#4 – appendix (Heckscher-Olin) Trade Theories: #4 – appendix (Heckscher-Olin)

Trade Equilibrium in H-O Model 45⁰ line Machines .. Qeu EXeu Aeu Ceu IMeu p Cind Aind IMind Qind EXind p .. Cloth

Notation from preceding graph 45O Line - assumption that countries are identical and trade is balanced. Ceu , cind = new (higher!) consumption levels of EU and India … (at intersection of price lines and 45o line) Blue “dash” – Trade triangle EU EXeu – EU exports of machinery Imeu – EU imports of cloth Red “dash” – Trade triangle IND EXind – IND exports of cloth Imind – IND imports of machinery

Trade Equilibrium in HO Model Terms of trade (p) are determined by reciprocal demand and lie between the two countries’ pre-trade price ratios Equilibrium production with trade exhibits incomplete specialization (due to increasing opportunity cost) Equilibrium consumption with trade implies a rise in standard of living (consumption at “c”) Trade triangles are congruent

Trade Equilibrium in HO Model Terms of trade (p) are determined by reciprocal demand and lie between the two countries’ pre-trade price ratios Equilibrium production with trade exhibits incomplete specialization (due to increasing opportunity cost) Equilibrium consumption with trade implies a rise in standard of living (consumption at “c”) Trade triangles are congruent

Big … Assumptions Perfect competition Constant returns to scale No factor mobility Two countries must be identical and trade must be balanced

Test of the Heckscher-Ohlin Model The Test: W. Leontief (1951) Could “H-O … Factor Proportions Theory” be used to explain the types of goods the United States imported and exported? The Method: Built input-output model for 200 U.S. industries for 1947

EMPIRICAL EVIDENCE ON THE H-O FACTOR-PROPORTIONS THEORY The Findings: The Leontief Paradox Leontief found that U.S. exports were less capital-intensive than U.S. imports, even though U.S. is the most capital-abundant country in the world

The Leontief Paradox The Controversy: Findings were the opposite of what was generally believed to be true!

Reconciliations of the Leontief Paradox U.S. workers are more productive than foreign workers (Leontief) and Human Skills Theory (1966) A third factor, natural resources, is not considered (Vanek) U.S. tariffs on labor-intensive goods are high (Travis) The identical tastes assumption is violated; Table (next page) shows that consumption patterns differ across countries

Consumption Shares by Product Type for OECD Countries Average Values 1985–1999*

Human Skills Theory Donald Keesing (1966) Emphasizes differences in endowments and intensities of skilled and unskilled workers. Explains the Leontief paradox: Since the U.S. has highly trained, educated workers relative to other countries, U.S. exports tend to be skilled-labor intensive.

#5 - FACTOR-PRICE EQUALIZATION Trade Theories: #5 - FACTOR-PRICE EQUALIZATION

FACTOR-PRICE EQUALIZATION AND THE DISTRIBUTION OF INCOME Moving from autarky to free trade What happens to the relative size of industries? What happens to the payments or returns to factors of production? What happens to the distribution of income within the country?

FACTOR-PRICE EQUALIZATION AND THE DISTRIBUTION OF INCOME When trade occurs between countries with different factor proportions, free trade will equalize the relative price of the goods (we saw this in H-O) … and cause the relative factor prices to converge Convergence of factor prices happens in the long run

FACTOR-PRICE EQUALIZATION AND THE DISTRIBUTION OF INCOME Whichever factor receives the lowest price before two countries begin to trade will therefore tend to become more expensive relative to other factors in the economy, … while those with the highest price will tend to become cheaper.

FACTOR-PRICE EQUALIZATION AND THE DISTRIBUTION OF INCOME For example – U.S. and India Trade opening up causes prices of machines and the prices of cloth to equalize between countries (H-O) Size of machine and cloth industries will change for each country changing their industrial structure

FACTOR-PRICE EQUALIZATION AND THE DISTRIBUTION OF INCOME (Assume) U.S. has a comparative advantage in machines … (machines are K intensive) This causes an increased demand for machines The price of machines rises relative to price of cloth Machine production expands Cloth production contracts Increased demand for inputs to make machines

FACTOR-PRICE EQUALIZATION AND THE DISTRIBUTION OF INCOME … (continued) Increase in capital greater than increase in labor as machines are capital intensive Resources shift from cloth to machines Cloth industry declines Imports replace much domestic production More labor than capital released on market Shortage of capital increase “profit” (return to K) Surplus of labor decreases wages Ratio of wages to “profit” (return to K) declines

FACTOR-PRICE EQUALIZATION AND THE DISTRIBUTION OF INCOME India has a comparative advantage in cloth Increased demand for cloth Price of cloth rises relative to price of machines Machine production contracts Cloth production expands Increased demand for inputs to make cloth

