _ S k V)
and by the measure of country size (Sk) 1/2. Here relative country size is measured by its share in
aggregate GDP.
b3 These results cannot be explained by trade imbalances, which are much too small for this purpose.
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The Structure of Foreign Trade 129
Figure 2
Factor Abundance and Factor Content Measures: Capital data
0.05
0 0
-0.6 -0.4 . *-0.2 0 * .0.2 . 0.4 0.6 * 0.8
-0.05
u -0.1
-0.15
-0.2J
Factor abundance
Source: Trefler (1995). Every observation has been divided by the quantity of the input in the
country.
This characterization is of lasting value. It gives us a better understanding of
the ways in which the data do not match the theory. It provides a clear theoretical
challenge: How should the model be modified to better fit the data?
Trefler also followed up on the earlier suggestion of Leontief that perhaps
these differences could be explained by differences in productivity across inputs
and countries. Suppose, as suggested by Leontief, that inputs are not equally
productive in all countries. If U.S. labor is, for example, two times as productive as
labor in Italy, then 1000 hours of U.S. labor services are equivalent to 2000 hours
of labor services in Italy. Taking one country as the benchmark, we can then
convert the endowment of all other countries into equivalent units of the bench-
mark country. It is then possible to use Trefler’s data to calculate what the
productivity differences would have to be between countries so that a modified
Vanek equation would hold exactly.7 Using this approach, Trefler (1993) first
calculated labor and capital productivity coefficients for a set of countries relative
to the United States, and he then compared them with the wage rate and the return
to capital in these countries relative to the United States. According to the theory,
7Taking one country as the benchmark, we can convert the endowment Vk of country k into T,V
equivalent units of the benchmark country, where irk is the productivity of input i in country k relative
to the same input in the benchmark country. Under these circumstances Vanek’s equation in the text
becomes
F=v kVj – Sk E TX
for all k and i, where the factor content of net exports F is calculated using the benchmark country’s
technology.
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130 Journal of Economic Perspectives
if there is factor price equalization, then in a cross-country comparison the relative
rewards should equal the relative productivity parameters. Indeed, Trefler found
the relative factor rewards to be highly correlated with the calculated relative
productivity parameters.
In a later paper, Trefler (1995) took several alternative approaches to estimat-
ing productivity parameters. In one approach, he assumed that the productivity
parameters are country-specific but not factor-specific; that is, if U.S. labor is two
times as productive as Italian labor, so is U.S. capital and land. Thus, each country’s
productivity is represented by a common productivity advantage in all lines of
business, and this advantage can be thought of as a Hicks-neutral technical differ-
ence. Trefler’s second observation-namely, that poor countries appear to export
too little of their abundant factors while rich countries export too much-suggests
that Hicks-neutral productivity differences can help explain these data. Trefler’s
second approach was to divide countries into two sets, developed and developing,
so that the factor-specific productivity parameters are the same in each group of
countries, but differ across the two groups. Of these two choices, Trefler concluded
that the Hicks-neutral specification performs better.8
To better account for the “missing trade”-that is, the finding that the factor
content of net exports as measured from trade statistics is so much smaller than the
difference between total factor endowments and factors that are embodied in
domestic consumption-Trefler also introduced a home bias in demand. He found
that this bias, together with the Hicks-neutral productivity differences, provides the
best explanation of the data. I find the use of a home bias in demand unappealing.
There is plenty of independent evidence that technologies differ across countries
(for example, Harrigan, 1997). There is no such evidence for demand patterns,
except for biases that are related to income levels.
Trefler uncovered patterns in the gaps between the Heckscher-Ohlin theory
and the actual data on factor content and factor abundance. Apparently, techno-
logical differences between countries help to explain these gaps. The work by Davis,
Weinstein, Bradford and Shimpo (1997) supports this emphasis. These authors set
out to evaluate the two fundamental relationships discussed earlier in this paper:
the production relationship in which sectoral output levels are used to calculate
aggregate demands for inputs which are then required to equal factor endowments;
and the consumption relationship that consumption vectors in different countries
are proportional to each other.
They evaluated the production relationship in a cross-section of countries and
a cross-section of Japanese regions, using Japan’s technology matrix in all cases.
They used output data to calculate the demand for inputs. According to the theory,
this vector of input demands should match the vector of factor endowments. To
examine how close these two vectors are to each other they performed on them
rank order tests of the type introduced by Bowen, Leamer and Sveikauskas (1987).
8 Bowen, Leamer and Sveikauskas (1987) also examined productivity differences. Unfortunately, due to
a programming error their results are not correct.
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Elhanan Helpman 131
They found that the match is not good in the international data, but is remarkably
accurate in theJapanese regions. One plausible interpretation of this finding is that
techniques of production are very similar across Japanese regions but differ signif-
icantly across countries. The failure of the common technology model to work in
the international data can emanate either from lack of factor price equalization
(which we know to be true from data on wages) or from differences in technolog-
ical opportunities (which we also know to be the case). At the moment there are no
estimates of how much of the failure is attributable to each of these potential
causes.9
In looking at the consumption relationship, Davis, Weinstein, Bradford and
Shimpo (1997) considered how accurately the structure of consumption can be
captured by a model which posits that the share of consumption going to different
goods is the same in all areas. In one exercise, they tested whether regional
“absorption” (consumption plus investment) vectors in Japan are proportional to
the aggregate Japanese absorption vector, concluding that they are. Next they
tested whether the Japanese absorption vectors are proportional to world produc-
tion, concluding that they are.
Since both the fundamental production and consumption relationships seem
to hold well for the regions of Japan, Davis, Weinstein, Bradford and Shimpo
(1997) went on to test a Vanek-st
