1 ECONOMICS 3150C Lecture 6 November 11

2 Heckscher-Ohlin Model 2X2X2 model –Two countries –2 factors of production –2 products – different factor intensities –Identical production technologies and state of technology –Different relative resource availabilities: {X1/X2} A  {X1/X2} B Basis for trade: different resource availabilities which give rise to different pre-trade relative prices –Comparative advantage: interaction between relative abundance (supply) of resources (factors of production) and technology of production (relative intensity with which different factors of production used in production of different goods)

3 Heckscher-Ohlin Model Factor intensity: {X1/X2} i –Min TC = P(X1)X1 + P(X2)X2 s.t. 0 Y1 = F 1 (X1, X2, T) –Factor intensity determined by intersection of isoquant and budget line –Constant returns to scale and factor intensity Factor intensity {X1/X2} 1 depends upon {P(X2)/P(X1)} –If {P(X2)/P(X1)}   {X1/X2} 1  Relative prices of factors of production depend upon relative availabilities of factors of production –If {X1/X2} A   {P(X2)/P(X1)} A 

4 Heckscher-Ohlin Model Relative prices of products {P1/P2} depend upon relative prices of factors of production [P=MC] {P(X1)/P(X2)} and relative factor intensities –Assume Y1 uses X1 relatively more intensively than Y2  {X1/X2} 1 > {X1/X2} 2 –As {P(X1)/P(X2)}  so too does P1/P2

5 Heckscher-Ohlin Model If {X1/X2} A > {X1/X2} B then {P(X1)/P(X2)} A < {P(X1)/P(X2)} B and {P1/P2} A < {P1/P2} B –A has comparative advantage in Y1 (Y1 uses X1 relatively more intensively and A has relative abundance of X1) –A will export Y1 and import Y2 –Specialization not necessary outcome even if one of the countries is a small country and the other is a large country –Trade will tend to equalize relative prices of products and factors of production

6 Heckscher-Ohlin Model Winners and losers –Net utility/income gains –Full employment and no transition costs –  D for Y1 post-trade   D for X1 in A  P(X1) in A –  S of Y2 post-trade   D for X2 in A   P(X2) in A Welfare effects of changes in terms of trade: {P1/P2} for A –Assume improvement in terms of trade for A –Leads to improvement in aggregate welfare in A and increase in trade volumes –Implications for income distribution between X1 and X2  D for X1 in A  D for X2 in A

7 Heckscher-Ohlin Model Increase in availability of factors of production in country A 1.Proportionate increase in both factors of production  no change in relative availabilities Increase in volume of trade Change in terms of trade  deterioration because of  S of Y1 from country A and  D for Y2 from country A 2.Increase in X1 (or disproportionate increase in X1) Biased growth Change in shape of PPF for country A  change in relative prices, change in terms of trade Larger impacts on volume of trade and terms of trade Growth leads to more trade

8 Heckscher-Ohlin Model Determinants of relative abundance of factors of production Natural resources including climate –Exploration/development –Climate change Labor –Skill level –Education, training –Population growth, demographics Capital –Types –Investment Technology –R&D Production, products

9 Economic Growth Long-term growth: –Growth in availability and use of factors of production Investment decisions Immigration policies Labor force participation –Improvements in quality of factors of production (human capital, technology) –Improvements in efficiency in use of factors of production (management, organizational structure and incentives) –New/better products, new production technologies, new ways of doing business –Changes in composition of production, with shifts towards sectors with above average levels of productivity (output per unit of input) –Improvements in competitiveness of domestic firms – higher profits (increase returns on capital)

10 Productivity Productivity growth depends on innovativeness and competitiveness of domestic firms – competitive strategies and creation of competitive advantage –Innovation: developing and successfully introducing new products, new production processes, organizational structures, distribution networks, etc. –Enhanced competitiveness resulting from adopting new production processes, new logistic arrangements, distribution networks, etc. Successful competitive strategies (cost, differentiation, niche) result in productivity gains –Cause-effect: development and execution of strategies enhances competitive position, producing measured productivity gains

