Chapter 8 The Basis for Trade Factor Endowments

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Chapter 8 The Basis for Trade: Factor Endowments and the Heckscher. Ohlin Model Mc.

Chapter 8 The Basis for Trade: Factor Endowments and the Heckscher. Ohlin Model Mc. Graw-Hill/Irwin Copyright © 2010 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Learning Objectives § Examine how relative factor endowments affect relative factor prices. § Demonstrate

Learning Objectives § Examine how relative factor endowments affect relative factor prices. § Demonstrate how different relative factor prices generate a basis for trade. § Describe how trade affects relative factor prices and income distribution. § Analyze how real-world phenomena can modify Heckscher-Ohlin conclusions. 8 -2

Heckscher-Ohlin In General § Heckscher, and his student Ohlin, worked in the early part

Heckscher-Ohlin In General § Heckscher, and his student Ohlin, worked in the early part of the 20 th century. § Paul Samuelson refined their work after WWII. § Closer attention is paid in this model to each country’s resource endowment. 8 -3

H-O-S Assumptions 2 countries 2 commodities 2 factors (labor and capital) Perfect competition exists

H-O-S Assumptions 2 countries 2 commodities 2 factors (labor and capital) Perfect competition exists in all markets. § Each country’s endowment of factors is fixed. § Factors are mobile internally, but immobile internationally. § § 8 -4

H-O-S Assumptions (cont’d) § Each producer has a wide range of options as to

H-O-S Assumptions (cont’d) § Each producer has a wide range of options as to how to produce X or Y • if K is cheap relative to labor, a relatively capital-intensive method will be adopted. • if K is expensive relative to labor, a relatively labor-intensive method will be adopted. § Each country has the same CRTS technology. § Tastes and preferences are the same for both countries. 8 -5

Concepts and Terminology § The capital-labor ratio for good X is simply KX/LX, and

Concepts and Terminology § The capital-labor ratio for good X is simply KX/LX, and for Y is KY/LY. • If KX/LX > KY/LY, production of good X is capital intensive relative to production of good Y. • For example, the amount of capital per worker in the U. S. petroleum and coal industry is $468, 000. • The similar figure for apparel products is $8, 274. • Therefore, petroleum and coal is produced in a relatively capital-intensive manner. 8 -6

Concepts and Terminology § Also, production of Y must be relatively labor intensive (If

Concepts and Terminology § Also, production of Y must be relatively labor intensive (If KX/LX > KY/LY, then LY/KY > LX/KX). • That is, clothing is produced in a labor-intensive manner (as compared to petroleum and coal). 8 -7

Relative Factor Intensities, Selected Canadian Industries (2006), in C$ Commodity Petroleum and coal Chemicals

Relative Factor Intensities, Selected Canadian Industries (2006), in C$ Commodity Petroleum and coal Chemicals Paper Transportation equipment Truck Transportation Leather and products Clothing Capital per employee $617, 066 $144, 029 $118, 777 $92, 315 $30, 180 $12, 573 $8, 954 8 -8

Concepts and Terminology § Country A is said to be capital abundant relative to

Concepts and Terminology § Country A is said to be capital abundant relative to Country B if (K/L)A > (K/L)B. • For example, if the U. S. has a capital stock of $4. 8 trillion and a labor force of 153 million, then K/L is about $32, 000. • K/L for Mexico works out to $328 billion/45 million = $7, 282. • Therefore, the U. S. is K- abundant relative to Mexico; Mexico is relatively L-abundant. 8 -9

Relative Factor Endowments, Selected Countries (2007), in U. S. $ Country Japan France U.

Relative Factor Endowments, Selected Countries (2007), in U. S. $ Country Japan France U. S. Australia Canada Mexico Capital per worker $49, 081 $31, 810 $31, 657 $30, 792 $24, 700 $7, 282 8 -10

Concepts and Terminology To summarize: • goods are produced relatively K or L intensively.

Concepts and Terminology To summarize: • goods are produced relatively K or L intensively. • countries are relatively K or L abundant. 8 -11

Concepts and Terminology § The factor price of labor (the wage) is denoted w.

