1. Slide 4-1Copyright © 2003 Pearson Education, Inc. Introduction  In the real world, while trade is partly explained by differences in labor productivity, it also reflects differences in countries’ resources.  The Heckscher-Ohlin theory: Emphasizes resource differences as the only source of trade Shows that comparative advantage is influenced by: –Relative factor abundance (refers to countries) –Relative factor intensity (refers to goods) Is also referred to as the factor-proportions theory

2. Slide 4-2Copyright © 2003 Pearson Education, Inc.  Assumptions of the Model An economy can produce two goods, cloth and food. The production of these goods requires two inputs that are in limited supply; labor (L) and land (T). Production of food is land-intensive and production of cloth is labor-intensive in both countries. Perfect competition prevails in all markets. A Model of a Two-Factor Economy

3. Slide 4-3Copyright © 2003 Pearson Education, Inc. One unit Input combinations that produce one calorie of food Unit land input a TF, in acres per calorie Unit land input a LF, in hours per calorie A Model of a Two-Factor Economy Input Possibilities in Food Production: In each sector producers do not face fixed labor requirement. They can trade off one input for the other given the input possibilities curve below. //Two units

4. Slide 4-4Copyright © 2003 Pearson Education, Inc. Factor Intensity –In a world of two goods (cloth and food) and two factors (labor and land), food production is land- intensive, if at any given wage-rental ratio the land- labor ratio used in the production of food is greater than that used in the production of cloth: T F /L F > T C / L C A Model of a Two-Factor Economy

5. Slide 4-5Copyright © 2003 Pearson Education, Inc. CC FF Wage-rental ratio, w/r Land-labor ratio, T/L A Model of a Two-Factor Economy: : Relation between factor intensity and wage-rental ratio Figure 4-2: Factor Prices and Input Choices

6. Slide 4-6Copyright © 2003 Pearson Education, Inc. SS Relative price of cloth, P C /P F Wage-rental ratio, w/r A Model of a Two-Factor Economy: Relation between relative goods prices and factor prices Figure 4-3: Factor Prices and Goods Prices

7. Slide 4-7Copyright © 2003 Pearson Education, Inc. FF CC SS Land- labor Ratio, T/L Relative price of cloth, P C /P F Wage-rental ratio, w/r (P C /P F ) 1 (T C /L C ) 2 (T C /L C ) 1 (T F /L F ) 2 (T F /L F ) 1 (w/r) 2 (w/r) 1 Increasing A Model of a Two-Factor Economy Figure 4-4: From Goods Prices to Input Choices (P C /P F ) 2

8. Slide 4-8Copyright © 2003 Pearson Education, Inc.  An increase in the price of cloth relative to that of food, P C /P F,will: Raise the income of workers relative to that of landowners, w/r. Raise the ratio of land to labor, T/L, in both cloth and food production and thus raise the marginal product of labor in terms of both goods. Raise the purchasing power of workers and lower the purchasing power of landowners, by raising real wages and lowering real rents in terms of both goods. A Model of a Two-Factor Economy