1. Chapter 4: Resources, Comparative Advantage, and Income Distribution
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2. Chapter Organization Introduction A Model of a Two-Factor Economy
Effects of International Trade Between Two-Factor Economies
The Political Economy of Trade: A Preliminary View
Empirical Evidence on the Heckscher-Ohlin Model
Summary
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3. Learning Points Students should be able to
Explain how differences in resources can cause international trade
Discuss why trade often creates losers as well as winners
Understand the meaning of gains from trade when there are losers
Discuss the reasons why trade is a politically contentious issue and the arguments for free trade despite the existence of losers.
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4. 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
Because the theory emphasizes the interplay between the proportions in which different factors of production are available in different countries and the proportions in which they are used in producing different goods, it is also referred to as the factor-proportions theory.
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5. A Model of a Two-Factor Economy
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.
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6. The Production Possibility Frontier
Figure 4-0: Production Possibility Frontier with Factor Substitution
Quantity of Cloth, QC
Quantity of Food, QF TT
Isovalue lines Q
The economy produces at the point that maximizes the value of production given the prices it faces
This is the point on the highest possible isovalue line. At this point, the opportunity cost of cloth in terms of food is equal to the relative price of cloth, PC/PF
Slope =- PC/PF
Slope = -PC/PF
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7. A Model of a Two-Factor Economy
Figure 4-1: Input Possibilities in Food Production
Unit land input aTF ,
in acres per calorie
Unit labour input aLF ,
in hours per calorie //
Input combinations
that produce one
calorie of food
A farmer can produce a calorie of food with less land if he or she uses more labor, and vice versa
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8. A Model of a Two-Factor Economy
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:
TF/LF > TC/ LC
Example: If food production uses 80 workers and 200 acres, while cloth production uses 20 workers and 20 acres, then food production is land-intensive and cloth production is labor-intensive.
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9. A Model of a Two-Factor Economy
Figure 4-2: Factor Prices and Input Choices
Wage-rental
ratio, w/r
Land-labor
ratio, T/L CC FF
Curve FF shows the land-labour ratio choices in food production, CC shows the corresponding choices in the production of cloth. Since CC lies to the left of the FF, at any given factor prices, production of food will always use a higher ratio of land to labor than the production of cloth.
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10. A Model of a Two-Factor Economy
Factor Prices and Goods Prices
Stolper-Samuelson Theorem (effect):
If the relative price of a good increases, holding factor supplies constant, then the nominal and real return (in terms of both goods) to the factor used intensively in the production of that good increases, while the nominal and real return (in terms of both goods) to the other factor decreases.
The reverse is also true.
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11. A Model of a Two-Factor Economy
Figure 4-3: Factor Prices and Goods Prices
Relative price of
cloth, PC/PF
Wage-rental
ratio, w/r SS
Because the cloth production is labour-intensive while food production is land-intensive, there is a one-to-one relationship between the factor price ratio w/r and the relative price of cloth Pc/Pf; the higher the relative cost of labour, the higher must be the relative price of the labour-intensive good. The relationship is illustrated by the curve SS.
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12. A Model of a Two-Factor Economy
Figure 4-4: From Goods Prices to Input Choices
Land-
labor
Ratio, T/L
Relative
price of
cloth, PC/PF
Wage-rental
ratio, w/r CC SS FF
(w/r)2
(PC/PF)2
(TC/LC)2
(TF/LF)2
(w/r)1
Given the relative price of cloth (PC/PF)1 the ratio of the wage rate to the rental rate on land must equal (w/ r) 1. This wage rental ratio then implies that the ratios of land to labor employed in the production of cloth and food must be (TC/Lc)1 and the TF/LF)1 . If the relative price of cloth rises to (PC/PF)2 , the wage ratio must rise to (w/ r) 2 . This will cause the land-labor ratio used in the production of both goods to rise.
(PC/PF)1
(TC/LC)1
(TF/LF)1
Increasing
Increasing
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13. A Model of a Two-Factor Economy
An increase in the price of cloth relative to that of food, PC/PF ,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.
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14. A Model of a Two-Factor Economy
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.
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15. A Model of a Two-Factor Economy
Figure 4-5: The Allocation of Resources
Increasing
Labor used in food production LF TF OF OC F
Increasing C 1
Land used in food production
Land used in cloth production LC TC
Increasing
The sides of the box measure the economy’s total supplies of labor and land. Inputs into cloth production are measured from the lower-left corner; inputs into food production from the upper-right corner.
