Full text of Economic Quarterly (Federal Reserve Bank of Richmond) : July 1972, Vol. 58 , No. 7

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FEDERAL RESERVE BANK OF RICHMOND

MONTHLY
REVIEW
The Housing Rebound
Changing Views of Comparative
Advantage

V o lu m e 58
Num ber 7

JULY

1972

THE HOUSING REBOUND
The construction industry has experienced an up
surge of record proportions since July 1970. Private
housing construction spearheaded the upsurge, al
though there were substantial increases in nonresidential and public building as well. From a cyclical
low of $30 billion in July 1970, the value of new
private residential construction put in place reached
a seasonally adjusted annual rate of $52.5 billion in
April 1972, 75% higher than July 1970. Total new
construction put in place rose from a cyclical low
of $91.1 billion in April 1970 to $122.6 billion in
April 1972. This gain, which represents an increase
of 34.6% , dramatically illustrates the position of the
construction industry as a leading source of economic
expansion in the past year and a half.
The recent surge has been a boon to the construc
tion industry, which was hard hit by the scarcity of
mortgage money and the high mortgage interest
rates of 1969 and early 1970. The effects of the two
latest tight money episodes (1966 and 1969) on
private residential housing were especially noticeable,

as clearly shown in Chart 1. The recoveries from
the ensuing downturns, however, differ considerably.
The recent housing recovery has been both sharp and
prolonged relative to comparable episodes in the past.
The implications of the data are unmistakable. A s
spokesmen for the construction industry are wont to
point out, the residential building rebound has been
the star of the recovery from the 1969-1970 business
slowdown. Underlying this rebound is a large back
log in housing demand built up mainly in earlier
tight money periods, changes in financial conditions
and in other governmental policies affecting housing,
and industry ingenuity in expanding supply apace
with housing demand.

DEMAND AND SUPPLY FORCES IN
THE HOUSING MARKET
Housing Cycles
Home building in this county appears to have
followed a wave-like pattern, as can be seen from the
data on new private housing starts shown in Chart 2.

C h a rt 2

NEW PRIVATE HOUSING UNITS STARTED
AND HOUSEHOLD FORMATIONS FOR
5-YEAR PERIODS
Thousands o f U nits
3,000 ---------------------------------------------------------------------------------------------

2,500 -

1,500 -

1,000

500 f -

A v e ra g e A n n u a l N e t H ousehold F o rm a tion s
(197 0 -7 5 E stim a te d )

1950

N o te :
Source:

M O N TH LY

REVIEW, JULY

1972

A rro w s in d ic a te p e a k m o nth .
U. S. D e p a rtm e n t o f C om m erce.

A s noted earlier, a major factor in the latest hous
ing rebound has been a sharp change in financial
conditions since 1969. The two recent tight money
episodes had a pronounced effect on the housing
market, but there are some interesting differences
in the two cycles associated with these episodes.
Chart 4 compares the November 1965-November
1968
period.

period

the January

1969-January

1972

A s can be seen from the chart, the trough

of the housing downturn was relatively deeper in the
1965-1968 cycle than in the 1969-1972 period.
recovery from

The

the trough, moreover, was much

stronger in 1969-1972.
Interestingly enough, further scrutiny of housing
starts since 1950 (Chart 2 ) reveals that there has
been very little long-run trend in the series.

Other

than cyclical and irregular variations, the distinguish
ing characteristic of housing starts in the fifties and
sixties has been the absence of any positive trend in
the series.

Thus, the behavior of housing starts

since 1970 has been all the more unusual.

Five distinct cycle-like movements in the series are
discernible, and the peak of each is designated in the
chart. T o facilitate comparison of these movements,
or so-called housing cycles, Chart 3 gives, for each
cycle separately, the number of housing starts in the
months subsequent to the peaks expressed as a per
centage of the peak value of the series for that cycle.
Four of the cycles, those prior to 1969, have an
average duration of 4 ^3 years from peak to peak.
The most recent cycle, which began in January 1969,
may not have yet run its course, although starts fell
off rather sharply in March and April of this year.
In any event, the most striking characteristic of this
latest cycle is the unusual strength of the recovery
phase as compared with the same phase in earlier
cycles. This strength is readily apparent from even
the most casual inspection of Chart 3.

FEDERAL RESERVE BAN K OF R IC H M O N D

Measuring the Supply of Shelter
Total private starts figures include both single and
multi-family dwellings. The number of multi-family
units started increased from 482 thousand units in
January 1970 to 1,342 thousand units in February
1972 at seasonally adjusted annual rates. The per
centage of total starts in multi-family dwellings also
increased, from 45.5% to 50.5%. Thus, the increase
in the total private starts series includes a relatively
large increase in multi-family units. Since each
dwelling unit in a multi-family unit is counted as a
separate start in the series, the increase in the per
centage of multi-family units does not result in an
understatement of individual dwelling places started.
Mobile homes, however, are not included in the
housing starts series, and mobile home shipments
totaled 497 thousand units in 1971, up from 401
thousand in 1970. Thus, shelter is becoming available
to more families than is indicated by the growth in
housing starts.

Demand Factors
The housing industry is influenced, over the long
run, by both population growth and changes in the
level of affluence. The average rate of net household
formation, published for five year intervals by the
National Industrial Conference Board, measures
fairly accurately the effect of population growth on
the demand for houses. This series is superimposed
on Chart 2, which shows housing starts since 1950.
Through the latter half of the 1960’s, the difference
between net household formation and the level of
housing starts was clearly smaller than in earlier
periods. Thus, housing demand was being stored
up during the late sixties. This pent-up demand
accounts for much of the strength of the recent hous
ing rebound. However, as is also clear from the
chart, the relationship between housing starts and
family formation has again changed. By January
1972 the difference was much larger than in any other
time period since 1950.

Current data thus indicate

that present levels of starts are higher than can be
sustained by net family formation.
The difference between starts and net family for
mation, however, does not by itself portend dire con
sequences for the housing industry.

