international trade lecture 8: the basis for trade factor endowments and the heckscher-ohlin model

INTERNATIONAL TRADE

LECTURE 8:

The Basis For Trade Factor Endowments and the Heckscher-Ohlin Model

Contents To introduce the relationship between labor stan

dards and comparative advantage

To research the relevance of supply, demand, and autarky prices

To explain the factor endowments and the Heckscher-Ohlin Theorem

To understand the theoretical qualifications to Heckscher-Ohlin Thorem

Introduction The role of labor standards in fostering

international trade is really important and attract interest widespread Production of labor-intensive goods has continued to

move to developing countries with increased globalization

Some economists believed that different categories of labor standards have an effect on comparative advantage in developing countries

low labor standards comparative advantage in unskilled labor intensive goods increased export

Introduction They insist to built import barriers to ensure a more

“level playing field”

Empirical work Focused on core labor standards rather than

acceptable conditions of work Core labor: elimination of discrimination against women;

union rights; freedom from forced labor; abolition of child labor; equal opportunities

Acceptable conditions of work: minimum wages; safety and health standards

Introduction Hypothesize: lower core labor standards would

lead to a relative increase in unskilled labor and thus increase relative exports of unskilled labor intensive goods

Conclusions greater discrimination against women weakened

comparative advantage Weaker union rights, greater child labor, and greater use

of forced labor increased export share The number of ratifications of the ILO conventions

appeared to have no significant effect Educational attainment and the overall relative labor

endowment had relatively stronger influences on the trade patterns than did the labor standard variables

Introduction It is necessary to use a more formal structure to sort out the

complexities of international comparative advantage What we discussed in last lecture is that a country will gain

from trade any time that the terms of trade differ from its own relative prices in autarky (source of trade gain)

This lecture we focus on differences in supply conditions and try to provide a deeper understanding of the critical factors underlying relative cost differences and therefore comparative advantage

Quantities of factor of production prices of factor of production international trade

International trade prices of factor of production comparative advantages

Supply, Demand, and Autarky Prices The source of difference in pretrade price ratios

between countries lies in the interaction of aggregate supply and demand

Supply, Demand, and Autarky Prices

It is clear that there is a basis for trade whenever supply conditions or demand conditions vary between countries

This assumes there is no intervention in the markets to alter prices from these general equilibrium results

Although taxes and subsidies can cause autarky prices to be more or less different prior to trade, we now only examined the role of factor availabilities in international trade

Factor Endowments and the Heckscher-Ohlin Theorem

Simplifying assumptions of H-O Theorem There are two countries, two homogeneous goods,

and two homogeneous factors of production whose initial levels are fixed and assumed to be relatively different for each country (different factor endowment)

Technology is identical in both countries; that is, production functions are the same in both countries (fixed PPF)

Production is characterized by constant returns to scale for both commodities in both countries

The two commodities have different relative factor intensities, and the respective commodity factor intensities are the same for all factor price ratios


Tastes and preferences are the same in both countries. Further, for any given set of product prices, the two products are consumed in the same relative quantities at all levels of income; that is, there are homothetic tastes and preferences (same IC and fixed slope)

Perfect competition exists in both countries (no invention) Factors are perfectly mobile within each country and not mobile

between countries (fixed and same domestic factor price) There are no transportation costs There are no policies restricting the movement of goods

between countries or interfering with the market determination of prices and output (no invention from the government)


Factor Abundance and Heckscher-OhlinFactor endowments

Different factor endowments refers to different relative factor endowments

Relative factor abundance may be defined in two ways: the physical definition and the price definition

The physical definition (quantity conception): in terms of the physical units of two factors (K/L)I > (K/L)II focus on physical availability of supply (capital intensity)

The price definition (monetary conception): in terms of the relative scarcity prices (r/w)I < (r/w)II focus on factor price (capital intensity)

What is the link between above two?

