Statement (I) : Trade between two countries takes place on account of differences in costs. Statement (II) : Different countries have different factor endowments.

Correct — A, (a) Both Statement (I) and Statement (II) are individually true and Statement (II) is the correct explanation of Statement (I).

This is the third of the paper's four assertion-reason items. Its Directions block and its four codes are printed once, at the head of the column over question 117, and govern this item too; a reader who has only the two statements in front of them is missing half of what the page printed.

STATEMENT (I) IS TRUE, and it is the founding proposition of the theory of international trade. Countries trade because the same good costs different amounts to produce in different places, so each can obtain some goods more cheaply by buying than by making. Two classical formulations refine it: ADAM SMITH'S ABSOLUTE ADVANTAGE — a country should specialise in what it can produce with fewer resources than anyone else, and exchange for the rest. DAVID RICARDO'S COMPARATIVE ADVANTAGE, set out in 1817, which is the stronger and more general result — a country gains by specialising in the good in which its OPPORTUNITY COST is lower, and it can gain from trade even if it is absolutely less efficient at producing everything. What matters is not whether costs differ absolutely but whether the RATIOS of costs differ; if two countries have identical cost ratios there is no basis for trade even if one is uniformly more productive.

STATEMENT (II) IS TRUE as a plain observation about the world. Countries are endowed very differently with the factors of production. Some have abundant land, some abundant labour, some abundant capital, some particular mineral or energy resources, some a large stock of skilled and educated workers. India is labour-abundant relative to its capital; the Gulf states are endowed with hydrocarbons; Australia and Canada have land and minerals in relation to their populations.

AND STATEMENT (II) IS THE EXPLANATION OF STATEMENT (I) — which is what separates code (a) from code (b) and is the substance of the item. Statement (I) says costs differ. Statement (II) says WHY they differ, and the chain of reasoning is short and complete:

a factor that is relatively ABUNDANT in a country is relatively CHEAP there, because supply relative to demand is greater — abundant labour means low wages, abundant capital means a low rate of return; goods differ in the proportions in which they use the factors, some being labour-intensive and others capital-intensive; so a good that uses a country's abundant factor intensively is relatively CHEAP to produce there; therefore relative costs differ between countries, and each has a comparative advantage in the goods that use its abundant factor intensively; and that difference in relative costs is exactly what makes trade profitable.

This is the HECKSCHER-OHLIN THEORY, also called the factor endowment or factor proportions theory, developed by the Swedish economists Eli Heckscher in 1919 and Bertil Ohlin in 1933. Ohlin shared the Nobel Memorial Prize in Economic Sciences in 1977. Its whole purpose was to answer the question Ricardo left open: Ricardo showed that differences in comparative cost cause trade, but treated those differences as given; Heckscher and Ohlin explained where the differences come from. So the relationship between the two statements in this item is precisely the relationship between the two theories, and it is causal, not merely companionable.

THE PREDICTION IT YIELDS, which confirms that the link is genuine and not verbal. A labour-abundant country should export labour-intensive goods and import capital-intensive ones. India's export basket — textiles and garments, leather goods, gems and jewellery, and labour-intensive manufactures — fits that prediction, as does the direction of its imports of capital equipment.

In the printed booklet both statement labels are set in italics with the roman numeral in brackets, each with a space before its colon, and each item prints its two statements as separate paragraphs, as this booklet sets them.

