4 1 Heckscher-Ohlin Model 2 Effects of Trade on Factor Prices 3 Extending the Heckscher-Ohlin Model 4 Conclusions Trade and Resources: The Heckscher-Ohlin Model Readings: Chap. 4, sections 1,3, plus Figure 4-6, 4-7, & related discussions.

© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor Why Resources? http://www.whitehouse.gov/raise-the-wage © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

© 2007 Worth Publishers ▪ International Trade ▪ Feenstra/Taylor Skill Premium in the U.S. Figure 7.6 © 2007 Worth Publishers ▪ International Trade ▪ Feenstra/Taylor

© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor Why a new Model? The specific factor model in the last chapter was a short run model since capital could not move between industries Our new model is a long run model because all inputs (factors) of production can move between the industries So our new model offers new perspectives about income inequality, and how U.S. trade policies are set. © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor Road Map Part 1 Assumptions and key elements of the model No-Trade Equilibrium Free Trade Equilibrium Part 2 How does trade affect wage and capital earning? Part 3 Who gain and who lose from trade? Part 4 How to measure factor abundance © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Heckscher-Ohlin Model There are two countries, Home and Foreign Each country produces two goods, computers and shoes Production uses two inputs (factors) of production, capital and labor © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Assumption 1. Mobile Factors Both factors (inputs) can move freely between industries Capital must earn the same rental rate, R, in both industries All labor earns the same wage in both industries Supply of capital = total capital employment = KC + KS Supply of labor = total labor employment = LC + LS © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Diminishing Returns & Labor Demand Diminishing returns still apply Holding KC constant © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Diminishing Returns & Capital Demand Diminishing returns still apply Holding LC constant © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Substitution in Production Suppose W is high and R is low. Do we want a lot of labor in production, or a lot of capital in production? © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Substitution and Relative Demand for Labor The relative demand for labor by the computers industry As labor becomes more expensive relative to capital, decrease LC and increase KC © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Substitution and Marginal Products We have seen that as W/R increases, KC increases and LC decreases. So MPL and MPK must adjust So as KC/LC is high MPLC is also high. However, KC/LC is high, MPKC is low. © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Assumption 2. Labor Intensity Shoe production is labor-intensive; it requires more labor per unit of capital to produce shoes than computers, so that LS/KS > LC/KC for the same W and R © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Relative Demand Curves Figure 4.1 © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor Notes: Assumption 2 Computer production is capital-intensive – more capital per worker is used to produce computers than to produce shoes Shoes production uses more labor per unit of capital Figure 4.1 shows relative demand curves for labor in each industry Because shoe production is more labor intensive, the relative demand curve for shoes lies to the right of the labor demand for computers © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Assumption 3. Labor Abundance Foreign is labor abundant; the labor-capital ratio in Foreign exceeds that in Home. Equivalently, Home is capital abundant. This means Intuitively, what is Home good at producing? What is Foreign good at producing? © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Assumption 3. Labor Abundance Output of Computers, QC Output of Shoes, QS Home’s PPF © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Assumption 3. Labor Abundance Foreign’s PPF Output of Shoes, QS Output of Computers, QC © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor Notes: Assumption 3 Production Possibility Frontier Home is capital abundant and computer production is capital intensive Home is better at producing computers than shoes Foreign is labor-abundant and shoe production is labor-intensive Foreign is better at producing shoes © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor Assumption 4. Free Trade Shoes and computers can be traded freely, without restrictions, between nations, but labor and capital do not move between countries. © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Assumption 5. Same Technology The technologies used to produce the two goods are identical across the countries. By “technology” we mean the input-output relationship. © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor Assumption 6. Same Taste Consumer tastes are the same across countries; i.e. Home and Foreign have the same set of indifference curves © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