Even though

central cities to suburbs (or vice versa), and/or
(3 ) an increase in subsidy programs made homes
available to those who previously could not buy
homes, the demand for houses would be much
stronger than would be indicated by the rate of new
family formation.
Even existing households who
are already housed can contribute to housing demand
since people often wish to up-grade their dwelling
unit as they become more affluent. From 1950 to
1960, median family income adjusted for inflation in
creased 37.6% .
From 1960 to 1970 it increased
33.9% . A s real income rose, so did the consumer’s
ability to buy a better home and also to buy a second
home. Both of these factors contributed to the growth
in the demand for housing during the late sixties.
The availability and cost of mortgage credit, both
of which are sensitive to general credit policy, have
an important bearing on the demand for housing.
Monetary policies designed to stem inflation tend to
make credit scarce, and such policies were clearly an
important factor in the 1969 housing downturn. But
specific governmental programs for providing funds
to the mortgage market cushioned this effect and
helped to keep the downturn from becoming as severe
as in 1966. Much of this government help to the
mortgage market was channeled through certain in
stitutions whose functions were either newly initiated
or re-thought after the 1966 episode with the specific
purpose of averting its repetition.
Although the availability of credit is difficult to
measure with precision, total funds flowing into
savings institutions and household savings accounts
at commercial banks provide a rough proxy for fund
availability in the mortgage market. Savings flows
from 1968 are shown in Chart 5a and mortgage in
terest rates in Chart 5b. The charts point up the
extreme stringency and the high cost of mortgage
money in 1966 and 1969. Once monetary policy
began to ease in early 1970, however, savings inflows
recovered quickly, and this helped account for the
housing rebound.
Federal Stimulus to Demand T h e Federal g o v
ernment has long been involved in programs to
stimulate the demand for housing and to promote
house ownership. Some of these provisions, as in
dicated earlier, are designed to increase the avail
ability and lower the cost of mortgage credit. Others

starts are much higher than family formations at the

involve direct government outlays for public housing,

present time, the new relationship can be sustained

community development, and rent subsidies and sup

if changes in other factors that contribute to demand

plements. Following the credit crunch of 1966, which

are sufficient to account for the difference.

For ex

bore so heavily on the construction industry, Federal

more houses were demolished or

programs in both areas were expanded significantly.

abandoned, ( 2 ) population shifted more rapidly from

This increased government activity in the mortgage

ample, if

(1)

M O N TH LY

REVIEW, JULY

1972

and housing markets has been an important factor
in the current housing rebound.
Federal National M ortgage Association One of
the functions of the Federal National Mortgage A s
sociation, or Fannie Mae, is to stabilize the mortgage
market by providing a secondary market for mort
gages. Prior to 1968, F N M A also had a special as
sistance and a management and liquidating function,
but these functions were split off from F N M A when
she became a privately owned corporation in 1968
and are now functions of the Government National
Mortgage Association (G N M A ).
W ith respect to providing a secondary market for
mortgages, therefore, F N M A has benefited from
several years of experience. The 1966 situation in
particular pointed to some problems that F N M A
would face when it was confronted with a major
reduction in the availability of funds in mortgage
markets. Under operating procedures existing at
that time, F N M A stood ready to buy all eligible
mortgages at announced prices. Because of sharply
rising interest rates, the agency was confronted with
a flood of mortgage offers, and its credit supplies
were soon exhausted, with mortgage holdings rising
to near statutory ceilings.
In 1968, with its conversion from a government
owned to a private corporation, Fannie Mae’s pur
chasing procedures were altered in a significant way.
Its function remained one of making a secondary
market for mortgages and gearing its purchases and
sales to current and prospective conditions in mort
gage markets, as reflected in mortgage rate move
ments. The new Fannie Mae continues, as before, to
finance its operations by selling its own debt obliga
tions in the market for government agency securities.
But as a private corporation, F N M A obligations
are not included as part of the government debt and
are not, therefore, subject to Congressionally-imposed
debt ceilings for U. S. public debt. F N M A is not free
to issue as much debt as it chooses, for the Secretary
of Housing and Urban Development must approve
the corporation’s total debt and the Secretary of
the Treasury must approve the timing, maturity, and
amount of all security issues. Nevertheless, its debt
ceilings are presently much higher than they were in
1966; and more importantly, they are more flexible.
A s a result of the 1966 “ credit crunch,” F N M A

cides how many of these offerings to accept. In
this fashion, prices (and, hence, rates on Fannie
Mae’s holdings) are determined by offers received
from the market. And most importantly, by vary
ing the dollar amount of commitments, Fannie Mae
can determine the exact dollar amount of mortgages

also changed its method of operating. Under the cur
rent procedure, Fannie Mae accepts bids each week
from the public, mostly mortgage companies, which
include the price and quantity of mortgages they
would like to sell over a future period (usually four
months).

