trade theories: #4 – appendix (heckscher-olin). trade equilibrium in h-o model machines cloth.. a...

Trade Theories:

#4 – appendix (Heckscher-Olin)

Trade Equilibrium in H-O Model

Machines

Cloth..

..

Aeu

Aind

Qeu

Qind

p

p

45⁰ line

Ceu

Cind

EXeu

IMeu

EXind

IMind

Notation from preceding graph45O Line - assumption that countries are identical and trade is

balanced.

Ceu , cind = new (higher!) consumption levels of EU and India … (at intersection of price lines and 45o line)

Blue “dash” – Trade triangle EU

• EXeu – EU exports of machinery• Imeu – EU imports of cloth

Red “dash” – Trade triangle IND

• EXind – IND exports of cloth• Imind – IND imports of machinery

Trade Equilibrium in HO Model

• Terms of trade (p) are determined by reciprocal demand and lie between the two countries’ pre-trade price ratios

• Equilibrium production with trade exhibits incomplete specialization (due to increasing opportunity cost)

• Equilibrium consumption with trade implies a rise in standard of living (consumption at “c”)

• Trade triangles are congruent

Big … Assumptions

• Perfect competition• Constant returns to scale• No factor mobility• Two countries must be identical and trade

must be balanced

Test of the Heckscher-Ohlin Model

The Test:• W. Leontief (1951)• Could “H-O … Factor Proportions Theory”

be used to explain the types of goods the United States imported and exported?

The Method:Built input-output model for 200 U.S. industries for 1947

EMPIRICAL EVIDENCE ON THE H-O FACTOR-PROPORTIONS THEORY

The Findings:

• The Leontief Paradox

– Leontief found that U.S. exports were less capital-intensive than U.S. imports, even though U.S. is the most capital-abundant country in the world

The Leontief Paradox

The Controversy:

Findings were the opposite of what was generally believed to be true!

Reconciliations of the Leontief Paradox

• U.S. workers are more productive than foreign workers (Leontief) and Human Skills Theory (1966)

• A third factor, natural resources, is not considered (Vanek)

• U.S. tariffs on labor-intensive goods are high (Travis)

• The identical tastes assumption is violated; Table (next page) shows that consumption patterns differ across countries

Consumption Shares by Product Type for OECD Countries Average Values 1985–1999*

Human Skills Theory

• Donald Keesing (1966)

• Emphasizes differences in endowments and intensities of skilled and unskilled workers.

• Explains the Leontief paradox: Since the U.S. has highly trained, educated workers relative to other countries, U.S. exports tend to be skilled-labor intensive.

Trade Theories:

#5 - FACTOR-PRICE EQUALIZATION

FACTOR-PRICE EQUALIZATION AND THE DISTRIBUTION OF INCOME

• Moving from autarky to free trade– What happens to the relative size of

industries?– What happens to the payments or returns

to factors of production?– What happens to the distribution of income

within the country?


• Factor-Price Equalization

– When trade occurs between countries with different factor proportions, free trade will equalize the relative price of the goods (we saw this in H-O)

– … and cause the relative factor prices to converge

– Convergence of factor prices happens in the long run


• Factor-Price Equalization

– Whichever factor receives the lowest price before two countries begin to trade will therefore tend to become more expensive relative to other factors in the economy, … while those with the highest price will tend to become cheaper.


• For example – U.S. and India

– Trade opening up causes prices of machines and the prices of cloth to equalize between countries (H-O)

– Size of machine and cloth industries will change for each country changing their industrial structure


• (Assume) U.S. has a comparative advantage in machines … (machines are K intensive)

– This causes an increased demand for machines – The price of machines rises relative to price of

cloth– Machine production expands– Cloth production contracts– Increased demand for inputs to make machines

FACTOR-PRICE EQUALIZATION AND THE DISTRIBUTION OF INCOME … (continued)

– Increase in capital greater than increase in labor as machines are capital intensive

– Resources shift from cloth to machines

– Cloth industry declines• Imports replace much domestic production• More labor than capital released on market• Shortage of capital increase “profit” (return to K)• Surplus of labor decreases wages

• Ratio of wages to “profit” (return to K) declines


• India has a comparative advantage in cloth

– Increased demand for cloth– Price of cloth rises relative to price of

machines– Machine production contracts– Cloth production expands– Increased demand for inputs to make cloth


• Increase in labor greater than increase in capital as cloth is labor intensive

• Resources shift from machines to cloth

• Machine industry declines– Imports replace much domestic production– More capital than labor released on market– Shortage of labor increase wages– Surplus of capital decreases “profit”

