Do Factor Endowments Matter for North-North Trade?

The central paradigm of world trade patterns divides this into two elements. Trade between North and South is viewed as determined by traditional comparative advantage, largely determined by differences in endowment patterns. Trade within the North is viewed as determined by specialization due to economies of scale and product differentiation. In this paper, we will argue that this division is seriously misleading about the nature of North-North trade. We will say that endowments matter for North-North trade if two conditions are met: (1) Patterns of net factor trade are systematically related to endowment differences; and (2) The magnitudes are economically large. Our empirical work confirms that both of these conditions are met. Using actual technology matrices, we show that true net factor service trade of wealthy countries is typically not zero but 10-12 percent of national endowments, and between 38 and 49 percent of their endowments devoted to tradables. Moreover, while an assumption of FPE forced empirical researchers to assume intra-industry trade carries no net factor content, we demonstrate that for half of the countries in our sample intra-industry trade is actually a more important conduit for net factor service trade than inter-industry trade. Finally, we show that contrary to the conventional wisdom, endowments are an important determinant of bilateral trade even among wealthy countries. Taken together, these results undermine the notion that North-North trade is largely devoid of factor content and that the prevalence of intra-industry trade is a puzzle for models of comparative advantage. 1 See the seminal papers of Krugman (1979) and Lancaster (1980). 2 These observations about trade patterns were offered specifically to motivate a move to the new trade theory view which could account for these facts even among countries with identical endowments. Krugman (1980) also appealed to one element apart from trade patterns: an apparent absence of substantial distributional impact of trade reform. Do Factor Endowments Matter for North-North Trade? The new trade theory of the 1980's is primarily recognized for its novel contributions regarding increasing returns, product differentiation and imperfect competition. Yet the influence of this literature goes beyond simply adding one more model to the canon. In a pair of influential papers, Krugman (1981) and Helpman (1981) articulated a vision of world trade patterns that integrated the new trade theory with the traditional factor endowments theory of HeckscherOhlin. In this formulation, each theory plays a role, but the roles differ. Trade among rich countries of the North is intra-industry and takes advantage of gains from specialization in a world of scale economies. Trade between North and South is inter-industry based on differences in factor endowment. This hybrid paradigm is now the profession’s dominant vision of the determinants of world trade patterns. In arguing for the empirical relevance of the scale economies element of this paradigm, Krugman (1981) cited two seeming-paradoxes in world trade patterns when viewed through a factor endowments lens: “First, much of world trade is between countries with similar factor endowments. Second, a large part of trade is intra-industry in character – that is, it consists of two-way trade in similar products.” In effect, this paradigm specifically denied that factor endowment differences are important for understanding trade among the rich countries of the North, for which instead it turns to the new trade theory. And the predominance of intra-industry