Chapter 4 -- HO Model INTERNATIONAL ECONOMICS, ECO 486 Eastwood's ECO 486 Notes Chapter 4 -- HO Model INTERNATIONAL ECONOMICS, ECO 486 Display your name card HO Model

Learning Objectives Examine the need to build a new model Eastwood's ECO 486 Notes Learning Objectives Examine the need to build a new model Understand five more assumptions Prove HO Theorem Prove Rybczynski Theorem Prove Factor-Price Equalization Theorem Prove Stolper-Samuelson Theorem. HO Model

Learning Objectives Examine the need to build a new model Eastwood's ECO 486 Notes Learning Objectives Examine the need to build a new model Understand five more assumptions Prove HO Theorem Prove Rybczynski Theorem Prove Factor-Price Equalization Theorem Prove Stolper-Samuelson Theorem. HO Model

Classical Model Strengths Weaknesses Trade is mutually beneficial Eastwood's ECO 486 Notes Classical Model Strengths Trade is mutually beneficial High & low wage countries may trade Explains some of the trade patterns we observe Weaknesses Why does so much trade occur among developed countries? Why does technology differ across countries? HO Model

Heckscher-Ohlin (HO) Model Eastwood's ECO 486 Notes Heckscher-Ohlin (HO) Model Built upon observed differences among Factors that countries possess Factors required to produce various goods Insights Causes of trade Effects of trade on factor prices Effect of economic growth on trade patterns Political behavior HO Model

Learning Objectives Examine the need to build a new model Eastwood's ECO 486 Notes Learning Objectives Examine the need to build a new model Understand five more assumptions Prove HO Theorem Prove Rybczynski Theorem Prove Factor-Price Equalization Theorem Prove Stolper-Samuelson Theorem. HO Model

Assumptions for HO Model Eastwood's ECO 486 Notes Assumptions for HO Model Keep assumptions 1 through 10 Drop assumptions 11 & 12 Add assumptions 13 through 17 HO Model

Eastwood's ECO 486 Notes Assumption #13 There are two factors of production, labor (L), and capital (K). Owners of capital are paid a rental payment (R) for the services of their assets, and labor receives a wage payment (W). HO Model

Eastwood's ECO 486 Notes Assumption #14 The technologies available to each country are identical. Any technology is available to any country Factor prices determine the technology chosen HO Model

A Model of a Two-Factor Economy Eastwood's ECO 486 Notes A Model of a Two-Factor Economy Compare to Figure 4-1: Input Possibilities in Soybean Production Unit Capital input aTS , in machines per bushel Unit Labor input aLF , in hours per bushel // Input combinations that produce one bushel of Soybeans HO Model

Eastwood's ECO 486 Notes Assumption #15 The production of T is labor intensive relative to the production of S That is, T requires more labor per machine Implies that production of S is capital intensive (relative to the production of T). That is, S requires more machines per worker HO Model

K per Worker for US Industries Eastwood's ECO 486 Notes K per Worker for US Industries Thousands of 1972 dollars. Item 4.1, page 89, 5th edition, Husted & Melvin HO Model

Factor Prices and Input Choices Eastwood's ECO 486 Notes Which line represents the Capital-intensive industry, 1 or 2? Wage-rental ratio, w/r Capital-labor ratio, K/L 1 2 Compare to Figure 4.2, page 70 HO Model

Factor Prices and Input Choices Eastwood's ECO 486 Notes Factor Prices and Input Choices Soybean production is capital-intensive at any given wage/rental ratio Wage-rental ratio, w/r Capital-labor ratio, K/L TT SS HO Model

Combing Figures 4-2 and 4-3 Compare to Figure 4-4, page 71 Capital- Eastwood's ECO 486 Notes Capital- labor Ratio, K/L Relative price of T, PT/PS Wage-rental ratio, w/r TT PW SS (w/r)2 (PT/PS)2 (KT/LT)2 (KS/LS)2 (w/r)1 (PT/PS)1 (KT/LT)1 (KS/LS)1 Increasing Increasing Compare to Figure 4-4, page 71 HO Model