11 Productivity “Luddite” Paradox: real labor compensation depends upon growth in labor productivity, but in short run with no increase in aggregate demand, growth in labor productivity translates into decrease in demand for labor –Productivity growth enhances competitive position of companies and so enables them to increase market share, value added (profit margin) –Productivity growth increases demand by increasing global market share –In absence of productivity growth, competitive positions of companies and country decline, and so either real income levels must decline to offset reduced competitiveness, or market shares decline and so too do demand and employment Higher productivity growth rates do not have to result in lower employment

Contributions to GDP Growth GDPLaborCapitalMulti-factor productivity Canada2.6%1.2%1.1%0.4% Australia France Germany Ireland Italy Japan Portugal Spain Sweden UK US

Unemployment UR 1995 UR 2008 Multi-factor productivity Canada9.5%6.1%0.4% Australia France Germany Ireland Italy Japan Portugal Spain Sweden UK US

14 Tariffs Tax on imports (ad valorem vs. per unit) Increases the relative price of the imported good within a country in comparison to the international traded prices –Relative prices in international market: {P1/P2} –Relative prices in country A (A imports Y2): {P1/[(1+  )P2]} Ignores possible effects on terms of trade –Reduces demand for Y2  if A a large country, P2 decreases so part of tariff paid by foreign producers (improvement in terms of trade); if A small country, world prices unaffected, so tariff paid by domestic consumers –Increase in D for X2 (factor used more intensively in production of Y2) in A   production of Y2 in A and  production of Y1 (because of change in relative prices in A) –Country B prefers to impose export tax (  %): generates same effects on relative prices but revenues collected by foreign country

15 Export Subsidy Negative tax on exports (ad valorem vs. per unit) – auto bailouts Decreases the relative cost of the exported good –Relative prices in international market: {P1/P2}  if unchanged,  profits in production of export product (Y1 for country A) Relative prices facing exporters in country A: {[P1(1+  )]/P2} Ignores possible effects on terms of trade –Increases S of Y1  if A a large country, P1 decreases so importers in country B benefit (decline in terms of trade); if A small country, world prices unaffected –Increase in D for X1 (factor used more intensively in production of Y1) in A   production of Y1 in A and  production of Y2 (because of change in relative prices in A) –Distortions created by need to raise tax revenues – tax systems creates distortions in decision-making and consumes resources  lowers PPF in A (efficiency losses)

16 Export Subsidy Regional Jets (RJs): Canada vs. Brazil Large Jets: Boeing vs. Airbus Why has Canada (US) attacked Brazil’s (EU’s) subsidization of Embraer (Airbus) and production of RJs (A380s and A350s)? –Canada (US) an exporter, not an importer –Deterioration in terms of trade –Regional income effects since Bombardier a Quebec-based company Why does Brazil (EU) provide export subsidies which reduce relative prices of RJs (wide-body jets)?

17 Industrial Policy  Comparative advantage can be created by combination of government policies and corporate competitive strategies – investment in skilled labour, specialized forms of capital, R&D/technology Competitive advantage vs. comparative advantage Porter: Competitive advantage of nations –Factor endowments –Demand conditions – sophisticated domestic market  better quality goods with higher income elasticities –Firm strategy and rivalry – strong rivalry  innovative firms –Related and supporting industries – industrial clusters  economies of scale, agglomeration benefits

18 Industrial Policy Comparative advantage can change over time: –Changes in relative supplies/productivities of factors of production –Changes in technology –Country-specific Competitive advantage – firm/ownership advantages to compete in foreign markets –Technological capacity, entrepreneurial talents –Product innovations – new varieties, change in tastes –First mover advantages and learning curve Country-specific characteristics can generate/sustain form-specific advantages – e.g. government policies re. investment in R&D, capital gains taxation, training