Concepts and Terminology § The factor price of labor (the wage) is denoted w. § The factor price of capital is denoted r. § If labor is relatively expensive, w/r will be a relatively big number. § If labor is relatively cheap, w/r will be a relatively small number. 8 -12

More on Factor Prices § What makes labor relatively expensive? • If it is

More on Factor Prices § What makes labor relatively expensive? • If it is relatively scarce. § What makes labor relatively cheap? • If it is relatively abundant. § So: If (K/L)A is a relatively big number (that is, capital is relatively abundant), w/r will be a relatively big number, reflecting the relative scarcity of L and abundance of K. 8 -13

A Review of Trade in the Neoclassical Model § Suppose the U. S. is

A Review of Trade in the Neoclassical Model § Suppose the U. S. is capital abundant relative to Mexico. § This, of course, means that Mexico is relatively labor abundant. § These differences affect the shape of each country’s PPF. § Suppose that cars are produced rel. K-intensively, and textiles labor intensively. 8 -14

Autarky in Mexico and the U. S. § The relative price of textiles in

Autarky in Mexico and the U. S. § The relative price of textiles in autarky is greater in the U. S. than in Mexico. § That is, the U. S. ’s autarky price line is steeper than Mexico’s. § In symbols, (PT/PC)U. S. > (PT/PC)Mex. § This means that Mexico has the comparative advantage in textiles. 8 -15

Autarky in Mexico and the U. S. § This also means that the relative

Autarky in Mexico and the U. S. § This also means that the relative price of cars in autarky is lower in the U. S. than in Mexico. § That is, (PC/PT)U. S. < (PC/PT)Mex. § This means that the U. S. has the comparative advantage in cars. 8 -16

Trade in the H-O Model Cars Y 3 Y 1 Mexico Y 5 C'

Trade in the H-O Model Cars Y 3 Y 1 Mexico Y 5 C' E Y 4 E' Y 2 X 3 X 1 U. S. Cars Y 6 X 2 Textiles e' e c' X 5 X 4 X 6 Textiles 8 -17

The Result § The relatively capital abundant country (U. S. ) exports the relatively

The Result § The relatively capital abundant country (U. S. ) exports the relatively capital intensive good (cars). § The relatively labor abundant country (Mexico) exports the relatively labor intensive good (textiles). 8 -18

The Heckscher-Ohlin Theorem § A country will export the commodity that uses relatively intensively

The Heckscher-Ohlin Theorem § A country will export the commodity that uses relatively intensively the factor that country has in relative abundance. § A country will import the commodity that uses relatively intensively the factor that is relatively scarce in that country. 8 -19

The Source of Comparative Advantage § So it is a country’s relative factor endowment

The Source of Comparative Advantage § So it is a country’s relative factor endowment that determines its comparative advantage. § This is why the H-O-S model is also called the factor proportions theory. 8 -20

Changes in Relative Commodity Prices : Review § As we learned before, • (PT/PC)US

Changes in Relative Commodity Prices : Review § As we learned before, • (PT/PC)US falls as the U. S. moves to trade. That is, the international relative textile price is lower than the U. S. ’s autarky price. • (PT/PC)Mex rises as Mexico moves to trade. That is, the international relative textile price is higher than Mexico’s autarky price. 8 -21

Changes in Factor Prices § In autarky, the K-intensive product (cars) is less expensive

Changes in Factor Prices § In autarky, the K-intensive product (cars) is less expensive to produce in the U. S. as compared to Mexico. • This is because K is relatively abundant in the U. S. , which makes the price of capital relatively low. § As trade commences, r will rise since demand for capital will rise. 8 -22

Changes in Factor Prices § In autarky, the L-intensive product (textiles) is more expensive

Changes in Factor Prices § In autarky, the L-intensive product (textiles) is more expensive to produce in the U. S. as compared to Mexico. • This is because L is relatively scarce in the U. S. , which makes the price of labor relatively high. § As trade commences, w will fall since demand for labor will fall. 8 -23

Commodity and Factor Prices In Trade: A Summary § In our example, (PT/PC)US falls

Commodity and Factor Prices In Trade: A Summary § In our example, (PT/PC)US falls as trade commences. § (w/r)US also falls. § In Mexico, the opposite is happening: • (PT/PC)Mex rises. • (w/r)Mex also rises. § Therefore relative commodity and factor prices move together as trade commences. 8 -24

The Relative Cost Curve PT/PC (PT/PC)US (PT/PC)Int (PT/PC)Mex Both relative commodity and factor prices

The Relative Cost Curve PT/PC (PT/PC)US (PT/PC)Int (PT/PC)Mex Both relative commodity and factor prices equalize in trade. (w/r)Mex (w/r)Int (w/r)US w/r 8 -25

The Factor Price Equalization Theorem In equilibrium, with both countries facing the same relative

The Factor Price Equalization Theorem In equilibrium, with both countries facing the same relative product prices, relative costs will be equalized. This can only happen if relative factor prices are equalized between countries. 8 -26

H-O and the Distribution of Income § The H-O theorem, together with the FPE

H-O and the Distribution of Income § The H-O theorem, together with the FPE theorem, also tell us about how the incomes of different groups within a country change as trade starts. § This provides insight into the politics of free trade. 8 -27

