Supplementary notes Chapter 4

Heckscher-Ohlin Model Resource endowment as the key to comparative advantage Two factors of production: Labor and Land The PPF is no longer a straight line. The opportunity cost in production increases as more of a product is produced. Why? More than one factor of production Possibility of substitution between the factors

Factor Intensity and Factor Abundance Assumption. Cloth is labor intensive and Food is land intensive. Assumption. Home is labor abundant, Foreign is land abundant: L/T > L*/ T* Assumption. The resource endowment is the only difference in the two countries. They share the same technology, same preferences, etc. In the textbook, the two factors are LABOR and LAND. the two goods are CLOTH and FOOD. the two countries are HOME and FOREIGN.

Factor Prices, Input Choices

Factor Prices and Goods Prices

Factor Prices, Goods Prices and Input Choices Suppose the price of cloth relative to the price of food is calculated as (PC/PF)1. If we also know the direct relationship between relative goods prices and relative factor prices given by the SS curve, then we can determine relative factor prices--the wage/rental ratio. Once we determine the wage/rental ratio and determine the CC and FF curves, we can determine the land to labor ratio in both the cloth and food industries. In sum, given goods prices, we can determine not only factor prices, but factor levels in the Heckscher-Ohlin model.

Relative Prices before and after trade

Equilibrium Production equilibrium Consumption equilibrium Occurs where the relative price and the slope of the PPF (the opportunity cost) are equal Consumption equilibrium Occurs where the relative price and the slope of an indifference curve (consumers’ relative evaluation) are equal

Equilibrium in autarky Occurs where the PPF and an indifference curve are tangent to each other and thus have the same slope. The equilibrium relative price is determined by the tangent line.

Autarky A: Home B: Foreign S: Cloth T: Food

The Heckscher-Ohlin Theorem A country has comparative advantage in the product which makes intensive use of productive factors with which it is abundantly endowed with. Home  labor abundant  CA in cloth which is labor intensive Foreign  land abundant  CA in food which is land intensive

Trade Equilibrium Home Foreign Initial condition RP of C low high Comp Adv. C F With Trade RP of C rises falls Production of C increases decreases Production of F decreases increases

Trade Equilibrium

The Factor Price Equalization Theorem H F Initial Wage low high Rental high low With trade Wage rises falls Rental falls rises Free trade leads to the international equalization of individual factor prices. Wages are equalized across countries even if there is no international mobility of labor.

Why factor prices are NOT equalized internationally? List the assumptions of the HO model Which of them are crucial for the factor price equalization theorem?

The Stolper-Samuelson Theorem In Home, abundant in labor, wages rise while rentals fall with trade. This benefits workers (the abundant factor) and hurts land owners (the scarce factor). The rise in wage is greater than the increase in the price of cloth. Thus, real income of workers increases in either good. The fall in rental is greater than the fall in the price of food. Thus, real income of capital owners declines in either good.

Political Economy of Trade Who will be more likely to oppose free trade? the owners of scarce factors of production the producers of import-competing products the consumers of export products Who will be free traders? the owners of abundant factors of production the producers of export products the consumers of import products In Home, Anti-trader will be: Land owners Food producers (both employers and employees) Cloth consumers Free traders are: Workers Cloth producers Food consumers

Gains from trade In the HO model, some gain and some lose from trade. Does the nation as whole gain or lose from trade? How to show it?

Trade and Income Distribution In the U.S. High skill labor – abundant factor Low skill labor – scarce factor The wage distribution has become more unequal since the late 70s. This is consistent with the Stolper-Samuelson Theorem. Does it mean that trade is responsible for the above trend?

The Leontief Paradox