Eastwood's ECO 486 Notes Assumption #16 Country A is relatively capital abundant, while B is labor abundant. HO Model

K per Worker: Selected Countries Eastwood's ECO 486 Notes K per Worker: Selected Countries 1985 international prices. Item 4.2, page 91, 5th edition Husted & Melvin HO Model

Quantity definition of factor abundance Eastwood's ECO 486 Notes Quantity definition of factor abundance Country A is relatively capital abundant, if the ratio of its capital stock to its labor force (K/L) is greater than that of the other country: HO Model

Price definition of factor abundance Eastwood's ECO 486 Notes Price definition of factor abundance Country A is relatively capital abundant, if its wage-rental ratio (W/R) is higher than the other country’s wage-rental ratio: HO Model

Strong factor abundance assumption Eastwood's ECO 486 Notes Strong factor abundance assumption If country A is relatively capital abundant, by the quantity definition, its wage-rental ratio (W/R) will be higher than the other country’s wage-rental ratio. That is, the price definition holds, too. HO Model

Increasing Opportunity Cost in A Eastwood's ECO 486 Notes Increasing Opportunity Cost in A S is K-intensive A is K-abundant 20 18 14 America’s PPF TEXTILES, T (millions of yards per year) 12 6 2 4 8 10 12 16 SOYBEANS, S (millions of bushels per year) HO Model

Increasing Opportunity Cost in B Eastwood's ECO 486 Notes Increasing Opportunity Cost in B T is L-intensive B is L-abundant 40 TEXTILES, T (millions of yards per year) 20 Britain’s PPF 5 10 SOYBEANS, S (millions of bushels per year) HO Model

Increasing Opportunity Cost in B Eastwood's ECO 486 Notes Increasing Opportunity Cost in B T is L-intensive B is L-abundant 40 TEXTILES, T (millions of yards per year) 20 Britain’s PPF 5 10 SOYBEANS, S (millions of bushels per year) HO Model

Assumption #17 Tastes in the two countries are identical. Eastwood's ECO 486 Notes Assumption #17 Tastes in the two countries are identical. Given same GDP & prices, same choice Implies that supply conditions alone determine the direction of comparative advantage (CA). Different tastes would imply different demand Could reverse the direction of CA. HO Model

Learning Objectives Examine the need to build a new model Eastwood's ECO 486 Notes Learning Objectives Examine the need to build a new model Understand five more assumptions Prove HO Theorem Prove Rybczynski Theorem Prove Factor-Price Equalization Theorem Prove Stolper-Samuelson Theorem. HO Model

Eastwood's ECO 486 Notes Rybczynski Theorem At constant world prices, if a country experiences an increase in the supply of one factor, it will produce more of the product intensive in that factor and less of the other. See Figure 4.5 , page 73, and 4.6, page 74 Krugman & Obstfeld See Figure 4.7, page 102 5th edition Husted & Melvin Evidence: read item on “Dutch Disease, p. 292 HO Model

Which is the K-intensive industry? Eastwood's ECO 486 Notes Which is the K-intensive industry? Labor used in _____________ production Increasing L__ K_ O_ O_ __ Capital used in ________ production Increasing __ 1 L_ K_ Increasing Capital used in _____ production Labor used in______production Increasing Compare to Figure 4-5, page 73 HO Model

S is K intensive, T is L intensive Eastwood's ECO 486 Notes S is K intensive, T is L intensive Labor used in Soybean production Increasing LS KS OS OT S Increasing Capital used in Textile production T 1 Capital used in S production LT KT Increasing Labor used in Textile production Increasing HO Model

Eastwood's ECO 486 Notes Rybczynski Theorem How do the outputs of the two goods change when the economy’s resources change? Increase the amount of one factor, say K, and observe the results HO Model

