The Heckscher-Ohlin model, which is good for projecting likely business models between countries where the factors of production are different, really did not explain this business pattern. Krugman`s theory is based on product differentiation and economies of scale. For example, a jeep and a Volkswagen are the two cars, but they are very differentiated, as the consumer sees. And both benefit from economies of scale; In other words, the larger the production, the more costs can be reduced in a wide range of volumes. Unlike wheat, where costs increase as quantity increases, the cost of each additional automobile produced decreases as production is increased, although with a very large volume of production costs likely increases. Goods such as automotive require large mechanized production processes and significant capital investments, and it can be extremely difficult for a new entrant to compete with a well-established company. Although the removal of barriers to trade is generally a step towards free trade, there are situations where the reduction of a tariff can effectively increase the effective rate of protection for a domestic industry. Jacob Viner cites an example: “Suppose there are import duties on both wool and wool, but despite tariffs, no wool is produced at home. The abolition of the wool obligation, while respecting the wool obligation, increases the protection of the fabric industry, while it does not matter for wool breeding.  A number of factors can influence the terms of trade, including changes in demand, supply or government policy.
In the example above, the terms of trade will shift in favor of the U.S. when Japanese demand for aircraft increases, as it may require more TVs for each aircraft. Alternatively, when the Japanese start producing aircraft, commercial conditions will shift in favor of Japan, as the supply of aircraft will now be larger and the Japanese will have other sources of supply. In reality, there are, of course, reasons other than trade barriers why factors of production such as capital or labour should not move across borders, even if there are no barriers and higher returns could be obtained in other markets. Workers, for example, are reluctant to leave their homes, family and friends, and investors are reluctant to invest in other markets where they are less familiar. As a result, even the removal of all state-imposed barriers to trade for capital and labor would not result in full compensation for costs between counties. In trade based on product differentiation and economies of scale, several countries can manufacture the same product in a broadly defined manner and exchange parts and differentiated products with each other. Thus, the United States could specialize in the production of jeeps and Europe could specialize in the production of Volkswagen. It is clear that much of the output in the modern economies of the industrialized countries is in sectors with rising staggered yields, and in these sectors the return to factors of production would not be offset by international trade. Indeed, in a low-labour economy, labour returns could rise rather than decrease, as the factor compensation theory would predict. It is clear that the United States is benefiting from the reduction of its trade barriers by its trading partners, because its exports will increase, which will lead to an increase in production and employment. Most economists also believe that the U.S.
benefits from removing its own trade barriers, as consumers benefit from cost reductions and producers are forced to improve efficiency through international competition. . . .
Posted Oct 12th, 2021