Given the land-labor ratio in cloth production, TC/LC, the cloth industry’s employment of resources must lie on OC/C, which is the line drawn from the origin with the slope TC/LC.
Similarly, the food industry’s employment of resources must lie on the line OFF. The allocation of resources can therefore be read off point 1, where these lines intersect.
Labor used in cloth production
Increasing
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16. A Model of a Two-Factor Economy
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.
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17. A Model of a Two-Factor Economy
Figure 4-6: An Increase in the Supply of Land
Increasing
Labor used in food production
O2F
L2F
L2C
L1F
L1C F2
O1F OC F1
Increasing
Land used in cloth production
Increasing C 1
T1F
T1C
What is surprising about this result? Notice that the quantities of labour and land used in cloth production actually fall, from L1c and T1c to L2c and T2c (i.e. allocation moves from from 1 to 2). Thus an increase in the economy’s supply of land will, holding prices constant, lead to a fall in the output of the labour-intensive good. The best way to think about it is in terms of how resources affect the economy’s production possibility possibilities (next slide)
Land used in food production
T2F
T2C 2
Labor used in cloth production
Increasing
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18. A Model of a Two-Factor Economy
Figure 4-7: Resources and Production Possibilities
Output of
food, QF
cloth, QC 2
Q2F
Q2C
Slope = -PC/PF
TT2
Slope = -PC/PF 1
Q1F
Q1C
TT1
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19. A Model of a Two-Factor Economy
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.
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20. Effects of International Trade Between Two-Factor Economies
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.
What happens if we introduce trade in to the model?
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21. Effects of International Trade Between Two-Factor Economies
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.
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22. Effects of International Trade Between Two-Factor Economies
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.
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23. Effects of International Trade Between Two-Factor Economies
Figure 4-8: Trade Leads to a Convergence of Relative Prices
Relative price
of cloth, PC/PF
Relative quality
of cloth, QC + Q*C
QF + Q*F RD RS
RS* 1 2 3
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24. Effects of International Trade Between Two-Factor Economies
The Pattern of Trade
In a country that cannot trade, the output of a good must equal its consumption.
International trade makes it possible for the mix of manufactures and food consumed to differ from the mix produced.
A country cannot spend more than it earns.
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25. Effects of International Trade Between Two-Factor Economies
Figure 4-9: The Budget Constraint for a Trading Economy
Consumption of cloth, DC
Output of cloth, QC
Consumption of food, DF
Output of food, QF
Budget constraint
(slope = -PC/PF)
Production possibility curve
Q1C 1
Q1F
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26. Effects of International Trade Between Two-Factor Economies
Figure 4-10: Trading Equilibrium
Quantity of cloth
Quantity of food
Home’s budget constraint
Foreign’s budget constraint
Foreign’s food exports
QFF
QFC
DFF
Home’s food imports
DHF
DFC
DHC
QHF
QHC
Home’s cloth exports
Foreign’s cloth imports
(a) Home
(b) Foreign
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27. Effects of International Trade Between Two-Factor Economies
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.
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28. Effects of International Trade Between Two-Factor Economies
Trade and the Distribution of Income
Trade produces a convergence of relative prices.
Changes in relative prices have strong effects on the relative earnings of labor and land in both countries:
In Home, where the relative price of cloth rises:
Laborers are made better off and landowners are made worse off.
In Foreign, where the relative price of cloth falls, the opposite happens:
Laborers are made worse off and landowners are made better off.
Owners of a country’s abundant factors gain from trade, but owners of a country’s scarce factors lose.
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29. Effects of International Trade Between Two-Factor Economies
Factor Price Equalization
In the absence of trade: labor would earn less in Home than in Foreign, and land would earn more.
Factor-Price Equalization Theorem:
International trade leads to complete equalization in the relative and absolute returns to homogeneous factors across countries.
It implies that international trade is a substitute for the international mobility of factors.
When home and foreign trade with each other, more is happening than just he exchange of goods. In an indirect way, the two countries are more or less in effect trading in factors of production. Home lets foreign have some of its abundant labour, not by selling the labour directly, but by trading goods produced with a high ratio of labour to land for goods produced with a low labour to land. The goods that home sells requires more labour to produce than it receives in return.
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30. Effects of International Trade Between Two-Factor Economies
Has international trade equalized the returns to homogeneous factors in different countries in the real world?
Even casual observation clearly indicates that it has not.
Example: Wages are much higher for doctors, engineers, technicians, mechanics and laborers in the United States and Germany than in Korea and Mexico.