K increases. S (K int.) expands. S needs more labor. T must contract Eastwood's ECO 486 Notes K increases. S (K int.) expands. S needs more labor. T must contract Increasing L used in S production O2S L2S L2T L1S L1T S2 O1S OT S1 Increasing K used in S production Increasing T 1 K used in T production K1S K1T K2S K2T 2 L used in T production Increasing HO Model

An increase in K in Country A. Eastwood's ECO 486 Notes An increase in K in Country A. Output of T, QT S, QS Slope = -PS/PT 1 Q1T 2 Slope = -PS/PT Q2T PPF2 PPF1 Q1S Q2S HO Model

An increase in L in country B. Eastwood's ECO 486 Notes An increase in L in country B. Output of T, QT S, QS 2 Q2T Q2S Slope = -PS/PT PPF2 Slope = -PS/PT 1 Q1T Q1S PPF1 Compare to Figure 4-7, page 75. Now try it yourself – solve problem 2 HO Model

Eastwood's ECO 486 Notes Rybczynski Theorem Also helps us to understand that an economy will tend to be more productive in industries that use its abundant factor intensively. HO Model

Learning Objectives Examine the need to build a new model Eastwood's ECO 486 Notes Learning Objectives Examine the need to build a new model Understand five more assumptions Prove HO Theorem Prove Rybczynski Theorem Prove Factor-Price Equalization Theorem Prove Stolper-Samuelson Theorem. HO Model

Heckscher-Ohlin Theorem Eastwood's ECO 486 Notes Heckscher-Ohlin Theorem A country will export the goods whose production is intensive in the factor with which that country is abundantly endowed. “Countries tend to export goods whose production is intensive in factors with which they are abundantly endowed.” page 76 Krugman & Obstfeld A country will have comparative advantage in, and therefore will export, that good whose production is intensive in the factor with which that country is relatively well endowed. Page 94, (5th edition) Husted & Melvin HO Model

Eastwood's ECO 486 Notes Autarky in A 18 a 15 CIC0 TEXTILES, T (millions of yards per year) 12 10 13 16 SOYBEANS, S (millions of bushels per year) HO Model

Eastwood's ECO 486 Notes Autarky in A (PS/PT )A = |slope| = 1 yd./bu. 18 a 6 million yards of T 15 CIC0 TEXTILES, T (millions of yards per year) 12 6 million bushels S 10 13 16 SOYBEANS, S (millions of bushels per year) HO Model

Autarky in B 40 a 30 CIC0 20 Britain’s PPF 10 4 6.5 9 Eastwood's ECO 486 Notes Autarky in B 40 a 30 CIC0 TEXTILES, T (millions of yards per year) 20 Britain’s PPF 10 4 6.5 9 SOYBEANS, S (millions of bushels per year) HO Model

Autarky in B 40 a 30 CIC0 20 Britain’s PPF 10 4 6.5 9 Eastwood's ECO 486 Notes Autarky in B (PS/PT )B = |slope| = 4 yd./bu. A has comp. adv. in S B has comp. adv. in T 40 a 30 20 mil. yards of T CIC0 TEXTILES, T (millions of yards per year) 20 Britain’s PPF 10 5 million bushels of S 4 6.5 9 SOYBEANS, S (millions of bushels per year) HO Model

Trade Leads to a Convergence of Relative Prices Eastwood's ECO 486 Notes Trade Leads to a Convergence of Relative Prices Relative price of S, ______ Relative quality of S, RD RSA RSB 1 2 3 Compare to Figure 4-8, page 77. HO Model

Trade Leads to a Convergence of Relative Prices Eastwood's ECO 486 Notes Trade Leads to a Convergence of Relative Prices Relative price of S, PS/PT Relative quality of S, QS + Q*S QT + Q*T RSB RSA 3 2 1 As prices converge, B produces less S and more T. A produces more S and less T. RD HO Model