closed-economy equilibrium Figure 4.2 © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Notes: closed-economy equilibrium Consumer tastes are the same across countries, so the shape of the indifference curves is the same The tangency with the country’s PPF is different because of the different shapes of the PPF’s When the indifference curves are tangent to the PPF, the slopes are equal The relative price that consumers are willing to pay for computers equals the opportunity cost of producing them – the no trade equilibrium The slope at tangency equals the relative price of computers – steeper the slope, the higher the relative price of computers © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Notes: closed-economy equilibrium Equilibrium Price Before Trade Different relative prices exist in each country because of the different shapes of the PPF’s At Home, the slope of the Home price line (PC/PS) is quite flat Low relative price of computers In Foreign, the slope of the price line (PC*/PS*) is quite steep High relative price of computers The no-trade relative price of computers at Home is lower than in Foreign The No trade relative price of shoes at Home is higher than in Foreign © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Summary: closed-economy equilibrium Home has comparative advantage in computers Why? (1) Computers require a lot of capital in production. (2) Home has a lot of capital. How does the price of computers change as Home opens up to trade with Foreign? © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Free-trade Equilibrium Going into Free Trade For the Home country, the price of computers goes up (relative to the price of shoes) © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Free-trade Equilibrium Home can now increase their utility by increasing consumption because of trade New consumption is now at point C consuming more shoes and the same amount of computers When trade opens, Home now faces the World Price. New production moves to point B increasing Q of Computers and decreasing Q of Shoes We start with Free Trade Equilibrium for Home Output of Shoes, QS World price line, slope = (PC/PS)W U2 C QS3 =QC3 QS1 A U1 B QS2 QC2 QC1 Output of Computers, QC © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Heckscher-Ohlin Theorem Pattern of Trade Home exports computers – the good that uses their abundant factor of production intensively – capital Foreign exports shoes – the good that uses their abundant factor of production intensively – labor This is the Heckscher-Ohlin Theorem: With two goods and two factors, each country will export the good that uses intensively the factor of production it has in abundance, and will import the other good © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor Summary Part 1 Diminishing Returns: how does marginal product of capital (labor) change with capital and labor employments? Substitution between capital and labor in production Why PPF of Home differs from PPF of Foreign? Labor intensity and labor abundance. © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

How does trade affect W and R? When trade opens: The relative price of computers in Home rises This gives home an incentive to produce more computers Assume that PC rises and PS does not change © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

How does trade affect W and R? Framework We can use the relative demand for labor in each industry to derive an economy-wide relative demand for labor We can then compare it to the economy-wide relative supply of labor, L/K This will determine Home’s relative wage and what happens after the relative price of computers changes © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Relative Demand for Labor Wage Rental LS /KS LC /KC Labor/Capital © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Relative Demand for Labor Economy-Wide Relative Demand for Labor The quantities of labor and capital used in each industry add up to the total available labor and capital K = KC + KS and L = LC + LS We can divide total labor by total capital to get the relative supply equal to the relative demand Relative Supply Relative Demand © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Relative Demand for Labor Wage Rental W/R A LS /KS RD LC /KC Economy-wide relative demand for labor Labor/Capital © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Notes: Relative Demand for Labor Home country’s relative demand is a weighted average of the labor-capital ratio to each industry This weighted average is obtained by multiplying the labor-capital ratio for each industry by KC/K and KS/K. The weights reflect the industries’ importance in Home’s economy. The Home country’s relative demand curve, therefore, lies between the relative demand curves of the two industries, computers and shoes. © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Notes: Relative Demand for Labor The equilibrium wage is determined by the intersection of the relative supply (L/K) and the relative demand curves in Home Where the curves intersect gives the wage relative to the rental: W/R Point A describes an equilibrium in the labor an capital markets – it combines these 2 markets into a single diagram. © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

How does trade affect W and R? Work Backwards W and R determined by RD RD has 3 components, relative labor demand by computers, relative labor demand by shoes, and their weights The weights depend on capital employments, or total outputs © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

