Slide th Sept Copyright © 2003 Pearson Education, Inc.  Resources and Output How is the allocation of resources determined? –Given the relative price of cloth and the supplies of land and labor, it is possible to determine how much of each resource the economy devotes to the production of each good. A Model of a Two-Factor Economy

Slide th Sept Copyright © 2003 Pearson Education, Inc. LFLF TFTF LCLC TCTC Labor used in food production Labor used in cloth production OFOF Increasing Land used in cloth production Land used in food production 1 F C OCOC A Model of a Two-Factor Economy Figure 4-5: The Allocation of Resources

Slide th Sept Copyright © 2003 Pearson Education, Inc.  How do the outputs of the two goods change when the economy’s resources change? Rybczynski Theorem (effect): –If a factor of production (T or L) increases, then the supply of the good that uses this factor intensively increases and the supply of the other good decreases for any given commodity prices. –The reverse is also true. A Model of a Two-Factor Economy

Slide th Sept Copyright © 2003 Pearson Education, Inc. C L2FL2F L2CL2C T1FT1F T1CT1C F1F1 L1FL1F L1CL1C T2FT2F T2CT2C 1 A Model of a Two-Factor Economy Figure 4-6: An Increase in the Supply of Land Labor used in food production Labor used in cloth production Increasing Land used in cloth production Land used in food production F2F2 O1FO1F O2FO2F 2 OCOC

Slide th Sept Copyright © 2003 Pearson Education, Inc. TT 1 TT 2 Output of food, Q F Output of cloth, Q C Slope = -P C /P F 2 Q2FQ2F Q2CQ2C 1 Q1FQ1F Q1CQ1C A Model of a Two-Factor Economy Figure 4-7: Resources and Production Possibilities Outward shift in PPF Biased towards food -good which is more Capital intensive

Slide th Sept Copyright © 2003 Pearson Education, Inc.  An increase in the supply of land (labor) leads to a biased expansion of production possibilities toward food (cloth) production.  The biased effect of increases (decreases) in resources on production possibilities is the key to understanding how differences in resources give rise to international trade.  An economy will tend to be relatively effective at producing goods that are intensive in the factors with which the country is relatively well-endowed. A Model of a Two-Factor Economy

Slide th Sept Copyright © 2003 Pearson Education, Inc.  Assumptions of the Heckscher-Ohlin model: There are two countries (Home and Foreign) that have: –Same tastes –Same technology –Different resources –Home has a higher ratio of labor to land than Foreign does Each country has the same production structure of a two-factor economy. Effects of International Trade Between Two-Factor Economies

Slide th Sept Copyright © 2003 Pearson Education, Inc.  Relative Prices and the Pattern of Trade Factor Abundance –Home country is labor-abundant compared to Foreign country (and Foreign is land-abundant compared to Home) if and only if the ratio of the total amount of labor to the total amount of land available in Home is greater than that in Foreign: L/T > L * / T * –Example: if America has 80 million workers and 200 million acres, while Britain has 20 million workers and 20 million acres, then Britain is labor-abundant and America is land- abundant. –In this case, the scarce factor in Home is land and in Foreign is labor. Effects of International Trade Between Two-Factor Economies

Slide th Sept Copyright © 2003 Pearson Education, Inc. When Home and Foreign trade with each other, their relative prices converge. The relative price of cloth rises in Home and declines in Foreign. –In Home, the rise in the relative price of cloth leads to a rise in the production of cloth and a decline in relative consumption, so Home becomes an exporter of cloth and an importer of food. –Conversely, the decline in the relative price of cloth in Foreign leads it to become an importer of cloth and an exporter of food. Effects of International Trade Between Two-Factor Economies

Slide th Sept Copyright © 2003 Pearson Education, Inc. RD RS RS * Effects of International Trade Between Two-Factor Economies Figure 4-8: Trade Leads to a Convergence of Relative Prices Relative price of cloth, P C /P F Relative quality of cloth, Q C + Q * C Q F + Q * F

Slide th Sept Copyright © 2003 Pearson Education, Inc.  Heckscher-Ohlin Theorem: A country will export that commodity which uses intensively its abundant factor and import that commodity which uses intensively its scarce factor. Effects of International Trade Between Two-Factor Economies