Eastwood's ECO 486 Notes With free trade, there will be one world relative price for S (PS/PT) and T (PT/PS). As PS/PT rises in Country A, their S industry expands while their T industry contracts. As PS/PT falls in Country B, their S industry contracts while their T industry expands. Tricky to draw the general equilibrium solution, so let’s try it together. Show/draw Figure 4.4, page 98, Husted & Melvin HO Model

International Trade Equilibrium Eastwood's ECO 486 Notes International Trade Equilibrium Incomplete specialization in Comparative Advantage good. Community Indifference Curve (CIC) & Terms of Trade line (ToT) tangent at consumption point Congruent trade triangles imply balanced trade. HO Model

Learning Objectives Examine the need to build a new model Eastwood's ECO 486 Notes Learning Objectives Examine the need to build a new model Understand five more assumptions Prove HO Theorem Prove Rybczynski Theorem Prove Factor-Price Equalization Theorem Prove Stolper-Samuelson Theorem. HO Model

Stolper-Samuelson Theorem Eastwood's ECO 486 Notes Stolper-Samuelson Theorem Free international trade benefits the abundant factor and harms the scarce factor. “Owners of a country’s abundant factors gain from trade, but owners of a country’s scarce factors lose.” page 77, Krugman & Obstfeld. Free international trade benefits the abundant factor and harms the scarce factor. Page 105, Husted & Melvin HO Model

As PS/PT rises in Country A, PT/PS and w/r fall. Eastwood's ECO 486 Notes As PS/PT rises in Country A, PT/PS and w/r fall. Look back at Figure 4-4, or slide 15. A is K abundant (L scarce) As PS/PT falls in Country B, PT/PS and w/r rise. B is L abundant (K scarce) Show/draw Figure 4.4, page 98, Husted & Melvin HO Model

Learning Objectives Examine the need to build a new model Eastwood's ECO 486 Notes Learning Objectives Examine the need to build a new model Understand five more assumptions Prove HO Theorem Prove Rybczynski Theorem Prove Factor-Price Equalization Theorem Prove Stolper-Samuelson Theorem. HO Model

Factor-Price Equalization (FPE) Theorem Eastwood's ECO 486 Notes Factor-Price Equalization (FPE) Theorem Given all the assumptions of the HO model, free trade will lead to the international equalization of individual factor prices. Look again at Figure 4-4, or slide 15. One relative price for T, PT/PS One wage-rental ratio, w/r HO Model

Factor-Price Equalization? Eastwood's ECO 486 Notes Factor-Price Equalization? “There isn’t any.” Why not? Some goods are not produced in some countries. Productivity (technology) does differ between countries. Goods’ prices differ due to natural and artificial barriers to trade. HO Model

Eastwood's ECO 486 Notes Reciprocal Demand See Figure 4.5, page 100 5th edition Husted and Melvin HO Model

Eastwood's ECO 486 Notes Importance of Tastes See Figure 4.6, page 102 5th edition Husted and Melvin HO Model

Learning Objectives Examine the need to build a new model Eastwood's ECO 486 Notes Learning Objectives Examine the need to build a new model Understand five more assumptions Prove HO Theorem Prove Rybczynski Theorem Prove Factor-Price Equalization Theorem Prove Stolper-Samuelson Theorem Introduce Specific-Factors Model HO Model

Specific-Factors Model Eastwood's ECO 486 Notes Specific-Factors Model Keep all HO assumptions except: one factor is immobile (say K) different rental rates for machines in S & T industries Labor still mobile, implying one wage, W W = VMPS = PS x MPLS Appendix 4.2, pages 118-120, Husted & Melvin. See Figures A4.5 and A4.6 HO Model

Specific-Factors Model Eastwood's ECO 486 Notes Specific-Factors Model W = VMPS = PS x MPLS W = VMPT = PT x MPLT HO Model

Eastwood's ECO 486 Notes The End of Chapter 4 HO Model