W hen the bidding closes, Fannie Mae de

FEDERAL RESERVE B A N K OF R IC H M O N D

that it is committed to buy and can therefore influ
ence directly the market supplies of mortgage funds.
Its operations also add to the liquidity of the port
folios of permanent and temporary mortgage lenders.
Fannie Mae’s operations can be keyed to ironing
out temporary ups and downs in the mortgage mar
ket, in which case purchases in one period may be
offset by sales shortly afterward. But the corpora
tion is principally a buyer of mortgages, and it holds
them on a permanent basis, which of course provides
additional funds for the mortgage market. By vary
ing its purchase activity, it can help to provide funds
for the housing industry in periods of mortgage
credit stringency. In the recent tight money period,
it allowed its mortgage holdings to rise substantially.
As shown in Chart 6 , its holdings of $7.3 billion in
January 1969 rose to $15.5 billion by January 1971.
They edged off slightly during the first half of 1971
but resumed their upward trend thereafter.
Government National Mortgage Association A n
other important functionary in the mortgage market
is the Government National Mortgage Association,
generally referred to as Ginnie Mae. G N M A is an
agency of the Federal Government that was or
ganized to take over some of F N M A ’s functions
when the latter became a private enterprise in 1968.
G N M A serves two major functions, a special assist
ance function and a management and liquidation
function. Special assistance funds can be used to
finance home mortgages qualifying under special pro
grams such as slum clearance and low-income hous
ing. Special assistance money can also be used to
purchase mortgages to resist declines in home build
ing activity if they appear to pose a threat to the
stability of the economy. In its management and
liquidation function, Ginnie Mae manages and liqui
dates several existing mortgage portfolios as an agent
for the Federal Government. Another function
given to G N M A by Congress was the “ pass-through”
security program. This program is designed to en
able more of the investing community to purchase
mortgages and thus to broaden the mortgage market.
Ginnie Mae’s mortgage portfolio is much smaller
than Fannie Mae’s and, as shown in Chart 6 , rose
at a much slower rate in 1970. But this is not the
only index of the relative importance of the new
government agency in the mortgage market. In
recent months, Ginnie Mae has had the responsibility
of administering a $2 billion program of Federal
subsidies designed to reduce mortgage rates on m od
erately priced houses.

The program allowed Ginnie

Mae to buy F H A and V A home and multi-family
loans at prices of 96 cents on the dollar for new

M O N TH LY

homes and 95 cents for existing structures. The
existing market rate when the program was instituted
was 91 and 92 cents, so G N M A purchased mortgages
or mortgage commitments at prices considerably
above the market level. Then G N M A either resold
the mortgages at the existing market price, taking a
loss on the transaction, or held them until prices
rose again. Although G N M A could purchase no
mortgages higher than $24,500 ($22,000 for less
than four bedroom hom es), which some builders
thought was an unreasonably low ceiling, the program
was, nevertheless, well received. Basically, G N M A
was helping to pay the discount charges (often called
“ points” ) for the homebuyer, and in the process
bringing more families into the housing market.
By December 1971, G N M A , using special assist
ance funds authorized by Congress, had issued $2.3
billion of commitments and purchased $50 million
of mortgages. G N M A still has almost $2 billion of
the funds available for use if support operations
again become necessary. These funds have not been
used to purchase mortgages or commitments this
spring, mainly because mortgage money has been
ample and rates have fallen below the support levels.
However, if mortgage rates again begin to rise,
G N M A is expected to reactivate the plan.
The Housing and Urban Development A ct of 1970
Another source of strength in the housing sector
was the Housing A ct of 1970. The A ct increased
spending for rent supplements, home ownership, and
rental subsidies, although its major purpose was to
develop new communities for urban growth. It
set up a new Community Development Corporation
(C D C ) to oversee a $500 million program of Fed
eral guarantees of obligations issued by developers of
new communities. The CDC can also make direct
loans on community development programs approved
by the Department of Housing and Urban Develop
ment and can help pay debt services for state land
development agencies on those programs.
Other programs A long with the $2.1 billion
allotted to G N M A to keep mortgage rates for m od
erately-priced homes from rising, the Federal Home
Loan Mortgage Corporation began actions to help
purchasers of somewhat larger homes. It announced
that it would buy mortgages larger than $ 22 ,000,
which helped to subsidize the purchase of homes
larger than those covered by the G N M A subsidy.
It also raised the price that it would pay for F H A
and V A loans by three full points to 94.
In another effort to support the housing market,
the Federal Home Loan Bank Board allowed Federal
associations to make mortgage loans on up to 95%

REVIEW, JULY

1972

same period, the Boeckh building cost index rose
22% . The Census index takes account of all cost
items that enter the selling price, including the value
of the undeveloped lot, the cost of construction, land
costs, selling expenses, and “ points” paid by the seller
in connection with mortgage financing. This index
is thus broader than the building cost index and more
reflective of productivity and financial changes.
Part of the difference in the performance of the
two indexes is attributable to changes in mortgage
rates and other finance charges and land prices. But
part is also attributable to cost-cutting innovations in
the construction industry.
The construction industry, contrary to some
commonly held beliefs, has been increasingly pro
ductive for the past several years. Builders use
prefabricated materials in almost every house con
structed.
The increased use of pre-hung doors
and prefabricated materials has improved produc
tivity by removing a greater percentage of the con
struction from the site. Off-site production is less
subject to the vagaries of weather and, since it can be
adapted to factory techniques, frequently requires
less skilled labor.
Modular Housing T he ultimate step in reducing
home building to a factory process is the modular
home. The modular home industry is in its infant
stages and has accounted for only a small fraction of
the new shelter built in recent years. Only 27,000
of a home’s assessed valuation. This change in
policy enabled more people to purchase homes by
lowering the required down payments. Also, liquid
ity requirements were lowered from 7 ^ % to 7%
for savings and loans, which freed around $800 mil
lion for mortgages.

Supply Factors
The Boeckh building cost index for residences,
shown in Chart 7, rose 22% from 1969 to 1972. This
building cost index takes into account prices for
building materials, common and skilled labor, and
sales and social security taxes. It is also adjusted
to reflect the impact of labor shortages and labor
efficiency.
Prices of new houses, while up substantially in
recent years, have lagged behind the increase in
building costs; partly because of significant tech
nological improvements in the construction industry.
The Bureau of the Census’ one-family houses index,
a price index for houses computed from actual trans
actions prices, rose 16% between the second quarter
of 1968 and the second quarter of 1972. For the