Factor Endowments and the Heckscher-Ohlin Theorem The factor price reflects not only the supply of avail

able factors but also the demand The demand for a factor of production is a derived dema

nd Factor prices reflect not only the physical availability of th

e factors in question but also the structure of final demand and the production technology employed

Assumption of H-O theorem: technology and tastes and preferences are the same in both countries

Conclusion: the country with the relatively larger K/L ratio also will have the relatively smaller r/w ratio with technology and demand influences neutralized between the two countries, no matter which definition we take


Commodity Factor Intensity and Heckscher-Ohlin (with physical definition) A factor-x-intensive commodity: the ratio of factor x to

a second factor y is larger when compared with a similar ratio of factor usage of a second commodity

H-O assumes not only that the two commodities have different factor intensities at common factor prices but also that the difference holds for all possible factor price ratios in both countries

This is a strong assumption and it is critical to the H-O analysis and it does not preclude substituting effect

Example: two country, two factors, two commodities


The Heckscher-Ohlin TheoremThe PPF will differ between two countries sole

ly as a result of their differing factor endowments

With identical technology, constant returns to scale, and a given factor intensity relationship between final products, the country with abundant capital will be able to produce relatively more of the capital intensive good, vice versa

The shape and position of the PPF is determined by the factor intensities of the two goods and the amount of each factor available


Considering K/L （ r/w）

Capital intensive Labor intensive

Country I’s PPF is oriented more toward steel, and Country II’s PPF is oriented more toward cloth


Combined the two PPF above and the same set of tastes and preferences, two different sets of relative prices will emerge in autarky, thus trade basis

The trade implications

Ps1<Ps2

Pc1>Pc2

Country I is capital abundant, and country II is labor abundant

Country I export steel, and country II export cloth


A similar discussion in terms of the price definition(r/w)I < (r/w)II With identical technology and c

onstant returns to scale, country I will be able to produce steel relatively more cheaply than country II, and country II can produce cloth relatively more cheaply than country I

Relationship between relative factor prices and relative product prices can be developed through isoquant-isocost analysis


(r/w)I < (r/w)II that is to say (w/r)I > (w/r)II

For country I, MN, (w/r)I, X and Y, S1 and C1

For country II M’N’, (w/r)II, Q and T, S1 and C2, C2>C1

Cloth in country II is cheaper, and steel in country I is cheaper

Conclusion: a higher w/r leads to a higher relative price of cloth


Different relative factor prices will generate different relative commodity prices in autarky, each country expanded production of and exported the good that made the more intensive use of its relatively abundant factor of production


Heckscher-Ohlin theoremA country will export the commodity that uses

relatively intensively its relatively abundant factor of production, and it will import the good that uses relatively intensively its relatively scarce factor of production


The Factor Price Equalization Theorem After participate in the trade, prices adjust until both countries fa

ce the same set of relative prices (before trade: (w/r)I > (w/r)II) In H-O framework, this convergence of product prices takes plac

e as the price of the product using the relatively abundant factor increases with trade and the price of the product using the country’s relatively scarce factor falls

Note: under perfect competition, production will shift along the PPF and resources must be shifted from one to another

The adjustment of commodity price will affect the price of factor. Considering Country II, labor abundant country

After participate in the trade, what will happen to country II? Pc rise, Ps fall Resources shift -> DL rise, DK fall PL rise, PK fall w/r rise -> K/L rise due to substitution effect


Capital Labor


The change of factor prices will cause the factor prices ratio, (w/r)II, to rise and induce producers to move to a different equilibrium point on each respective isoquants (C decrease and S increase). the K/L will rise

Similar adjustment take place in Country I while the w/r decrease and K/L decrease


The Factor Price Equalization Theorem Prior to trade (w/r)I > (w/r)II

After trade (w/r)I = (w/r)II

In equilibrium, with both countries facing the same relative (and absolute) product prices, with both having the same technology, and with constant returns to scale, relative (and absolute) costs will be equalized. The only way this can happen is if, in fact, factor prices are equalized.