FACTOR-PRICE EQUALIZATION AND THE DISTRIBUTION OF INCOME Increase in labor greater than increase in capital as cloth is labor intensive Resources shift from machines to cloth Machine industry declines Imports replace much domestic production More capital than labor released on market Shortage of labor increase wages Surplus of capital decreases “profit” Ratio of wages to “profit” increases

FACTOR-PRICE EQUALIZATION AND THE DISTRIBUTION OF INCOME Wages Decline in U.S. Increase in India “Profits” (return to capital) Increase in U.S. Decrease in India Overall – Factor Prices get closer to equalization (just as we saw with “Goods Prices” in H-O

FACTOR-PRICE EQUALIZATION AND THE DISTRIBUTION OF INCOME Trade and the Distribution of Income Trade produces a convergence of relative prices Changes in relative prices have strong effects on the relative earnings of labor and capital in both countries In U.S., where the relative price of machines rises Capitalists are made better off and workers are made worse off In India, where the relative price of machines falls, the opposite happens Capitalists are made worse off and workers are made better off Owners of a country’s abundant factors gain from trade, but owners of a country’s scarce factors lose

FACTOR-PRICE EQUALIZATION AND THE DISTRIBUTION OF INCOME Table 4.4 Economic Data for South Korea and India Economic Variable South Korea India Year Value GDP per Capita 1953 $796 $641 1962 $928 $760 1972 $1,450 $786 1982 $3,395 $936 1991 $7,251 $1,251 Capital/Worker 1965 $2,093 1975 $6,533 $1,259 1085 $12,036 $1,712 1992 $17,995 $1,997 Degree of Openness [(Exports + Imports)/GDP] 11.8% 10.4% 22.1% 11.2% 44.5% 8.8% 71.5% 14.5% 1990 62.5% 21.2%

#6 - The Stolper-Samuelson Theorem Trade Theories: #6 - The Stolper-Samuelson Theorem

The Stolper-Samuelson Theorem Derived from the HO model Assumptions: Labor earns wages proportionate to its skill level Owners of capital earn profits Landowners earn rents The amount of income earned per unit of input depends on both the demand for inputs and the supply of inputs (demand for an input = derived demand)

The Stolper-Samuelson Theorem An increase in the demand for a good (opening International Trade?) … increases the price of a good…. and raises the income earned by factors that are used intensively in its production Conversely, decrease in the demand for a good … decreases the price of a good…. and reduces the income earned by factors that are used intensively in its production

The Stolper-Samuelson Theorem Example … increase production of steel … increase need for K ...

The Stolper-Samuelson Theorem Note: Not all factors used in the export industries will be better off, and not all factors used in import competing industries get hurt: Abundant factors will benefit, while scarce ones will be hurt

The Stolper-Samuelson Theorem Ultimately, the effects on income of an opening of trade depends on the flexibility of the affected factors If labor is stuck in bread production and unable to move to making steel, it will be hurt much worse than when it is flexible and free to move U.S. avocado producers might not oppose Mexican avocado imports as fiercely as they do, if they could easily move to producing other goods

Implications of Stolper-Samuelson Theorem Some groups in society will oppose international trade. Scarce factors will lobby government for trade protection. Even though some in society lose, the country overall benefits from international trade relative to autarky. A system of taxation and transfers could be developed to compensate the losers while leaving the gainers better off relative to autarky.

#7 – Specific Factors and Income Distribution Trade Theories: #7 – Specific Factors and Income Distribution

Introduction If trade is so good for the economy, why is there such opposition? There are two main reasons why international trade has strong effects on the distribution of income within a country: Resources cannot move immediately or “costlessly” from one industry to another. Industries differ in the factors of production they demand.

Specific Factors Model The HO model assumes that factors are mobile, meaning that they can migrate easily from one sector to another The Specific Factors model assumes that: land and capital are immobile and cannot migrate .... (specific factors) labor is fully mobile and can migrate from one sector to another ... (variable factor)

Specific Factors Model A country’s endowment of a specific factor plays a more critical role than a factor in the HO model in determining comparative advantage When trade opens, incomes rise for the owners of the abundant specific factor The income distribution effect on labor is indeterminate, as workers can easily move to the expanding sector

A Specific Factors Model Inputs Bread Steel Specific Factors Land Capital Variable (Mobile) Factors Labor Outputs The Specific Factors of land and capital can be used to produce only one good., each. The variable factor of labor is used in both bread and steel production.

The Specific Factors Model The specific factors model allows trade to affect income distribution. Assumptions of the model: Two goods … bread and steel. Three factors of production: labor (L), capital (K) and land (T for land/terrain). Perfect competition prevails in all markets.

The Specific Factors Model (cont.) Land and capital are both specific factors used only in the production of one good. steel produced using capital and labor (but not land). bread produced using land and labor (but not capital). Labor is a mobile factor that can move between sectors.