How does trade affect outputs? Figure 4-11 © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor How does RD shift? Wage Rental (W/R)1 L/K The increase in the output of computers causes the relative demand curve to shift left – toward computers RD1 RD2 A (W/R)2 B LS /KS LC /KC Labor/Capital © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor How does L/K change? Wage Rental (W/R)1 L/K The decrease in w/R increases the amount of workers per unit of capital in both industries A (W/R)2 B (LC/KC)2 (LS/KS)2 LS /KS LC /KC (LC/KC)1 (LS/KS)1 Labor/Capital © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Shifting of RD and Change of L/K (Animation) Wage Rental (W/R)1 L/K Initial equilibrium before change in relative price of computers The real wage falls which increases the amount of workers per unit of capital in both industries The increase in the relative price of computers causes the relative demand curve to shift left – toward computers RD1 RD2 A (W/R)2 B (LC/KC)2 (LS/KS)2 LS /KS LC /KC (LC/KC)1 (LS/KS)1 Labor/Capital © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Notes: How does RD shift after trade? PC/PS increases at Home (Assume that PC increases and PS does not change) Production shifts away from shoes to computers Shoe production decreases and computer production increases Labor and capital both move from shoe production to computer production Relative labor supply does not change Since capital has shifted to the computer industry, the relative demand for labor changes The terms used in the weighted average, KC/K and KS/K, change © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Notes: How does RD shift after trade? The relative demand for labor is now more weighted toward computers The relative demand for labor is now less weighted toward shoes The relative demand curve shifts left from RD1 to RD2 Shifts in the direction of computers Equilibrium moves from point A to B © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

How does trade affect W and R? Result 1: W/R decreases Intuition: Computers industry expands, shoes industry contracts Computers industry accounts for larger fraction of economy, and it is capital intensive This reduces relative demand for labor. © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

How does trade affect W and R? Result 2: the labor-capital ratio rises in both shoes and computers The relative labor demand curves of shoes and computers do not shift. We move along them. Intuition: substitution As W/R decreases, labor is cheaper relative to capital Both industries substitute labor for capital in production © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Summary part 2 Relative demand for labor What does it mean? How is RD constructed? How does RD shift when trade opens up? Key Results for effects of trade on Home Assumption: PS unchanged, PC rises W/R falls L/K ratios rise for both industries

Winners and Losers from trade: Home Determination of the Real Wage and Real Rental Assumption: PC rises but PS does not change We need to determine how the real wage and real rental rate change © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor Real Wage Change in the Real Wage As before the wage is determined by the marginal product of labor and the price of goods W = PC*MPLC and W = PS*MPLS Rearranging MPLC = W/PC, MPLS = W/PS So real wage equals marginal product of labor © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor Notes: Real Wage Change in the Real Wage W/PC is the quantity of computers that can be purchased the with wage W/PS is the quantity of shoes that can be purchase with the wage Again we make use of the fact that the labor/capital ratio increases in both industries Therefore, the marginal product of labor must decrease in both industries MPLC and MPLS decrease, so W/PC and W/PS decrease Labor is clearly worse off due to the increase in the price of computers; i.e. W/PS decreases This means ΔW/W < ΔPS/PS = 0. © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor Real Rental Rate Change in the Real Rental The rental rate of capital is determined as R = PC*MPKC R = PS*MPKS Rearranging MPKC = R/PC, MPKS = R/PS So real rental rate equals marginal product of capital © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Notes: Real Rental Rate Change in the Real Rental we make use of the fact that the labor/capital ratio increases in both industries Therefore, the marginal product of capital must increase in both industries R/PC measures the quantity of computers that can be purchased with the rental. R/PS measures the quantity of shoes that can be bought with the rental Since the MPKC and MPKS both increase, R/PS and R/PC must increase as well Therefore, capital owners are clearly better off when rental rate increases relative to wage. This means ΔR/R > ΔPC/PC > 0. © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Summary: Winners and Losers from Trade: Home When trade opens up with Foreign, PC rises. We can assume that PS does not change (i.e. ΔPS/PS = 0), ΔW/W < 0 < ΔPC/PC < ΔR/R Real wage falls, real rental increases © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Summary: Winners and Losers from Trade The Stolper-Samuelson Theorem In the long run when all factors are mobile, an increase in the relative price of a good will increase the real earnings of the factor used intensively in the production of that good and decrease the real earnings of the other factor. The Heckscher-Ohlin model The abundant factor gains from trade, and the scarce factor loses from trade © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Summary: Winners and Losers from Trade Friends and enemies Computers Shoes Capital Friends Enemies Labor © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Application: Support for and Opposition to Free Trade ΔW/W < 0 < ΔPC/PC < ΔR/R This shows how changes in the prices of goods have magnified effects on the earnings of factors (so it is called the “magnification effect”) This shows why some are opposed to trade and some support it. © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Congressional Voting for Free Trade Vote for NAFTA Vote for GATT Actual 229 283 Predicted by Model 290 Without Labor Contributions 291 346 Without Business Contributions 195 257 NAFTA is in 1993. GATT is in 1994. House of representatives. Positions of labor and business were very clear: labor against, business for. Point: without labor contributions, more would have voted for free trade. Without business contributions, more would have opposed free trade. Source: “Is Trade Policy for Sale? Congressional Voting on Recent Trade Bills”, Robert E. Baldwin and Christopher S. Magee, NBER working paper 6376.

