1. Shortcomings of the Heckscher-Ohlin model

• Predictions of the model may not match data
  • Factor price equalization
  • Leontief Paradox
• Assumptions are unrealistic
• No explanation for intra-industry trade

2. Increasing returns to scale

• Average cost decreases as firm produces more output
• Contrast with assumption in traditional theories of trade:
  • Ricardian model
  • Heckscher-Ohlin model

3. Imperfect competition

• Small number of firms in an industry
• Firms produce differentiated products
• Possible strategic interaction between firms
  • Example: Duopoly (Kodak and Fuji)

• Decreasing average cost
  • As output rises, firm's average cost declines
  • Same as IRTS
• Many firms producing a slightly differentiated good
  • Several varieties
  • Consumers prefer variety
  • Example: Several makes of cars

4. International trade

• Provides a larger market for firms
• Leads to lower costs of production (Why?)
• More varieties of goods are produced
• Explanation for intra-industry trade:
  
  • Country A will specialize in certain varieties
  • Country B will specialize in the other varieties
    

5. Pattern of trade

• Comparative advantage on the basis of:
  • Differences in labor productivity (Ricardian model)
  • Differences in factor endowments (H-O model)

• Which country produces what varieties?
• Historical accident!!

6. External economies of scale

• Cost per unit decreases with size of industry (not necessarily the size of a firm):
  • Individual firm's AC depends on the industry output
• In such an industry, you have many firms in perfect competition
  • Financial firms clustered on Wall Street; computer firms in Silicon Valley
• Why do clusters form?
  • Input Sharing: Specialized suppliers move to where the big firms are.
  • Labor Pooling: Skilled workers move to where the jobs are.
  • Knowledge Spillovers: Ideas trade faster when everyone is in the same "hub."

• Determined by historical accident
• May run counter to comparative advantage:
  • The low-cost producer may not be the one producing the good

• Restrict imports --> allow domestic industry to reduce average cost --> enable them eventually to compete in the world market
  
• Does this justify protectionism?

7. Dynamic Increasing Returns

• Economies of scale from accumulation of knowledge ("from eternity to here")
• Learning curve
  • Unit cost declines with cumulative output (over time)
• Pioneer versus follower
  • Country with experience (pioneer)
  • The pioneer may continue to produce the good despite having higher costs than that of a follower