The Specific Factors Model (cont.) How much of each good does the economy produce? The production function for steel gives the quantity of steel that can be produced, given any input of capital and labor: Qs = Qs (K, Ls) Qs is the output of steel K is the capital stock Ls is the labor force employed in steel

The Specific Factors Model (cont.) The production function for bread gives the quantity of bread that can be produced given any input of land and labor: Qb = Qb (T, Lb) Qb is the output of bread T is the supply of land Lb is the labor force employed in bread

Production Possibilities How does the economy’s mix of output change as labor is shifted from one sector to the other? When labor moves from bread to steel … bread production falls while output of steel rises.

The Production Function for steel (“c”)

Production Possibilities (cont.) The shape of the production function reflects… the law of diminishing marginal returns. Adding one worker to the production process (without increasing the amount of capital) means that each worker has less capital to work with. Therefore, each additional unit of labor adds less output than the previous one...

Production Possibilities (cont.) Use a four-quadrant diagram to construct production possibilities frontier Lower left quadrant indicates the allocation of labor. Lower right quadrant shows the production function for steel Upper left quadrant shows the corresponding production function for bread. Upper right quadrant indicates the combinations of steel and bread that can be produced.

The Production Possibility Frontier in the Specific Factors Model Output of bread output of steel

Production Possibilities (cont.) Why is the production possibilities frontier curved? Diminishing returns to labor in each sector cause the opportunity cost to rise when an economy produces more of a good. Opportunity cost of steel in terms of bread is the slope of the production possibilities frontier – the slope becomes steeper as an economy produces more steel.

Prices, Wages, and Labor Allocation At the production point, the production possibility frontier must be tangent to a line whose slope is minus the price of steel divided by that of bread. slope = MRT = -PBPB

Production in the Specific Factors Model Output of bread slope = -(Ps/Pb)1 Qb1 Qs1 Output of Steel

Prices, Wages, and Labor Allocation (cont.) What happens to the allocation of labor and the distribution of income when the prices of bread and steel change? Two cases: An equal proportional change in prices A change in relative prices

Prices, Wages, and Labor Allocation (cont.) When both prices change in the same proportion, no real changes occur. The wage rate (w) rises in the same proportion as the prices, so real wages (i.e., the ratios of the wage rate to the prices of goods) are unaffected. The real incomes of capital owners and landowners also remain the same.

Prices, Wages, and Labor Allocation (cont.) When only Ps rises, labor shifts from the bread sector to the steel sector and the output of steel rises while that of bread falls.

Response of Output to a Change in the Relative Price of steel Output of bread slope = -(Ps/Pb)1 Qb1 Qb2 slope = -(Ps/Pb)2 Qs1 Qs2 Output of Steel Relative Price of steel up … output of steel up…

Prices, Wages, and Labor Allocation What is the economic effect of this price increase on the incomes of the following three groups? Workers, owners of capital, and owners of land

Prices, Wages, and Labor Allocation (cont.) Owners of capital are definitely better off. Landowners are definitely worse off. Workers: cannot say whether workers are better or worse off: Depends on the relative importance of steel and bread in workers’ consumption.

International Trade in the Specific Factors Model Trade and Relative Prices Free trade relative price of steel is determined by the intersection of world relative supply of steel and world relative demand. Opening up to trade increases the relative price of steel in an economy whose relative supply of steel is larger than for the world as a whole.

Trade and Relative Prices of steel, Ps/Pb (Ps/Pb)2 (Ps/Pb)1 Relative quantity of steel, Qs/Qb

International Trade in the Specific Factors Model (cont.) Gains from Trade Without trade, the economy’s output of a good must equal its consumption. International trade allows the mix of steel and bread consumed to differ from the mix produced.

International Trade in the Specific Factors Model (cont.) The economy as a whole gains from trade. It is able to afford amounts of steel and bread that the country is not able to produce itself. (Just as we saw with H-O) The budget constraint with trade lies above the production possibilities frontier

Income Distribution and the Gains from Trade International trade shifts the relative price of steel to bread, so factor prices change. Trade benefits the factor that is specific to the export sector of each country, but hurts the factor that is specific to the import-competing sectors. Trade has ambiguous effects on mobile factors.

THE SPECIFIC-FACTORS MODEL The results arising from the existence of specific factors are short-run effects The existence for specific factors helps explain why some groups resist free trade Owners of abundant factors are likely to favor free trade Owners of scarce factors are likely to favor trade restrictions

Income Distribution and the Gains from Trade (cont.) Trade benefits a country by expanding choices. Possible to redistribute income so that everyone gains from trade. Those who gain from trade could compensate those who lose and still be better off themselves. That everyone could gain from trade does not mean that they actually do – redistribution usually hard to implement.

The Political Economy of Trade: A Preliminary View Income Distribution and Trade Politics Typically, those who gain from trade are a much less concentrated, informed, and organized group than those who lose. Example: Consumers and producers in the U.S. sugar industry, respectively Governments usually provide a “safety net” of income support to cushion the losses to groups hurt by trade (or other changes). Most economists strongly favor free trade.