Summary Part 3 Home continues to make both computers and shoes after trade Real wage depends on MPLC and MPLS Real rental rate depends on marginal products of capital Who win and who lose from trade? Friends and enemies

How to measure factor abundance? Measuring Factor Abundance How should we measure factor abundance when there are many countries and many factors? To determine whether a country is abundant in a certain factor, we count the quantities of that factor We then compare the country’s share of that factor with its share of world GDP If the share of a factor > share of world GDP The country is abundant in that factor If the share of factor < share of world GDP The country is scare in that factor © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

measure factor abundance. Fig. 4-6 Figure 4.9 © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor Notes: Figure 4-6 Capital Abundance We can use the data in Figure 4.6 For example, 24% of the world’s physical capital is located in the US, 8.7% is located in china, 13.3% in Japan, etc. The final bar in the graph shows the % of each country in world GDP In the US had 21.6% of world GDP, China had 11.2%, Japan had 7.5%, etc. We can conclude that the US was abundant in physical capital in 2000 © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor Notes: Figure 4-6 Capital Abundance This is true for Japan and Germany The opposite holds for China and India – their shares of world capital are less than their share of GDP and so they are scarce in capital Other Inputs/factors We can use a similar comparison to determine whether each country is abundant or not in R&D scientists, in types of labor distinguished by skill, in arable land, or any other factor of production © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor Puzzle China is abundant in R&D scientists! © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Puzzle Solved: Effective Labor Force R&D scientists are not the same in China and the U.S. e.g. 1 U.S. scientist = 2 Chinese scientists If labor is highly productive in the US and less productive in the rest of the world, the effective labor force in the US is much larger than if we just count people © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor Effective Labor Force Effective labor force is number of workers times worker productivity The amount of effective labor in the world is found by adding up the effective factor endowments across all countries we compare the country’s share of that effective factor with share of world GDP If share of an effective factor is less than its share of world GDP then that country is abundant in that effective factor If share of an effective factor is less than its share of world GDP, then that country is scarce in that effective factor © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

measure factor abundance. Fig. 4-7 Figure 4.10 © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor Notes: Figure 4-7 Effective R&D Scientists The effectiveness of an R&D Scientist depends on what they have to work with One way to measure this is through a country’s R&D spending per scientist If more spending, then scientist will be more productive Take the total number of scientists and multiply that by the R&D spending per scientists Figure 4-7 shows these shares With these productivity corrections, the US is more abundant in effective R&D scientists and China is lower © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Part 4 Summary How to measure factor abundance? Compare share of labor (capital, land, etc.) with share of GDP Supply of effective labor (land, etc.)