Trade in final goods essentially substitutes for movement of factors between countries, leading to an increase in the price of the abundant factor and a fall in the price of the scarce factor among participating countries until relative factor prices are equal


We do not observe factor price equalization theorem in practice for its assumptions are not realized or not realized as fully as stated in the model

Transportation cost Tariffs and subsidies, and economic policies Imperfect competition Nontraded goods Unemployed resources Factor of production are not homogeneous Technology is not identical …


Despite the limitations, the H-O model provides some helpful insights into the likely impact of trade on relative factor prices

Trade based on comparative advantage should tend to increase the demand for the abundant factor and ultimately exert some upward pressure on its price

With earning from trade, countries can import needed goods The same result would obtain with respect to commodity

prices and factor prices if factors were mobile between countries and final products were immobile internationally

Conclusion: goods movements and factor movements are indeed substitutes for each other


The Stolper-Samuelson Theorem and Income Distribution Effects of Trade in the Heckscher-Ohlin Model It explains that with international trade, changes of fac

tor price will have income distribution effects in general

Assume a labor abundant country participate the trade Its labor price will increase and capital price will decrease Thus, its labor’s total nominal income will increase and capita

l’s total nominal income will decrease Real income is not the same as nominal income, it depends

not only on changes in income, but also on changes in product prices


If workers only consume labor intensive export good, whether their real income increase or decrease?

Depends on which increased relatively more than others, income and commodity price

Wage = MPL X P Both wage and P is increase With trade, because wage rate increase, then less labor

will be used in production, thus increase the productivity of labor at the margin, that is to say, MPL increase

Conclusion: wage rate in the labor abundant country will rise relatively more than the price of the export good. Similarly, the real income of the owners of the scarce factor is decreasing with trade


Stolper-Samuelson theorem: with full employment both before and after trade takes place, the increase in the price of the abundant factor and the fall in the price of the scarce factor because of trade imply that the owners of the abundant factor will find their real incomes rising and the owners of the scarce factor will find their real incomes falling

Owners of the relatively abundant resources tend to be “free traders” while owners of relatively scarce resources tend to favor trade restrictions


In real world, we may not see the clear-cut income distribution effects with trade

Personal income distribution also depends on ownership of the factors of production

Individuals or households often own several factors of production

Thus, the final impact of trade on personal income distribution is far from clear

Concept Check on P139

Theoretical Qualifications to Heckscher-Ohlin

We need to examine strict assumptions of H-O and to determine the impact of their absence

Demand Reversal H-O: tastes and preferences are identical in the

trading countries Real world: each country may value the products in

very different ways and extreme example is referred to as demand reversal


Country I: capital abundant, but (PC/PS)I<(PC/PS)II

After trade, country I will export cloth and import steel from country II

It will cause the relative price of capital to fall in country I and that of labor to fall in country II

It could interfere with factor price equalization


Factor-Intensity ReversalH-O: a commodity is always relatively

intensive in a given factor regardless of relative factor prices (the strong-factor-intensity assumption)

In real world: the degree of substitution between the two factors is sufficiently different between industries so that we cannot guarantee that a given product will always be relatively intensive in the same factor


L and K can be substituted for each other more easily in cloth production

At (w/r)1, capital is relatively expensive, the K/L ratio represents that steel is the capital-intensive product

At (w/r)2, cloth is the capital intensive product

(w/r)1< (w/r)2

Capital is more expensive

(in one country )

Labor is more expensive

(in another country)


If (w/r)1 applies to country I (labor abundant) and (w/r)2 to country II (capital abundant), what will happen?