FEDERAL RESERVE B A N K OF R IC H M O N D

modulars were produced in 1970 and 52,160 in 1971.
But the process could well prove to be a major in
novation in the housing market, especially in the
market for second, or vacation, homes.
The advantages of modular construction stem
from the ability of modular builders to use fewer
skilled workers, to schedule work more efficiently,
and in general to speed up the construction process.
Essentially, modular construction amounts to on-site
operations moved indoors. By doing the bulk of
the building indoors, year-round production can be
scheduled, and labor can be utilized more efficiently.
Not only can workers be hired on a more permanent
basis, but their tasks can be more specialized. Thus,
modular construction is a relatively new application
of the economic principle of specialization and divi
sion of labor to the housing industry.
A number of special problems in modular con
struction have thus far held back the growth of the
process. The diversity of building codes in various
municipalities has inhibited standardized production,
and financial institutions have not yet accommodated
themselves to the industry. The financial community
often views modular companies as simple construc
tion companies. Construction loans to finance con
ventional buildings are usually made in various stages
as the structure nears completion on the lot. The
modular house, however, is virtually completed when
is arrives on the site, and work done in the factory

C h a rt 8

YEAR-ROUND RENTAL UNITS VACANT AND
AVAILABLE FOR RENT
P ercentage
D is trib u tio n

is not eligible for interim construction loans of the
traditional type. Also, as compared with other busi
nesses, the modular firm has a unique inventory prob
lem, since bad weather on the prospective home site
can cause a piling up of finished modules. On the
other hand, the modular building firms should have a
working capital advantage over the traditional builder
since construction time is shortened. Shorter con
struction time should also result in less interest e x
pense per house than for traditional building.
A final difficulty that has plagued the modular
builder is that of controlling the output of the firm.
The builder must know exactly where his factory’s
output will go when it comes off the assembly line,
and he must make sure that the purchaser will be
ready to accept the house when it is completed. In
many cases modular producers have been forced to
become land developers in order to solve this control
problem. The capital needs of the modular pro
ducer are thus likely to be far greater than those of
the ordinary builder.

CONCLUSION
Spurred by a congenial turn in credit conditions,
a number of Federal Government initiatives, and
technological developments in construction, housing
has rebounded sharply in the past two and a half
years. Through 1970 and 1971, residential building
was a major prop holding up a sagging economy.
But the sharpness of the rebound, coupled with its
extended duration, has precipitated some forms of
over-building. A s noted earlier, the rate of housing
completions is far in excess of the rate of new
family formation. M oreorer, the vacancy rate for
rental units, shown in Chart 8 , is seemingly begin
ning to rise, although it edged lower in the first
quarter of 1972. A t the end of 1971, this rate was
still considerably below the level maintained in the
early sixties, but a large number of houses started in
the second half of 1971 and the first months of 1972
were not yet ready for occupancy at that time. R e
gionally, there are signs of over-building. Apart
ments in some parts of California and in some major
Southern and North Eastern cities appear to be e x
periencing rental difficulties.

In some markets, ac

cording to H ouse and H om e Magazine, vacancy rates
are as high as 20% .

All in all, it seems unlikely

that the recent rapid rate of growth of housing will
continue through 1972.

Source:

U. S. D e p a rtm e n t o f C om m erce.

Digitized for
8 FRASER

Even so, total starts seem

likely to remain for a time yet at levels that, by
historical standards, are h igh ; and the construction
industry appears likely to remember 1972 as an ex
cellent year.
William E. Cullison
MO N TH LY

REVIEW,

JULY

1972

CHANGING VIEWS OF

COMPARATIVE ADVANTAGE
International trade theory is based on the funda
mental concept of comparative advantage.
This
concept refers to the relative cost or productivity
advantage one country enjoys over others in the pro
duction of certain commodities.
Since the early
nineteenth century, economists have employed the
concept to explain why nations trade, to demonstrate
the gains from trade, and to predict the commodity
composition and geographical pattern of trade flows.
Events, empirical research, and policy debates have
all combined in recent years to focus attention once
again on the subject of comparative advantage.
Chief among the events has been the sharp deteriora
tion of the U. S. merchandise trade balance since
1964, culminating in the $2.9 billion deficit in 1971
— the first deficit since 1935. This experience has
convinced many observers that there has been an ad
verse structural shift in the sources of U. S. com
parative advantage, an interpretation that is rela
tively new.
Up to 1970, short-run, cyclical in
fluences rather than long-run structural factors were
cited as the principal cause of the dwindling trade
balance. That is, domestic inflation accompanying a
sharp business upswing, associated in part with the
Vietnam W ar, was thought to be the chief factor con
tributing to a strong surge in U. S. imports and to
declining price competitiveness of U. S. exports.
Specifically, analysts attributed the trade balance
deterioration to such factors as excess aggregate de
mand, slowing productivity growth, escalating wage
rates, and rising unit labor costs— all characteristics
of the inflationary boom of the late 1960’s. By 1971,
however, the inflation interpretation seemed inade
quate. For instance, excess demand had been elimi
nated in the recession of 1970. It is true that costpush inflation had not disappeared, but its effect
on the trade balance should have been partly neutra
lized by price movements abroad. In 1971, many of
this country’s trade competitors were experiencing
rates of inflation, rises in unit labor costs, and in
creases in export prices that outstripped those here.
Despite this relative improvement on the inflation
front, however, the U. S. trade balance deterioration
persisted. But if cyclical changes in relative rates
of inflation could not explain all of the trade balance
decay, what additional explanations might there be?