Why the others are wrong

• (b)Both Statement (I) and Statement (II) are individually true but Statement (II) is not the correct explanation of Statement (I) — The first half of this code is right and the second half is wrong, which makes it the natural error for a candidate applying a good habit too rigidly. Because examiners so often pair two true but unrelated statements, a cautious candidate learns to distrust code (a) — and here that caution costs the mark, because the link is genuinely explanatory. Differences in factor endowment are not merely another true fact about countries that happen to trade; they are the accepted account of WHY production costs differ between countries, and the whole of the Heckscher-Ohlin theory exists to make that derivation. Abundant factors are cheap, goods use factors in different proportions, so goods using a country's abundant factor are cheap there, so relative costs differ. Every step follows from the one before. The lesson is that the explanatory test must actually be applied rather than answered by a rule of thumb: state the reason for Statement (I) in your own words, and if Statement (II) turns out to be that reason, choose (a) without hesitation.
• (c)Statement (I) is true but Statement (II) is false — This code requires the second statement to be false, and it is among the least controversial statements in economics. Countries plainly do differ in their endowments of land, labour, capital, natural resources and skills, and those differences are visible without any theory: a densely populated country with a young workforce is labour-abundant, a country with large proven hydrocarbon reserves is resource-abundant, a mature industrial economy with deep financial markets is capital-abundant. The proposition is descriptive rather than theoretical, which is why no economic school disputes it. What IS disputed within economics is how completely factor endowments explain observed trade patterns — Wassily Leontief's finding in 1953 that United States exports appeared more labour-intensive than its import substitutes, the so-called Leontief Paradox, is the standard challenge, and later theories added economies of scale, product differentiation and technology gaps to the account. But a challenge to the sufficiency of an explanation is not a denial that endowments differ, and this code asks the candidate to deny the observation itself.
• (d)Statement (I) is false but Statement (II) is true — This code requires the first statement to be false, and it is the central proposition of the entire theory of international trade — that trade arises from differences in the cost of producing goods in different places. Denying it would leave no reason for countries to trade at all. The one refinement worth making, and it is a refinement rather than a contradiction, is that in the Ricardian analysis it is differences in COMPARATIVE cost, that is in the ratios of costs, rather than differences in absolute cost, that create the basis for exchange: a country absolutely less efficient at producing everything still gains by specialising where its disadvantage is smallest, and two countries with identical cost ratios have nothing to gain from trade even if one is uniformly more productive. Statement (I) as printed says only that trade takes place on account of differences in costs, which is true at the level at which the item is set, and it is the statement that the second one goes on to explain.

WHY COUNTRIES TRADE is the question this item asks, and the answers form a short historical sequence that is worth holding in order.

THE MERCANTILIST VIEW, before the classical economists, treated trade as a means of accumulating bullion, with exports good and imports bad. It saw trade as zero-sum: one country's gain was another's loss.

ADAM SMITH'S ABSOLUTE ADVANTAGE, 1776, replaced that with a positive-sum account. If each country specialises in what it produces most efficiently and exchanges for the rest, total output rises and both gain. The weakness is that it seems to leave nothing for a country that is less efficient at everything.

DAVID RICARDO'S COMPARATIVE ADVANTAGE, 1817, removed that weakness and remains the core of the subject. A country should specialise where its OPPORTUNITY COST is lowest — where producing one good costs it least in terms of the other good forgone. Even a country absolutely less efficient at everything has a comparative advantage in something, because it cannot be relatively worse at everything simultaneously. The condition for trade is that the RATIOS of costs differ between the countries; identical ratios mean no gains from trade.

THE HECKSCHER-OHLIN THEORY, or factor endowment theory, from Eli Heckscher in 1919 and Bertil Ohlin in 1933, then explained where Ricardo's cost differences come from. Its argument: countries differ in their relative endowments of factors of production; an abundant factor is a cheap factor; goods differ in factor intensity, some being labour-intensive and others capital-intensive; therefore a good using a country's abundant factor intensively is relatively cheap to produce there; therefore each country exports the good that uses its abundant factor intensively and imports the other. Its usual assumptions are two countries, two goods and two factors, identical technology and tastes across countries, perfect competition, factors mobile within a country but not between countries, and constant returns to scale. Ohlin shared the Nobel Memorial Prize in Economic Sciences in 1977.

TWO THEOREMS THAT FOLLOW FROM IT. The FACTOR-PRICE EQUALISATION theorem, associated with Paul Samuelson, holds that free trade in goods tends to equalise factor prices across countries even without factor movement, since trade in goods substitutes for trade in the factors embodied in them. The STOLPER-SAMUELSON theorem holds that a rise in the relative price of a good raises the real return to the factor used intensively in producing it and lowers the return to the other — which is why trade liberalisation has distributional consequences within a country and not only aggregate ones.