Both export cloth……??? Factor-intensity reversal occurs when a commodity ha

s a different relative factor intensity at different relative factor prices

Factor-intensity reversal could also interfere with factor price equalization

One of the country can end up exporting the good that intensively uses its relatively scarce factor

For country I, if it import cloth, labor price will decrease and capital price will increase just like country II, so (w/r) will move in the same direction instead of converging toward each other


Transportation CostsH-O: no transportation costs In real world: definitely has transportation

costsAssume two country: Norway and France; two

autarky price for corn: PF<PN; France attempts to pass the entire transportation cost on to Norway


Without transportation cost, the quantity for trade should be Q1Q2 and q1q2

With transportation cost, PN rise and imports fall thus France export fall, PF fall. Consequently the quantity move to Q1’Q2’ or q1’q2’

The difference between the price of corn in the two countries will equal exactly the transportation costs involved


The participating countries will not necessarily share the transportation costs equally

The incidence of the transportation cost will depend on the elasticities of supply and demand in each country

Conclusion: Who inelastic, who pay more transportation cost Transportation costs had demonstrated a downward trend becau

se of new transport technologies and emerging marketing concerns

Transport time is important as well as distance The implications of transportation costs do not alter H-O conclusi

ons about the composition of trade, although the amount of trade and specialization of production will be reduced

Under this situation, relative factor prices will not equalize and complete factor price equalization cannot be attained.

If transportation costs are sufficiently large, they can prevent trade from taking place and lead to the presence of nontraded goods


Imperfect Competition H-O: perfect competition In the real world: imperfect competition,

eg. Monopoly Example I: the monopolist maintains the

monopoly position at home (price setter) but at some point chooses to export at world prices (price taker)

For production: MR=MC P0 and Q0 In the world market: MR=MC PINT and Q1 Sold in the domestic market: Q2 and P2 a

nd Q1Q2 export International trade leads to an increased

difference between the domestic price and the world price, not a convergence to a single commodity price


Example 2: pure monopolistic price discrimination to international trade

Single world supplier and the markets in the various countries can be kept separate and elasticities of demand differ between the various markets

Assume: two markets, MC constant MR=MC, a higher price will be charged in the market where

demand is less elastic

More elasticLess elastic


Pure price discrimination leads to the charging of different prices in different markets and tends to reduce the degree of factor price equalization that takes place

Several major suppliers may band together and form a cartel (as only supplier in the market)


Immobile or Commodity-Specific Factors H-O: factors are completely mobile between different

uses in production within a country (permit production adjustments move smoothly along the PPF according to product price changes)

In real world: it is not easy or even possible for factors to be moved from the production of one product to another

Analyze adjustment in short run through the specific-factors model


SF model: an attempt to explore the implications of short-run factor immobility between sectors in an H-O context

Three factors: labor (mobile), capital in industry X, and capital in industry Y

Assume: in short time, it is not possible for KX moved to KY In the SF model, the contract curve is the horizontal line

point A


The different contract curves will be associated with different PPFs

RA’S and TA’V Considering A to B, and A to C The SF PPF will lie inside the normal PPF except a

t point A (compare B and C point)


Implications for trade: Suppose country located A and labor intensive in autarky In H-O model

after trade, move from A to B and result in labor price increase and K/L increased in each industry, and thus productivity and wages rise

The flip side of the rise in wages is the fall in the real return to capital

Policy implications: the country’s abundant factor prefers free trade to autarky and the country’s scarce factor prefers autarky to free trade


In SF model, move from A to C The increased demand for labor will increase the money wage of all lab

or However, the increased demand for capital will face fixed capital supply

which result in the return to capital rises in X (specialize in X production). Similarly, the return to capital decreased in Y

Policy implication: owners of capital in industry Y will argue against free trade, while those in industry X will argue in favor of it

About return to labor, the money wage for labor rises does not mean its real wage rises

Consider money wage in industry X, W=PX MPLX

MPLX decreased (more labor with same capital) thus w/Px fall which means money wages haven’t risen as much as the price of good X

The direction of the real return for a worker therefore depends on the bundle of goods being consumed

Concept Check on P149

Summary To introduce the relationship between labor stan

dards and comparative advantage

To research the relevance of supply, demand, and autarky prices

To explain the factor endowments and the Heckscher-Ohlin Theorem

To understand the theoretical qualifications to Heckscher-Ohlin

international trade lecture 8: the basis for trade factor endowments and the heckscher-ohlin model

Documents

role of labor standards

greater child labor

lower core labor standards

trade factor endowments

greater use of forced

relative prices

demand conditions

demand supply