Some economists began to suspect that long-run
forces were altering the basic determinants (techno
logical superiority, factor proportions, resource avail
ability) of the pattern of U. S. comparative ad
vantage.
Suspicions of an adverse structural shift in U. S.
comparative advantages were strengthened by other
developments, including: ( 1 ) the phenomenal rise
in the economic capability of such leading U. S.
trade partners as Japan and Germany; (2 ) the trend
toward increased economic integration within re
gional trade blocs, which has resulted in intra-bloc
trade creation and extra-bloc trade diversion; and
(3 ) the growth of the multinational corporation,
which has provided a major channel for the inter
national transmission of technology, capital, and
managerial skills. These developments have forced
policymakers and businessmen to reassess longerrun U. S. trade prospects.
The resurgence of discussion on the topic of com
parative advantage has not resulted solely from de
velopments on the world trade scene, however.
Statistical research, too, has played a role. Recent
empirical studies have severely challenged some longestablished notions about the nature and sources of
U. S. comparative advantage. For example, as re
cently as the mid-1950’s it was widely believed that
the superior competitive position of U . S. products
in world markets stemmed from the large stock of
tangible capital with which American labor worked.
Moreover, the structure of U. S. comparative ad
vantage was thought in some quarters to be stable
and enduring. Within the past decade, however, reseachers have found evidence indicating that U. S.
comparative advantage emanates from skills, knowl
edge, and technology rather than from a high
capital/labor ratio, and that the structure of com
parative costs is continually being altered by the
generation and diffusion of technical knowledge.
The subject of comparative advantage has also
surfaced in current debates over trade policy.
Modern protectionists claim that the comparativecost doctrine has little contemporary validity, while
free-traders maintain that it is still a valid policy
guide.
These recent events, empirical studies, and policy

FEDERAL RESERVE B AN K OF R IC H M O N D

debates have had a substantial impact on interna
tional trade theory. Current explanations of com
parative advantage differ markedly from older, tra
ditional explanations.
This article indicates how
economists’ conceptions of the nature and sources
of comparative advantage have been altered by recent
empirical research and by the changing position of
the United States in world trade.
T h e Classical D octrin e of Com parative A d v a n
tage A nation is said to have a com parative ad
vantage in the production of a good when its efficien
cy in producing that good compared to its efficiency in
producing another good is higher than that of other
nations. The first clear statement of this concept
dates back to the early nineteenth century when
David Ricardo formulated his celebrated EnglandPortugal, cloth-wine example. Suppose that in Eng
land it takes 10 labor hours to produce a unit of
cloth and 12 labor hours to produce a unit of wine.
That is, the productivity of an hour of English
labor is 1/ 10 unit of cloth or 1/ 12 unit of wine.
In Portugal, however, the labor requirements per
unit of output are nine and eight, respectively, in
cloth and wine. That is, the productivity of an hour
of Portuguese labor is 1 /9 unit of cloth or 1/8 unit
of wine. Then the ratio of labor productivity (output
per labor hour) in cloth production to that in wine
production is higher for England than for Portugal
(1 2 /1 0 vs. 8 /9 ) .
England, in this example, al
though absolutely less efficient than Portugal in the
production of both commodities, nevertheless clearly
has a comparative advantage in cloth.
Portugal,
conversely, has a comparative advantage in wine.
Ricardo’s chief objective in using his illustration
was to demonstrate the mutual profitability of inter
national specialization and free trade, i.e., that the
gains from trade would accrue to all nations. Ricardo
explained that each nation, by specializing in the
production and export of its comparative advantage
good, could obtain the other good with a smaller
sacrifice of its export good than if it endeavored to
produce the import good itself with labor transferred
from the export industry. If England, for example,
sought to be self-sufficient in wine, the production
of each unit of that commodity would require the
release from cloth production of labor-hours suf
ficient to produce 12/10 units of cloth. The cloth

trading it to Portugal, where a unit of wine costs
less than one unit of cloth, than by producing it at
home at a cost of more than one unit of cloth. Like
wise, Portuguese could get cloth more cheaply by
producing wine and trading it to England, where
cloth costs less than one unit of wine, than by pro
ducing it domestically at a cost of more than one
wine unit. In short, by specializing and engaging in
free trade, England could obtain wine from Portugal
at a smaller sacrifice of English cloth, and Portugal
could obtain cloth from England at a smaller sacrifice
of Portuguese wine. Each nation, therefore, could
obtain via specialization and trade more of both
goods from the same amount of labor input or, al
ternatively, obtain the same amount of goods witli
less expenditure of labor, than if it endeavored to be
self-sufficient. As Ricardo emphasized, these gains
from trade in no way depended on absolute levels
of productivity. For instance, one country might be
absolutely more efficient than its trading partners in
the production of all com m odities; yet that country
would still find trade beneficial as long as its relative
costs, or productivity ratios, differed from those in
other countries.
Taking their cue from Ricardo, other nineteenth
century classical economists attributed comparative
advantages solely to national differences in relative
labor productivity, i.e., ratios of output per man
hour for pairs of commodities. N o explicit recogni
tion was given, in the classical analysis, to the
productivity of other factor inputs, such as capital
and land, nor was it explained why the labor produc
tivity ratios differed among countries.
T he F actor-P rop ortion s T h eory Later, in the
1920’s and 1930’s, economists added a second factor
of production, capital, to the model and attempted
to link comparative advantages to nations’ relative
endowments of capital and labor. According to the
factor-proportions theory, a country with a rela
tively high capital/labor ratio would export capitalintensive commodities and import labor-intensive
ones. The former commodities tend to be relatively
inexpensive in the capital-rich country, because they
use intensively the country’s relatively abundant
(hence relatively cheap) resource, capital. Labor-in
tensive commodities, however, tend to be compara
tively dear since they embody large amounts of the

cost, therefore, of each wine unit in England (1 2 /1 0 )

country’s relatively scarce and expensive resource,

is much higher than its cost in Portugal ( 8 /9 ) .

labor.

Conversely, a country with a relatively high

Similarly, the wine sacrifice per unit of cloth in a

labor/capital ratio would export labor-intensive goods

self-sufficient Portugal ( 9 /8 ) would be higher than

and import capital-intensive ones.

Clearly, Englishmen could

a comparative advantage in producing goods that use

obtain wine more cheaply by producing cloth and

intensively the country’s relatively plentiful resource.

England (1 0 /1 2 ).

