international economics x topic 4 t

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International Economics

Topic 4 (T)

English Group

Grado en EconomiaInstructor: Gaetano D’Adamo



The Heckscher – Ohlin theory

• The Limits of the Ricardian model

The Ricardian model made us conclude that:

- When we open up to trade, countries will specialize in the production of

the good in which they have a comparative advantage.

- If each country produces the good(s) in which it has CA, trade is mutuallybeneficial.

However,

- We only had one factor of production (Labor)

- … thus CA was the result of «higher productivity»: where does that come

from?

G. D'Adamo - Int'l Economics - UV 2




• A model with two factors

Given the drawbacks of the Ricardian model, we now extend our model of tradeto one with two factors.

Assume we have:

- 2 goods: cloth (C), food (F)

- 2 factors: labor (L), land (T)

- 2 countries: Home, Foreign (*)

aTC = acres of land to produce 1 yard of cloth L = supply of labor

aLC = hours of labor to produce 1 yard of cloth T = supply of land

aTF = acres of land to produce 1 calory of food

aLF = hours of labor to produce 1 calory of food





• A simple example: fixed factor requirements

Let’s look at the Home country first.Assume the proportion of factors used in

the production of each good is fixed (we cannot modify the ratio of labor to

land used).

We assume moreover that:

>

→ Cloth requires relatively more labor than food.

The economy will have two resource constraints to be satisfied at the same time:

+ ≤

+ ≤





L/aLF

T/aTF

L/aLC T/aTC Q C

Q F

Production possibility

frontier

Labor constraint

Land constraint

Since we have two

constraints, the PPF will

define the area where both

constraints are fulfilled.

In this simple example, it will

thus be a kinked line

• Numerical example

1

2


all same line: we use all labour and land

available ( there are 2 constraints)




L/aLF

T/aTF

L/aLC T/aTC Q C

What happens if there is anincrease in available resources?

Example: Increase in the

endowment of land (i.e. Due to

drainings of wetlands):

• The land constraint becomes

less binding

• Production possibilities are

expanded non-proportionately

towards food (intensive in land)

(Rybczynski effect)

What if there is an increase in

labor?

Q F


1 AMOUNT AVAILABLE OF 1 FACTOR CHANGES

2 PRICE OF GOODS CHANGES

L= aLC · Qc + aLF · QF Labour cost

T= aTC · Qc + aTF · QF Land constraint

If amount of land increase it willNOT affect the Land constraint

if total amount available a 1factor increase the PPF is

expanded more proportionately

in the factor increased

aLC/ aTC bigger aLC/ aTF

clothes labour -intensive, it uses relatively + L than F

aLF =3

aLC=4

aTF=3

aTC=2

L=120

T=100

T'=110

Labour const QF= 40 - 4/3Qc

Land const QF= 100/3 - 2/3 Qc

T' = aTF · QF + aTC · Qc

110= 3QF + 2Qc




• Prices of goods and prices of factors

= price of 1 yard of cloth

= price of 1 calorie of food

w = salary from 1 hour of work

r = rental rate of 1 acre of land.

= +

These equations define the combinations of w and r for which the cost of production is

equal to the price of cloth and food, respectively.

= +


PERFECT COMPETITION

Price of goods = marginal cost of production

price of factor = value of output produced with that factor

Pc = cost of labour + cost of land used to produce 1 unitPF = " + " 1 unit of food.




PC/aTC

PF/aTF

PC/aLC PF/aLF w

r

1r1

w1

Cloth production is more

instensive in labor than food

production:

>

Thus the line for cloth is steeper

In point 1, the price of both goods

is equal to its cost of production,therefore it is an equilibrium point.


