1OVERVIEWIn the past (up to roughly the 1970s), trade theory hasbeen focused on applications, modiÞcations, or extensionsof standard (Ricardian, HOS and speciÞc factors) mod-els, where trade is based on differences between countries.However, empirical work, while consistent with Ricar-dian model, repeatedly rejects the predictions of the HOSmodel. Data also indicates that a substantial amountof trade occurs between similar developed coun tries andwithin the same product categories (intraindustry trade),instead of between very different countries and acrosspro duct categories (interindustry trade). Du e to the exis-tence of a large proportion of unexplainable trade, manytrade theorists abandoned the old theories and turned toconstructing new theories capable of explaining the yetunexplained. Also, old theories say trade conßicts shouldbreak out when countries try to restrict trade (by us-ing tariffs or quotas), but trade disputes commonly occurbetween countries subsidizing exports. Finally, a thirdof international trade occurs through multinational Þrms(foreign direct investment), with the bulk of FDI also oc-curring between similar countries. FDI is growing fasterthan international trade, which is growing faster thanworld output. Conßict between theory and reality dic-tated a need for some new international trade theories.COMPARATIVE ADVANTAGEMost standard trade models are based on the notion ofcomparative advantage. Suppose two countries producetwo goods and have different autarkic relative prices. Theautarkic relative price in each country equals the marginalrate of substitution (MRS), which equals the marginalrate of transformation (MRT). Since the two countriesOVERVIEW 1hav e different autarky prices, they have differen t MRSand MRT from each other. An opportunity for gains fromtrade exists: trade equalizes MRS and MRT across coun-tries. Accordingly, the greatest gains from trade arisefrom the greatest differences between countries. Sincetrade permits countries to concentrate in producing whatthey do well, imports should be quite different from ex-ports in composition. In the Ricardian model, differencesin technology (unit labor requirements, with labor as theonly factor) provide the source of CA.HECKSCHER-OHLIN-SAMUELSON THEORYIn the HOS theory, differences in factor endowments pro-vide the source of comparative advantage. Two countries(home and *foreign) produce two goods ( apples A andbearings B) usin g two factors (capital K and labor L).The two countries differ only in their endowments of thesetwo factors, and these factors are not able to move acrossborders. The assumption that both factors are interna-tionally immobile is common to most models of interna-tional trade: goods need to move across borders becausefactors cannot. While factors can indeed often cross bor-ders in reality, goods can cross most borders more easilythan factors in most cases.Suppose the home country is capital abundant rela-tive to the foreign country: K/L > K∗/L∗. Thereforehome country has higher wage to rental ratio: w/r >w∗/r∗. Suppose bearing production is capital intensive,uses more capital per unit of labor than apple produc-tion. The home country has comparative advantage in thecapital-intensive go od (bearings). The price of a bearingin terms of an apple in autarky (absence of internationaltrade) will be lower at home than abroad. Internationaltrade causes the home country to shift resources out ofproducing apples into producing bearings. The relativeprice of apples in terms of bearings and wage to rentalratio falls in home country and rises in the foreign coun-try in the move from autarky to free trade.As long as home still produces both goods, the wage2 OVERVIEWfalls and rental rate rises relative to both goods prices.This general result, called the Stolp er-Samuelson theo-rem, states that international trade lowers the r eal re-ward of the relatively scarce factor and raises the realreward of the relatively abu ndant factor. Due to this re-distribution of income across owners of different factors,a country openinguptotradeshouldresultinconßictsbetween groups associated with different factors within acountry. These groups are deÞned by s ource of income,not sector where employed, since they can move betweensectors within a country.Also, factor prices will become equalized across coun-tries if factor endowments are not too different. This re-sult, aptly called the factor price equalization theorem,implies that with equal factor prices, no incentive re-mains for factors to ßow between countries (if they could).Thus, countries with similar factor endowments shouldhave identical factor prices and no observed factor ßowsbetween them. Due to the equalization of factor prices,trade in goods and trade in factors are substitutes: noadditional gains from trade in factors occur if free trade ingoo ds already, also no additional gains to trade in goodso ccur if free trade in factors already.If home acquires more capital, additional capital mustbe absorbed by expansion in the capital-intensive sector.Expansion of the capital-intensive sector draws labor outof the labor-intensive sector. Thus, factor endowmentchanges cause ampliÞed changes in production: outputof the capital-intensive good rises more than proportion-ately to an increase in capital, while output of the labor-intensive good falls, the Rybczynski theorem. Grow thbiased towards exports should deteriorate terms of trade(TOT).The overall HOS result is that a country exports thegood that relatively intensively uses its relatively abundantfactor. We can also predict trade pattern based on autar-kic relative prices - a country exports the good where itsautarkic relative price is lower that the foreign country’sautarkic relative price; however, autarkic prices are rarelyobserved so that version is not very useful in practice.OVERVIEW 3REALITY CHECKThe implications of these standard theories do not per-form well at describing the world. The Leontieff paradoxprov ides evidence that U.S. exports are less capital inten-sive than imports, the wrong content for a capital abun-dant country such as the U.S. Reducing trade barriers inWestern Europe f ailed to lead to greater specialization.Most world trade is intraindustry trade between similarcountries, not interindustry between dissimilar countries.Foreign direct investment is becoming increasingly two-way and occurs principally between similar countries. Ex-port