M O N TH LY

REVIEW, JULY

1972

Each country has

In short, each country’s product-mix, as well as the
commodity composition and geographical pattern of
its trade, would be determined by international dif
ferences in factor proportions.
Leontief’s Test A lth ou gh relatively simple, the
factor proportions theory seemed to exhibit con
siderable explanatory power, thereby accounting for
its almost universal acceptance prior to the early
1950’s when its validity was finally challenged by
empirical research. The factor-proportions theory
predicted that the U. S., certainly the most capitalabundant country in the world, would export capitalintensive goods and import labor-intensive ones.
But a 1953 study by Harvard University’s Wassily
Leontief revealed that, contrary to the theory, U. S.
exports were actually less capital-intensive than U. S.
imports. Evidently, the U. S. had a comparative ad
vantage in relatively labor-intensive goods and a
comparative disadvantage in relatively capital-in
tensive ones, despite the relative scarcity of labor
and the relative abundance of capital in this country.
Leontief’s paradoxical findings created much con
sternation among adherents of the factor proportions
theory. Leontief himself attempted to reconcile his
findings with the theory by suggesting that U. S.
labor is three times more efficient than foreign labor,
the difference being due to “ entrepreneurship and
superior organization” rather than to a high capital/
labor ratio. In other words, U. S. labor measured
in terms of efficiency units (i.e., units of equivalent
foreign labor) is three times more plentiful than
when conventionally measured (i.e., U. S. man
years). Thus, because of the efficiency factor, or
labor-quality differential, of three, the U. S. is
actually a labor-abundant country.
Consequently,
the measured factor composition of U. S. trading
patterns conforms to the factor proportions explana
tion. Leontief’s conjecture, however, was an un
satisfactory resolution of the paradox, because it
did not adequately identify the factors augmenting
labor’s efficiency. Subsequent research has focused
on the precise specification of these factors. In con
trast to Leontief, however, recent researchers have
tended to treat these efficiency-augmenting factors as
types of capital instead of as additional units of labor.
Sources of U. S. Comparative Advantage If U. S.
comparative advantage is not based on the large
am ount of tangible capital per w orker in this
country, then what is its basis? Several possible
sources of comparative advantage have been studied,
including, among others: ( 1 ) the large amounts of
human capital embodied in the labor force, i.e., high
labor skills stemming from education and training;

( 2 ) technological superiority based on research and
development (R and D ) expenditures; (3 ) economies
of scale resulting from the large domestic market,
which enables goods to be produced at lower costs
in the U. S. than abroad; (4 ) greater availability of
entrepreneurial talent and innovativeness in the U. S.
than abroad; (5 ) the domestic availability of certain
raw materials combined with their nonexistence
abroad; and ( 6 ) tariff structures that bias U . S.
production and export toward labor-intensive com
modities.
Empirical Findings O f the possible determinants
of U. S. comparative advantage, the most important,
according to recent empirical studies, appear to be
human capital (skills) and R and D activity. Recent
studies indicate that inputs of human capital—
measured either by the capitalized value of the dif
ferential between the annual wages of skilled and
unskilled labor, or by the ratio of highly skilled
workers to total workers— tend to be significantly
higher in U. S. industries with strong net export
positions than in those industries having weak export
positions. Moreover, comparisons of representative
bundles of U. S. export and import-competing goods
(the latter being a proxy for foreign-produced im
ports) show the former to have a higher skill con
tent than the latter. In fact, when estimates of
human capital are combined with estimates of tangible
capital in a measure of total capital input, U. S. ex
ports become more total-capital-intensive than the
products of U. S. import-competing industries. R e
searchers have also found fairly strong positive cor
relations between various measures of industry R
and D activity (e.g., R and D spending as a per
centage of total sales, or the ratio of scientists and
engineers to total employment) and alternative
indices of export performance (e.g., gross and net
exports as a percent of total sales, or U. S. share of
total exports of major industrial countries).
These studies, of course, are not without short
comings, and should be interpreted with some
skepticism. For example, the assumption that wage
differentials (a measure of skill differences) stem
solely from disparities in education, training, and
other types of human investment, seems unwarranted.
Also, in view of the probable close correlation be
tween skill intensity and R and D activity in given
industries, one could question whether skills and R
and D activity are mutually exclusive determinants
of comparative

advantage.

Despite these short

comings, however, recent evidence is sufficient to
suggest that the chief determinants of our com
parative advantage

FEDERAL RESERVE B A N K OF R IC H M O N D

are

(1)

human

capital

and
11

(2)

technological superiority, as represented by R

and D activity.
The importance of the technology factor is il
lustrated in Chart 1, which contrasts the strong
trade surplus in technology-intensive manufactured
products with the increasing trade deficit in non
technology-intensive products.

H igh -tech n ology

products account for more than one-half of U. S.
total exports and about one-third of total imports.
Low-technology products, too, compose roughly onethird of U. S. total imports but constitute only oneeighth of U . S. exports.
Factor-Proportions or Technology Gap?

The

finding that U. S. exports are skill-intensive and
technology oriented is consistent with both the old
factor-proportions interpretation of comparative ad
vantage and a newer interpretation based on the
concept of a “ technology gap.” A s mentioned pre
viously, the older interpretation is still valid pro
vided one extends the concept of capital to include
labor skills (human capital) and capital-embodied
technology as well as tangible capital (plant and
equipment). That is, with capital broadly defined,
advocates of the factor-proportions theory can still
maintain that U. S. exports are indeed capital in
tensive, as the theory predicts.
Many economists, however, prefer a newer in
terpretation, which states that labor skills and
technology indirectly promote the development of
temporary trade advantages by fostering the new
product or process innovations that generate those
advantages. This interpretation of the role of skills
and technology in the creation of comparative ad
vantages is a component of a new theory of inter
national trade.
The New View T h e new view integrates a
number of previously mentioned determinants of
comparative advantage into a dynamic, “ technology
gap” explanation of international trade. According
to this theory, the availability of entrepreneurial,
scientific, and engineering talent enables domestic
firms to generate continually the sophisticated new
products increasingly demanded by consumers in
the affluent U. S. After its introduction in the do
mestic market, a new good is usually exported to
profitable foreign markets.
The knowledge, tech
nical capabilities, and special managerial skills re
quired for the successful introduction of the innova
tion provides the U. S. producer with an initial ad
vantage in world markets. In other words, U. S.
competitiveness is based on a “ technology gap.”
The technological advantage enjoyed by the U. S.
2
Digitized for 1FRASER