Pc = aLC · w + aTC · raTC · r = Pc - aLC · W

r= Pc/ aTC - aLC/ aTC · W FOOD

r = PF/ aTF - aLF/ aTF · W CLOTH

Pf = aLF · w + a TF · r rental rate and wage salary

waranty both sectors ( F & C)

are in equilibrium




PF/aTF

PF/aLF w

r

1

P’C/a’TC

2r1

r2

w2w1

What happens if the price of cloth

increases?

• The intercept of the blue line

increases, therefore the blue

line shifts upwards

• Equilibrium moves from 1 to 2:

the rental rate has fallen and

the wage has increased

•

An increase in the price of clothhas strong income distribution

effects (Stolper-Samuelson

effect).

What happens if productivity changes?


income of workers higher because price of goods

which is intensive in labour INCOME DISTRIBUTIONEFFECTS

when we open to trade relative prices changes and

the salaries w and rental rate change

if productivity changes there is a change in the slope

Pc = 8 Pc = aLC · w + a TC · r

PF = 6 PF = a LF · w + aTF · r

CLOTH 8 = 4w + 2r r= 4 - 2w

FOOD 6 = 3w + 3r r = 2 - w




If we are able to move production factors from one sector to the other, then

the opportunity cost of food in terms of cloth increases if we increases the

quantity of food produced ⇒ the PPF will have a bowed shape.

→ Intuition: If we produce more food, we necessarily have to quit some cloth

production, moving labor and land to the food sector. However, as more and moreworkers and land move to the food sector, their productivity falls (for example: we

use land that is less apt to agriculture, or workers which were specialized in

textiles), and to produce one more unit of food we need more and more production

factors.


factors proportion is fixed: producer can NOt change the relative factor he uses in production




Q C

Q F

T

We now look at what happens

when you can modify the

proportion in which you use the

factors.

First, there is no fixed definition

of which good is lad- or labor-

intensive, it depends on the

endowment.

The PPF becomes a curve, TT

What happens if there is an increase in the endowment of one of the factors?

T


A

B

Move from A to B, form cloth to food sector,

opportunity cost of cloth increases you have to reduced

quantity of cloth more than proportionally.

Productivity falls: using big land and cloth specialized

workers in production of food you are loosing efficiency

C

FACTORS ARE NOT FIXED




Q C

Q F

T2

Suppose the labor supply

increases.

The PPF shifts outwards, because

now we can produce more of

both goods, but it moves more outwards towards the good that

is intensive in labor, i.e. cloth.

The effect on income distribution

is always the same: w increases

more than proportionately, r falls.

T2

T1

T1





The total value of the economy’s production is:

And this is called the isovalue line = the locus of the combinations of food and cloth

production that have all the same total value.

• The slope of the isovalue line is – PC/PF

= + (*)


Efficient point when production factors are FIXED

best production point : maximize value of outputV = PF · QF + Pc · Qc

QF = V/ PF - Pc/ PF · Qc

The more you move to the right, the higher total value represented by isovalue line




Q C

Q F

PP

Isovalue lines

The upper and to the right the

isovalue is, the higher the total

value of output it defines.Q

At point Q the PPF touches the

highest possible isovalue line

NOTE: Those lines above the PPF definecombinations we can’t afford; those

below are combinations where we

waste resources.


PPF match higher isovalue line

use all our resources to produce our maximum total value

you can move the factors from one sector to another and change the technology to be + efficient




• Summing up the main points:

Assumptions: - perfect competition ⇒factor are paid at marginal product

- only difference across countries: relative factor

endowment- same preferences across countries ⇒ one single RD curve

Results:


In a model with two countries, two goods and two factors, with perfect

competition, same technology in both countries and different endowment

of the production factors, when the two countries open up to trade each

will export the good which is intensive in the factor of which the country is

relatively well-endowed.

(1) Heckscher-Ohlin Theorem

price of good is equal to cost of production




(2) Rybczynski theorem

When the amount of each factor needed to produce one good is fixed

and factors are fully employed , an increase in the endowment of onefactor increases the amount produced of the good that uses thatfactor intensively, and reduces the amount produced of the othergood.