• Ratio of wages to “profit” increases


• Wages – Decline in U.S.– Increase in India

• “Profits” (return to capital)– Increase in U.S.– Decrease in India

Overall – Factor Prices get closer to equalization (just as we saw with “Goods Prices” in H-O


• 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 capital in both countries• In U.S., where the relative price of machines rises• Capitalists are made better off and workers are made worse

off• In India, where the relative price of machines falls, the

opposite happens• Capitalists are made worse off and workers are made better

off– Owners of a country’s abundant factors gain from

trade, but owners of a country’s scarce factors lose


Table 4.4 Economic Data for South Korea and IndiaEconomic Variable South Korea India

Year Value Year Value

GDP per Capita 1953 $796 1953 $641

1962 $928 1962 $760

1972 $1,450 1972 $786

1982 $3,395 1982 $936

1991 $7,251 1991 $1,251

Capital/Worker 1965 $2,093 1965 $786

1975 $6,533 1975 $1,259

1085 $12,036 1085 $1,712

1992 $17,995 1992 $1,997

Degree of Openness[(Exports + Imports)/GDP]

1953 11.8% 1953 10.4%

1962 22.1% 1962 11.2%

1972 44.5% 1972 8.8%

1982 71.5% 1982 14.5%

1990 62.5% 1990 21.2%

Trade Theories:

#6 - The Stolper-Samuelson Theorem

The Stolper-Samuelson Theorem

• Derived from the HO model

• Assumptions:– Labor earns wages proportionate to its skill level– Owners of capital earn profits– Landowners earn rents– The amount of income earned per unit of input depends on

both the demand for inputs and the supply of inputs (demand for an input = derived demand)


• An increase in the demand for a good (opening International Trade?) … increases the price of a good…. and raises the income earned by factors that are used intensively in its production

• Conversely, decrease in the demand for a good … decreases the price of a good…. and reduces the income earned by factors that are used intensively in its production


Example … increase production of steel … increase need for K ...


• Note:

• Not all factors used in the export industries will be better off, and not all factors used in import competing industries get hurt: Abundant factors will benefit, while scarce ones will be hurt


• Ultimately, the effects on income of an opening of trade depends on the flexibility of the affected factors

– If labor is stuck in bread production and unable to move to making steel, it will be hurt much worse than when it is flexible and free to move

– U.S. avocado producers might not oppose Mexican avocado imports as fiercely as they do, if they could easily move to producing other goods

Implications of Stolper-Samuelson Theorem

• Some groups in society will oppose international trade.

• Scarce factors will lobby government for trade protection.

• Even though some in society lose, the country overall benefits from international trade relative to autarky.

• A system of taxation and transfers could be developed to compensate the losers while leaving the gainers better off relative to autarky.

Trade Theories:

#7 – Specific Factors and Income Distribution

Introduction

• If trade is so good for the economy, why is there such opposition?

• There are two main reasons why international trade has strong effects on the distribution of income within a country:– Resources cannot move immediately or “costlessly” from

one industry to another.– Industries differ in the factors of production they demand.

Specific Factors Model

• The HO model assumes that factors are mobile, meaning that they can migrate easily from one sector to another

The Specific Factors model assumes that:

1. land and capital are immobile and cannot migrate .... (specific factors)

2. labor is fully mobile and can migrate from one sector to another ... (variable factor)

Specific Factors Model

• A country’s endowment of a specific factor plays a more critical role than a factor in the HO model in determining comparative advantage

– When trade opens, incomes rise for the owners of the abundant specific factor

– The income distribution effect on labor is indeterminate, as workers can easily move to the expanding sector

A Specific Factors Model

Inputs Bread Steel

Specific Factors Land Capital

Variable (Mobile) Factors

Labor Labor

Outputs

The Specific Factors of land and capital can be used to produce only one good., each.

The variable factor of labor is used in both bread and steel production.

• The specific factors model allows trade to affect income distribution.

• Assumptions of the model:– Two goods … bread and steel.– Three factors of production: labor (L), capital

(K) and land (T for land/terrain).– Perfect competition prevails in all markets.

The Specific Factors Model

– Land and capital are both specific factors used only in the production of one good.

• steel produced using capital and labor (but not land).

• bread produced using land and labor (but not capital).

– Labor is a mobile factor that can move between sectors.

The Specific Factors Model (cont.)

• How much of each good does the economy produce?

• The production function for steel gives the quantity of steel that can be produced, given any input of capital and labor:

Qs = Qs (K, Ls)

– Qs is the output of steel– K is the capital stock– Ls is the labor force employed in steel


• The production function for bread gives the quantity of bread that can be produced given any input of land and labor:

Qb = Qb (T, Lb)

– Qb is the output of bread

– T is the supply of land

– Lb is the labor force employed in bread


• How does the economy’s mix of output change as labor is shifted from one sector to the other?