M O N TH LY

producer is transitory, however. The technology gap
is continually narrowing for particular products as
knowledge of the innovation spreads abroad and
foreign producers adopt it. Eventually the transfer
of technology is completed, and the technological
lead of the U. S. in this product vanishes. Produc
tion of the good may eventually pass almost entirely
from the U. S. to foreign countries, which then ex
port it to the U. S.
Note, however, that while this country’s techno
logical advantages in some products are disappearing,
others are constantly being created.
The entire
structure of trade advantages, in fact, is continually
being modified by the simultaneous destruction and
generation of technology gaps. It is this dynamic
conception of comparative advantage, which views
individual advantages as transient components of an
evolving structure, that distinguishes the new view
from the older interpretations.

REVIEW, JULY

1972

Faster Diffusion of Technology A n im portant
implication of the new view is that U. S. producers
systematically must generate innovations as rapidly
as knowledge of the old technology is disseminated
abroad, if the U. S. is to maintain its traditionally
strong foreign trade position in manufactured goods.
Pessimists fear that it is becoming more difficult for
U. S. producers to maintain the required pace of
innovation.
For one thing, the required pace may be increas
ing. Foreign producers seem to adopt new methods
more quickly now than they formerly did. The in
ternational diffusion of technical knowledge is much
faster than it used to be.
Trade in research-in
tensive new products, international licensing and
sale of patents, foreign travel by scientists and pro
fessionals, private direct investment, and, of course,
faster means of transportation and communication
all serve as vehicles for the rapid transmission of
technical knowledge.
The more rapid spread of
technology, of course, shrinks the average lead-time
that U. S. producers have to profitably exploit
foreign markets. In short, acceleration in the rate
of transfer of technology may have increased the
required rate of innovative activity while simul
taneously reducing the potential profitability of any
given innovation and thus the incentive of U. S.
producers to undertake it.
The Multinational Firm A m ajor factor con
tributing to the more rapid propagation of U. S.
technology has been the phenomenal growth in direct
investment by U. S. firms in manufacturing fa
cilities abroad. Such investment, the outstanding
value of which increased from $32 billion in 1960
to $71 billion in 1970, promotes the transfer of
technology in two ways. First, investment is often
accompanied by direct transfer of a “ package” of
capital, production techniques, skills, and managerial
methods to foreign subsidiaries. Skilled personnel
are often considered as indispensable complementary
inputs to be used in combination with physical
capital facilities. Therefore, managerial and technical
people are frequently dispatched abroad by the
parent firm to tend the equipment as well as to
advise and train the employees of its subsidiaries.
Second, the increased competition provided by U. S
subsidiaries stimulates local producers to adopt the
latest technology and spurs them to undertake in

D spending in the United States is almost triple that
of Western Europe and eight times that of Japan,
too much of this spending, it is claimed, is for sterile
defense purposes. Our civilian research effort—
measured by civilian R and D expenditures as a per
cent of G N P or by the proportion of the population
engaged in civilian R and D work— was surpassed
by that of Japan and Western Europe in the 1960’s.
The pessimists’ case is by no means proved, how
ever. It is too early to determine whether the U . S.
has suffered a permanent reduction in its techno
logical lead. A longer run perspective is useful here.
One need only remember that as recently as five
years ago spokesmen for the nations of Western
Europe were raising the specter of inevitable domina
tion of European markets by U. S. owned firms (the
so-called “ American Challenge” thesis of French
journalist J. J. Servan-Schreiber). These same
people were also predicting a growing technology
gap, with Europe receding progressively behind the
U. S. position of technological superiority. M ore
over, these people w ere lam enting the loss o f
scientists and other skilled professionals to the U. S.
via emigration (the so-called “ brain drain” ). Just
as the tide has turned for Western Europe, so it may
also turn for the U. S. In contrast to the pessimists,
some observers are confident that U. S. producers
can continue to generate innovations at an expanded
rate. Moreover, the optimists point out that the
transfer of technology is two-way, i.e., U . S. pro
ducers have benefitted from the reverse transfer of
foreign innovations, capital, and skilled personnel.
Finally, contrary to the “ sterility” contention of the
pessimists, defense related research expenditure may
ultimately have a high commercial pay-off, although
admittedly the rate of technological advance may be
less than it would be if the same research effort
were allocated by the private sector according to
economic instead of military criteria.
Is the Comparative Advantage Principle Ob
solete?
D oes the doctrine of com parative ad
vantage provide a useful and valid guide for trade
policy in the modern w orld? Should the U. S. con
tinue to press for freer trade according to the
dictates of this doctrine, even though foreign goods
are becoming increasingly competitive with ours?
Should the U. S. adhere to the doctrine and dis
continue producing goods that can be obtained at
lower opportunity cost via importation than via d o

novative activity of their own.
Pessimists also fear that our research lead is being

mestic production?

These questions form the heart

eroded by the willingness of other industrial powers

of much of the current controversy surrounding U . S.

to devote a greater proportion of their resources to

foreign economic policy.

productive research than we do.