The Stolper-Samuelson Theorem As trade commences, the owners of the relatively abundant factor will

The Stolper-Samuelson Theorem As trade commences, the owners of the relatively abundant factor will find their real incomes rising; the owners of the relatively scarce factor will find their real incomes falling. 8 -28

H-O and the Distribution of Income § According to the S-S theorem, if the

H-O and the Distribution of Income § According to the S-S theorem, if the U. S. is a relatively K-abundant country, who in America should favor free trade? § Who in America should favor protectionism? 8 -29

Theoretical Qualifications to H-O § Suppose we relax some of the many assumptions. Will

Theoretical Qualifications to H-O § Suppose we relax some of the many assumptions. Will the implications of the H-O-S model still be the same? 8 -30

Qualification #1: Demand Reversal § Suppose we let demand conditions differ. § Suppose domestic

Qualification #1: Demand Reversal § Suppose we let demand conditions differ. § Suppose domestic demand for the good that uses relatively intensively the relatively abundant factor is very strong in each country. § That is, suppose demand for cars is very strong in the U. S. , and that demand for textiles is very strong in Mexico. 8 -31

Qualification #1: Demand Reversal § Such strong demand makes the autarky car price in

Qualification #1: Demand Reversal § Such strong demand makes the autarky car price in the U. S. higher, and the textile price in Mexico higher. § In the extreme, demand reversal could occur: (PC/PT)US > (PC/PT)Mex, and § (PT/PC)US < (PT/PC)Mex 8 -32

Bottom Line on Demand Reversals § If demand reversals occur, the H-O theorem no

Bottom Line on Demand Reversals § If demand reversals occur, the H-O theorem no longer holds: the Kabundant country is exporting the L -intensive good, and the L-abundant country is exporting the K-intensive good. 8 -33

Qualification #2: Factor Intensity Reversal § Implicitly, we’ve assumed that if good X is

Qualification #2: Factor Intensity Reversal § Implicitly, we’ve assumed that if good X is K-intensive relative to good Y at one factor price ratio, it will be K-intensive at all factor prices. § A FIR is when a good is relatively Kintensive at one set of factor prices, but relatively labor intensive at another. 8 -34

Qualification #2: Factor Intensity Reversal § FIRs occur when capital and labor can be

Qualification #2: Factor Intensity Reversal § FIRs occur when capital and labor can be substituted more easily in the production of one good than another. 8 -35

Factor Intensity Reversal: Implications for Trade § Suppose France is K-abundant relative to Germany

Factor Intensity Reversal: Implications for Trade § Suppose France is K-abundant relative to Germany (that is (K/L)F > (K/L)G). § This means that (w/r)F > (w/r)G. § Suppose further that there is a FIR: in France, at (w/r)F apples are produced relatively K-intensively but in Germany at (w/r)G apples are produced in a relatively L-intensive way. 8 -36

Factor Intensity Reversal: Implications for Trade § If trade begins, according to the HO

Factor Intensity Reversal: Implications for Trade § If trade begins, according to the HO theorem the relatively Kabundant country (France) will export the rel. K-intensive good (apples) and the rel. L-abundant country will export the rel. Lintensive good (also apples). § H-O theorem breaks down. 8 -37

Qualification #3: Transportation Costs § In the real world, it is costly to transport

Qualification #3: Transportation Costs § In the real world, it is costly to transport goods internationally. § How do the implications of our model change if we allow for transportation costs? § Consider the supply and demand curves for textiles in Mexico and the U. S. 8 -38

Adding Transportation Costs § Unless Mexico is the only seller in the world, transportation

Adding Transportation Costs § Unless Mexico is the only seller in the world, transportation costs will be borne by both the consumer (the U. S. ) and the seller (Mexico). § How does this look on the graph? 8 -39

Adding Transportation Costs PT U. S. SText PT Mexico SText PIntl Imp. t-costs Exp.

Adding Transportation Costs PT U. S. SText PT Mexico SText PIntl Imp. t-costs Exp. DText q 1 q 2 QT PIntl DText q 1 q 2 QT 8 -40

Adding Transportation Costs: the Bottom Line § In general, the H-O theorem will still

Adding Transportation Costs: the Bottom Line § In general, the H-O theorem will still hold. § The FPE theorem breaks down, since factor prices only equalize if the commodity prices do. § Therefore, in the presence of transportation costs, factor prices have a tendency to move towards each other, but we should not expect equalization. 8 -41

Relaxing Other Assumptions § One can relax many other assumptions and examine how the

Relaxing Other Assumptions § One can relax many other assumptions and examine how the implications of the model change: • perfect competition • CRTS • identical production technologies • lack of policy obstacles • factors being perfectly transferable 8 -42