• When labor moves from bread to steel … bread production falls while output of steel rises.

Production Possibilities

The Production Function for steel (“c”)

• The shape of the production function reflects… the law of diminishing marginal returns.

– Adding one worker to the production process (without increasing the amount of capital) means that each worker has less capital to work with.

– Therefore, each additional unit of labor adds less output than the previous one...

Production Possibilities (cont.)


• Use a four-quadrant diagram to construct production possibilities frontier

– Lower left quadrant indicates the allocation of labor.– Lower right quadrant shows the production function for

steel – Upper left quadrant shows the corresponding production

function for bread.

– Upper right quadrant indicates the combinations of steel and bread that can be produced.

The Production Possibility Frontier in the Specific Factors Model

Output of bread

output of steel


• Why is the production possibilities frontier curved?

– Diminishing returns to labor in each sector cause the opportunity cost to rise when an economy produces more of a good.

– Opportunity cost of steel in terms of bread is the slope of the production possibilities frontier – the slope becomes steeper as an economy produces more steel.

• At the production point, the production possibility frontier must be tangent to a line whose slope is minus the price of steel divided by that of bread.

slope = MRT = -PBPB

Prices, Wages, and Labor Allocation

Production in the Specific Factors Model

Output of bread

slope = -(Ps/Pb)1

Qb1

Qs1 Output of Steel

• What happens to the allocation of labor and the distribution of income when the prices of bread and steel change?

• Two cases:1. An equal proportional change in prices2. A change in relative prices


(cont.)

• When both prices change in the same proportion, no real changes occur.

– The wage rate (w) rises in the same proportion as the prices, so real wages (i.e., the ratios of the wage rate to the prices of goods) are unaffected.

– The real incomes of capital owners and landowners also remain the same.

Prices, Wages, and Labor Allocation (cont.)

• When only Ps rises, labor shifts from the bread sector to the steel sector and the output of steel rises while that of bread falls.


Response of Output to a Change in the Relative Price of steel

Output of bread

Qs1 Qs

2 Output of Steel

Qb1

Qb2

slope = -(Ps/Pb)2

slope = -(Ps/Pb)1

Relative Price of steel up … output of steel up…

• What is the economic effect of this price increase on the incomes of the following three groups?– Workers, owners of capital, and owners of land


• Owners of capital are definitely better off.• Landowners are definitely worse off.• Workers: cannot say whether workers are

better or worse off: – Depends on the relative importance of steel and

bread in workers’ consumption.


• Trade and Relative Prices

– Free trade relative price of steel is determined by the intersection of world relative supply of steel and world relative demand.

– Opening up to trade increases the relative price of steel in an economy whose relative supply of steel is larger than for the world as a whole.

International Trade in the Specific Factors Model

Trade and Relative PricesRelative price of steel, Ps/Pb

(Ps/Pb)2

(Ps/Pb)1

Relative quantity of steel, Qs/Qb

4-57

• Gains from Trade– Without trade, the economy’s output of a good

must equal its consumption. – International trade allows the mix of steel and

bread consumed to differ from the mix produced.

International Trade in the Specific Factors Model (cont.)

• The economy as a whole gains from trade.

– It is able to afford amounts of steel and bread that the country is not able to produce itself. (Just as we saw with H-O)

– The budget constraint with trade lies above the production possibilities frontier

International Trade in the Specific Factors Model (cont.)

4-59

Income Distribution and the Gains from Trade

• International trade shifts the relative price of steel to bread, so factor prices change.

• 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.

• Trade has ambiguous effects on mobile factors.

THE SPECIFIC-FACTORS MODEL

• The results arising from the existence of specific factors are short-run effects

• The existence for specific factors helps explain why some groups resist free trade– Owners of abundant factors are likely to favor

free trade– Owners of scarce factors are likely to favor

trade restrictions

4-61

• Trade benefits a country by expanding choices.– Possible to redistribute income so that everyone

gains from trade.– Those who gain from trade could compensate

those who lose and still be better off themselves.– That everyone could gain from trade does not

mean that they actually do – redistribution usually hard to implement.

Income Distribution and the Gains from Trade (cont.)

• Income Distribution and Trade Politics– Typically, 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, respectively

– Governments usually provide a “safety net” of income support to cushion the losses to groups hurt by trade (or other changes).

– Most economists strongly favor free trade.

The Political Economy of Trade: A Preliminary View

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