Although R and

Protectionists, convinced that freer external trade

FEDERAL RESERVE B AN K OF R IC H M O N D

and investment would result in the export of U. S.
jobs and the loss of U. S. technological supremacy,
argue that the comparative advantage doctrine has
little contemporary validity, although admittedly the
doctrine might apply in a static world.
In a
stationary world, capital and labor would be fixed
in quantity and immobile internationally. Moreover,
technological change would be absent, thereby freez
ing international differences in technology at their
initial levels. In such a world each nation would
have a well-defined, enduring set of comparative ad
vantages based either on factor proportions or on
technological superiority. There would be no prob
lem of sudden shifts in the ranking of comparative
cost differences with consequent disruption in the
industrial com position of the w orld ’s m ajor
economies. The stability and durability of the pat
tern of comparative advantages would insure the
virtual absence of risks of specialization.
In the real world, however, these conditions are
violated. The real world is dynamic, not stationary.
Change is the rule; static conditions the exception.
Factors of production are mobile internationally; and
technological leadership waxes and wanes, contrary
to the assumptions underlying the classical free trade
model. Protectionists contend that the international
mobility of capital and managerial resources can
quickly alter factor proportions.
For example, a
domestic U. S. industry could exhibit a high ratio
of capital and entrepreneurial skill relative to labor
and natural resources in one decade, but a low one
in the next, as U. S. capital and management go
abroad to combine with foreign labor and natural
resources.
Similarly, the rapid dissemination of
knowledge may eliminate and even reverse a nation’s
technological lead. In short, in the modern world,
there is no stable, lasting basis for comparative ad
vantages. The list of rankings is constantly shifting.
Protectionists maintain that the rapidly shifting list
of comparative advantages requires an unattainable
degree of adaptability in the economy. Lacking in
finite flexibility, the economy cannot alter its productmix or reallocate its resources swiftly enough to
keep up with changing comparative cost conditions.
Consequently, free trade must lead to structural
maladjustment, resource unemployment, and periodic
deficits in the merchandise trade balance.
Thus, according to the protectionist argument, a
free-trade policy is harmful to a country confronted
with shifting comparative advantages and con
strained by an imperfectly flexible industrial struc
ture. This very line of reasoning has been employed
by labor leaders and businessmen who advocate con
trols on U. S. trade and direct foreign investment.

M O N TH LY

The free trade school disagrees with the pro
tectionists. W hile not denying that comparative ad
vantages change more rapidly today than in Ricardo’s
time, free traders think that the economy has suf
ficient flexibility to adjust to such changes. Free
traders do not necessarily believe that the declining
merchandise trade balance is indicative of a funda
mental incapacity of the economy to adjust. Instead,
they see it as a perfectly normal adaptation to chang
ing comparative advantages, in which our net exports
of merchandise have been supplanted by net exports
of capital, technology, and skills. In fact, some free
traders are predicting persistent deficits in the U. S.
merchandise trade accounts over the next several
decades. This prospect does not alarm them, how
ever. They think the merchandise trade deficits can
be offset by earnings from net exports of services
together with the dividend earnings of U. S. capital
located abroad, thereby maintaining overall equi
librium of our total balance of payments. That is,
the earnings of new U. S. comparative advantage
activities— supplying the rest of the world with ad
vanced services, skills, and technology either em
bodied in capital or complementary to it— would
compensate for the deficit incurred in this country’s
former comparative advantage activity, merchandise
trade. If the U. S. reaches a position characterized
by a persistent trade deficit offset by net exports of
services and return on foreign investment, it will
have attained the same “ mature creditor” stage in
the development of its balance of payments that
Great Britain reached in the nineteenth century.
Great Britain, although confronted with a chronic
excess of imports over exports, experienced little
difficulty up to W orld W ar I in balancing its inter
national accounts. That country simply covered its
import surplus with the interest and dividend yield
from its accumulated foreign investments.
In answer to protectionist claims that trade re
strictions are needed because the economy is not
sufficiently adaptable to changing comparative ad
vantages, free traders point out that trade restrictions
would actually reduce adaptability.
By shielding
domestic producers from foreign competition, pro
tection would permit them to be more sluggish in
adapting to technological change initiated abroad.
Finally, free traders point out that comparative ad
vantages zvithin the U. S. are continually being
altered by changes in tastes, technology, and the
geographical location of resources. Yet, protectionists
do not advocate restrictions on domestic trade or on
the domestic migration of labor and capital.
Free traders, of course, are not unaware of the
dislocations incidental to rapid change.
But they

REVIEW, JULY

1972

emphasize that such dislocations are better alleviated
by tax-financed adjustment assistance (jo b retrain
ing, employment counseling, relocation subsidies,
etc.) than by departure from the principle of com
parative advantage. Financed by the beneficiaries
of change, adjustment assistance would permit a
more equitable sharing of the costs of change while
simultaneously redirecting dislocated resources into
the new lines of comparative advantage.
In short, free traders point out that the doctrine
of comparative advantage is still the blueprint for
the most efficient allocation of resources. They argue
convincingly that policies that combine the precepts
of this doctrine with adjustment assistance to groups
dislocated by change will do more to promote overall
welfare than will protectionist policies.
Summary E con om ists' view s of the sources and
nature of comparative advantage have undergone
significant change since Ricardo’s time. Originally
thought to be based on international differences in
labor productivity and later on relative endowments
of factor proportions, the comparative advantages en
joyed by developed countries such as the U. S. are
now seen as emanating largely from human skills,
knowledge, and technology.

Recent developments in the world economy— in
cluding the increasing international mobility of
capital, the faster dissemination of technology, and
the narrowing differential between the economic
capability of the U. S. and her trading partners—
have also altered economists’ conceptions of the pat
tern of this country’s comparative advantage. The
structure of comparative advantage, once thought
to be stable and enduring, is now seen as shifting
rapidly and frequently, thereby raising the risks of
specialization and the costs of adjustment. P ro
tectionists, claiming that these adjustment costs are
unduly high, hold that the doctrine of comparative
advantage is no longer valid. But free traders still
contend, as did Ricardo, that the principle of com
parative advantage provides the best guide for the
optimal allocation of any nation’s resources and
the maximization of world welfare. In short, free
traders argue convincingly that the benefits of un
restricted commerce outweigh the costs.
In con
cordance with this latter view, most economists
would probably agree that the basic conclusion of
the comparative advantage doctrine— that free trade
is mutually beneficial— remains as cogent today as
it was in Ricardo’s time.
Thomas M . Humphrey

B IB LIO G R A PH Y
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Lawrence, (eds.) New Y o rk : Columbia University
Press, 1968.

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1972