Under these circumstances, it is more realistic to say that international trade has reduced, rather than completely eliminated, the international difference in the returns to homogeneous factors.
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31. Effects of International Trade Between Two-Factor Economies
Table 4-1: Comparative International Wage Rates (United States = 100)
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32. Effects of International Trade Between Two-Factor Economies
Three assumptions crucial to the prediction of factor price equalization are in reality untrue:
Both countries produce both goods
Both countries have the same technologies in production
Both countries have the same prices of goods due to trade
One thing the factor-price equalization theorem does not say is that international trade will eliminate or reduce international differences in per capita incomes.
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33. The Political Economy of Trade: A Preliminary View
Trade often produces losers as well as winners.
Optimal Trade Policy
The government must somehow weigh one person’s gain against another person’s loss.
Some groups need special treatment because they are already relatively poor (e.g., shoe and garment workers in the United States).
Most economists remain strongly in favor of more or less free trade.
Any realistic understanding of how trade policy is determined must look at the actual motivations of policy.
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34. The Political Economy of Trade: A Preliminary View
Income Distribution and Trade Politics
Those who gain from trade are a much less concentrated, informed, and organized group than those who lose.
Example: Consumers and producers in the U.S. sugar industry
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35. Income Distribution and the Gains from Trade revisited
To assess the effects of trade on particular groups, the key point is that international trade shifts the relative price of cloth and food.
Trade benefits the factor that is specific to the export sector of each country, but hurts the factor that is specific to the import-competing sectors.
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36. Income Distribution and the Gains from Trade revisited
Could those who gain from trade compensate those who lose, and still be better off themselves?
If so, then trade is potentially a source of gain to everyone.
The fundamental reason why trade potentially benefits a country is that it expands the economy’s choices.
This expansion of choice means that it is always possible to redistribute income in such a way that everyone gains from trade.
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37. Income Distribution and the Gains from Trade
Figure 4-11: Trade Expands the Economy’s Consumption Possibilities
Consumption of manufactures, DC
Output of cloth, QC
Consumption of food, DF
Output of food, QF PP 2
Q1C
Q1F 1
Budget constraint
(slope = - PC/PF)
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38. Empirical Evidence on the Heckscher-Ohlin Model
Testing the Heckscher-Ohlin Model
Tests on U.S. Data
Leontief paradox
Leontief found that U.S. exports were less capital-intensive than U.S. imports, even though the U.S. is the most capital-abundant country in the world.
Tests on Global Data
A study by Bowen, Leamer, and Sveikauskas tested the Heckscher-Ohlin model using data for a large number of countries.
This study confirms the Leontief paradox on a broader level.
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39. Empirical Evidence on the Heckscher-Ohlin Model
Table 4-3: Factor Content of U.S. Exports and Imports for 1962
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40. Empirical Evidence on the Heckscher-Ohlin Model
Table 4-4: Testing the Heckscher-Ohlin Model
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41. Empirical Evidence on the Heckscher-Ohlin Model
Tests on North-South Trade
North-South trade in manufactures seems to fit the Heckscher-Ohlin theory much better than the overall pattern of international trade.
The Case of the Missing Trade
A study by Trefler in 1995 showed that technological differences across a sample of countries are very large.
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42. Empirical Evidence on the Heckscher-Ohlin Model
Table 4-5: Trade Between the United States and South Korea,
1992 (million dollars)
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43. Empirical Evidence on the Heckscher-Ohlin Model
Table 4-6: Estimated Technological Efficiency,
1983 (United States = 1)
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44. Empirical Evidence on the Heckscher-Ohlin Model
Implications of the Tests
Empirical evidence on the Heckscher-Ohlin model has led to the following conclusions:
It has been less successful at explaining the actual pattern of international trade.
It has been useful as a way to analyze the effects of trade on income distribution.
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45. Summary
The Heckscher-Ohlin model, in which two goods are produced using two factors of production, emphasizes the role of resources in trade.
A rise in the relative price of the labor-intensive good will shift the distribution of income in favor of labor:
The real wage of labor will rise in terms of both goods, while the real income of landowners will fall in terms of both goods.
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46. Summary
For any given commodity prices, an increase in a factor of production increases the supply of the good that uses this factor intensively and reduces the supply of the other good.
The Heckscher-Ohlin theorem predicts the following pattern of trade:
A country will export that commodity which uses intensively its abundant factor and import that commodity which uses intensively its scarce factor.
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