THE LEONTIEF PARADOX, 1953. Wassily Leontief found that United States exports were less capital-intensive than the goods the United States imported, the opposite of what the theory predicted for the world's most capital-abundant economy. The finding provoked a large literature and refinements involving human capital, natural resources and differences in technology.

LATER EXPLANATIONS OF TRADE, which supplement rather than replace the classical ones. The TECHNOLOGY GAP and PRODUCT CYCLE accounts, associated with Posner and Vernon, explain trade in newly innovated goods. The NEW TRADE THEORY, associated with Paul Krugman, explains why similar countries trade similar goods with one another — INTRA-INDUSTRY trade — through economies of scale and consumers' taste for variety, which factor endowments cannot account for.

THE INDIAN APPLICATION. India is labour-abundant relative to capital, and its comparative advantage has historically lain in labour-intensive manufactures — textiles and garments, leather, gems and jewellery — and, more recently, in services that use its large stock of educated English-speaking workers, most visibly software and business services.

Key facts

• Trade between countries arises from differences in the cost of producing goods, and specifically from differences in comparative or relative costs.
• Adam Smith's theory of absolute advantage holds that a country should specialise in what it produces most efficiently.
• David Ricardo's theory of comparative advantage, 1817, holds that a country gains by specialising where its opportunity cost is lowest, even if it is absolutely less efficient at everything.
• If two countries have identical cost ratios there is no basis for trade, however different their absolute efficiencies.
• The Heckscher-Ohlin or factor endowment theory explains why comparative costs differ: countries have different factor endowments.
• An abundant factor is a relatively cheap factor, and a good using a country's abundant factor intensively is relatively cheap to produce there.
• The theory was developed by Eli Heckscher in 1919 and Bertil Ohlin in 1933; Ohlin shared the Nobel Memorial Prize in Economic Sciences in 1977.
• The factor-price equalisation theorem holds that free trade in goods tends to equalise factor prices across countries.
• The Stolper-Samuelson theorem holds that a rise in a good's relative price raises the real return to the factor used intensively in it.
• The Leontief Paradox, 1953, found United States exports to be less capital-intensive than its imports, contrary to the theory's prediction.
• New trade theory explains intra-industry trade between similar countries through economies of scale and product variety, which factor endowments cannot explain.

Common traps

• Rejecting code (a) as a matter of policy because examiners often pair unrelated true statements. The explanatory test must be applied to each item on its merits.
• Learning Ricardo and Heckscher-Ohlin as competing theories. They are successive links in one argument: one establishes that cost differences cause trade, the other explains the cost differences.
• Believing a country absolutely less efficient at everything cannot gain from trade. Comparative advantage says otherwise.
• Confusing absolute with comparative cost differences. It is the ratios that matter, and identical ratios mean no trade.
• Confusing a free trade area with a customs union. A free trade area removes internal barriers; a customs union adds a common external tariff.
• Assuming factor endowments explain all trade. They do not explain intra-industry trade between similar economies, which is what new trade theory addresses.

• practice — not a real PYQ

  The Heckscher-Ohlin theory of international trade explains the pattern of trade primarily in terms of

  • (a)differences in technology between countries
  • (b)differences in the relative endowments of factors of production
  • (c)economies of scale in production
  • (d)differences in consumer tastes between countries

  Answer(b) differences in the relative endowments of factors of production — a country exports the good that uses intensively the factor with which it is relatively abundantly endowed, because an abundant factor is a cheap one. The theory in fact assumes identical technology and identical tastes across countries, and economies of scale belong to the later new trade theory.

• practice — not a real PYQ

  According to the principle of comparative advantage, a country that is absolutely less efficient than another in producing every good

  • (a)cannot gain from international trade
  • (b)can gain by specialising in the good in which its disadvantage is least
  • (c)should impose tariffs on all imports
  • (d)must first achieve absolute advantage in at least one good

  Answer(b) can gain by specialising in the good in which its disadvantage is least — what makes trade profitable is a difference in the ratios of costs, not in their absolute levels, so a uniformly less efficient country still has a comparative advantage somewhere and both parties gain from specialisation and exchange.