(3) Stolper – Samuelson theorem

The increase in the relative price of a good increases, in terms of both

goods, the income of the factor that is used intensively in the

production of that good and reduced, in terms of both goods, theincome of the other factor.


fixed production endowment, use intensively that factor

PRICE CONVERGENCE Pc/ PF increases

aLC/ aTF bigger aLF/ aTF

w increases

r decreases




• Opening up to trade

We have two countries, Home labor-abundant and Foreign land-abundant :

> ∗

∗

Therefore, home will tend to produce relatively more cloth and foreign will tend

to produce relatively more food.

Before we open up to trade each country must consume what it produces:

= ; = ; ∗ =

∗ ; ∗ =

∗

Opening up to trade, the value of consumption must equal the value of production:

+ = +

Total value of

consumption

Total value of

productionG. D'Adamo - Int'l Economics - UV 17

FACTOR INTENSITY production process of the 2 goods aLC/ aTC bigger aLF/ aTF

different

FACTOR ABUNDANCY amount of each factor available L/ T bigger L*/ T*




Rearranging it becomes:

− =

× −

And therefore the value of imports must now equal the value of exports (budget

constraint).

Food imports Food exports


HOME

Pc Dc + PF DF = Pc Qc + PF QF

total value of

consumption

total value of

production



The Heckscher – Ohlin theoryP

C/P

F

Relative quantity

of cloth

3

1

2

RS*

RS

RD

• Relative Demand is the same

at Home and in Foreign

• Home is labor-abundant ,

cloth is labor intensive

therefore Home produces

relatively more cloth at the

same price (PC

/PF

)1

• Foreign is land-abundant ;

food is land-intensive, thus

Foreign produces relatively

more food at the same price

(PC/PF)3

• Trade makes relative prices

converge and the relative

quantities produced in each

country will no longer equal

consumption

(PC/PF)1

(PC/PF)3

+

∗ +

∗

+

∗ +

∗


autarky

autarky




DC , Q C

DF , Q F

PP

Point 1 represents the initialHome economy’s production

point. The PPF is tangent to the

BC in 1.

International trade makes

relative prices change: clothbecomes relatively more

expensive, production on C

increases and production of F

falls. The final production point is

2.

Home will export cloth and

import food.

Since Foreign is relatively well –

endowed with food, its PPF will be

more skewed towards food.

2

Q 2C

Q 2F

1





Quantity of Cloth Quantity of Cloth

Quantity of Food Quantity of Food

HOME FOREIGN

DCH DC

FQ CH Q C

F

Q FF

DF F

DFH

Q FH

EXP

E X P

I M P

IMP





• Trade and the distribution of income

Since trade causes a convergence in relative prices, this in turn will have

strong effects on income distribution.

Home: relative price of cloth increases → income of workers in cloth sector ↑

Foreign: relative price of food increases → income of landowners ↑

Owners of a country’s abundant factors gain from trade, while owners of a

country’s scarce factor lose.





Table 4-1. Comparative International Wage Rates (U.S. = 100)

Country Hourly compensation of Production workers, 2000United States 100

Germany 121

Japan 111

Spain 55

South Korea 41

Portugal 24

Mexico 12

Sri Lanka* 2

*1999

Table taken from Krugman-Obstfeld (2007)

•

Factor price equalization

The H-O model predicts full factor price equalization. Is it the case in reality?





Why is the prediction of wage (i.e. factor price) equalization so largely

violated?

→ Because there are some assumptions at the basis of the H-O model that

are clearly not true in the real world:

(1) The country produces both goods : this is not the case for all kinds of

goods; some countries don’t produce some goods at all due to natural,

technological or resource constraints.

(2) Countries have the same technology of production: in reality, there arebig productivity differences across countries.

(3) Complete convergence of goods prices: in reality, barriers to trade,

natural barriers etc make complete convergence of prices impossible.


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