19 Industrial Policy R&D as factor of production –Comparative advantage in R&D-intensive products not pre- determined; combination of following –Firm specific advantages –Country-specific advantages

20 R&D Growth in real GDP per capita –Static (one-time gains) free trade gains including specialization, economies of scale, increased competition and decrease in X-inefficiency, increase in number of varieties –Dynamic gains – innovation, learning curves –Growth in in real income per capita: growth in capital per capita; productivity growth (residual) Productivity growth most important Learning curves Improvements in management Improvements in utilization of labor and capital

21 Industrial Policy Objective of industrial policy: engineering competitive advantage to increase growth rate of real Y per capita (growth rate of productivity) Industrial policy must correct market failures – otherwise, functioning of markets (continuous search for unexploited opportunities/economic rents) will maximize growth rate of real GDP per capita

22 New Trade Theory Economies of Scale External economies of scale – clustering effects –Productivity levels within each firm depends on size of industry – min. AC depends upon size of industry –Compatible with perfect competition –Specialized suppliers – feasible with larger market of customers –Labor market pooling – multiple employment opportunities reduce unemployment risks for labor with specialized skills, increase availability of such workers –Knowledge spillovers – informal diffusion through personal contacts

23 New Trade Theory Economies of Scale Internal economies of scale – production, distribution, R&D –Productivity levels within each firm depend upon size of each firm –Learning curves – dynamic increasing returns –Economies of scale stem from selection of production technology Information re. available technologies R&D to generate new technologies –Not compatible with perfect competition

24 Economies of Scale: Imperfect Competition Internal economies of scale Natural monopoly case –Pricing: P > MC –X-inefficiency  incentives for senior management Oligopoly case –Minimum efficient scale of operations (MES) –Interaction between size of market and MES determines number of firms –P > MC  depending on oligopoly model (Cournot, Stackelberg, Bertrand, game theory – fixed end-point, repetated, indefinite end-point)

25 Models of Imperfect Competition Profit Maximization Monopoly Oligopoly – interdependence –Cournot model: output competition  P > MC –Bertrand model: price competition  P = MC –Prisoners’ dilemma  P = MC –Repeated version of P.D. Fixed endpoint  P = MC Indefinite endpoint  P > MC

26 External Economies of Scale Small country-large country model Assumptions: –Two countries: A (small country); B (large country) –Two factors of production –Two products –Same tastes –Same production technologies –Same relative availabilities –Y1: external economies of scale –Y2: constant returns to scale

27 External Economies of Scale  i : unit cost (AC) for product i [  1 ] A > [  1 ] B [  2 ] A = [  2 ] B Perfect competition: P = AC (zero economic profits) –P i =  i  {P1/P2} A > {P1/P2} B Country B has comparative advantage in Y1, country A in Y2 –Large country will produce Y1 to fully exploit economies of scale Industry 1 expands in country with initial cost advantage (B) and contracts in the other (A) –Gains from trade result from expansion of industry with external economies of scale

28 Internal Economies of Scale Small country-large country model Assumptions: –Two countries: A (small country); B (large country) –Two factors of production –Two products –Same tastes –Same production technologies –Same relative availabilities –Y1: internal economies of scale –Y2: constant returns to scale

29 Internal Economies of Scale Internal economies of scale for Y1  imperfect competition –P1 > AC1 =  1 No assurance that {P1/P2} A > {P1/P2} B –Monopolist: may produce Y1 in both A and B, but not necessarily with same technologies  different degrees of economies of scale Competitive advantage  How was monopoly position obtained? –Oligopoly: possible that more than one firm will produce Y1 in the large country because economies of scale may be exploited at well below market demand level (MES < D) P/AC may be lower than in case of monopoly  depends on degree of rivalry Smaller number of oligopolists in small country, thus P/AC margin may be greater than in large country Competitive advantage  How did oligopolists arise?