NEOCLASSICAL TRADE THEORY CHAPTER 3 NEOCLASSICAL TRADE THEORY

affect the distribution of income Review Beneficial to everybody One input Two or more inputs H-O Model Specific Factor Model affect the distribution of income

Neoclassical Compare with Classical Factor Two or more than two One factor Study technique General equilibrium Partial equilibrium Emphases Income distribution Gain from trade

The Heckscher-Ohlin Model （Factor Endowment Theory) Founder The basic H-O model Testing the H-O model Summary

H-O Model’s Founder: Ohlin Bertil Ohlin 1899-1979 1977 Nobel Prize Winner Wrote between 1921 and 1949.

H-O Model’s Founder: Heckscher ELI FILIP HECKSCHER Famous Swedish Economist Wrote on Mercantilism, Swedish History, and International Economics

The basic H-O Model Relations with Ricardian Model Basic Assumptions Basis for trade Pattern of production and trade Numerical example Effects of Trade Rybczyski Theorem

Relations with Ricardian Model What are the ultimate determinants of comparative advantage? Ricardo did not bother to answer this question He just assumed that the differences in comparative advantage depended on comparative difference in labor productivity (that is, differences in technology), but he did not explain the basis for these differences. Implicit reason in his example was climate...

Relations with Ricardian Model It remained to Heckscher and Ohlin to offer an explanation for this. And this theory has become, since 1930s, the orthodox explanation of the ultimate cause of international trade Their basic idea is: 1. Commodities differ in their factor requirements 2. Countries differ in their factor endowments

Relations with Ricardian Model A country has comparative advantage in those commodities that use its abundant factors intensively. This is why labor-abundant countries, such as India, China and Korea export footwear, rugs, textiles, and other labor intensive commodities; and land-abundant countries, such as Argentina, Australia, and Canada, export meat, wheat, wool, and other land-intensive commodities

Basic Assumptions 1. Number of countries, factors, and commodities are all two 2 x 2 x 2 model Two inputs (factors): Labor (L) & Capital (K) Two outputs: Cloth (Qc) & Steel (QS) Two Countries, e.g. US & China Different proportion of factor endowment: US is a capital-abundant country and China is a labor-abundant country (K/L)US > (K/L)China

Basic Assumptions 2. Technology is the same in both countries same production functions Qc = Qc (Kc, Lc), QS = QS (KS, LS) （cloth is labor-intensive good both in US & China ) 3. Strong factor intensity Cloth is labor-intensive good , Steel is capital-intensive good  At any given factor price ratio w/r, KS /LS > Kc /Lc

Basic Assumptions 4. Constant returns to scale 5. Incomplete specializationincreasing opportunity costs 6. Perfect competition 7. Factors are perfectly mobile within each country but not so between countries 8. Tastes are largely similar between countries 9. Free trade, transportation costs are zero

Factor Abundance (1) “physical” Definitions Cloth Steel PPFChina PPFUS A B Physical definition is based on the total amounts of factors: US is relatively capital abundant compared to China

Factor Abundance (2) “price” Definitions Price definition uses wage/rental ratios: US is relatively capital abundant compared to China. (Why?) K Iso-cost line for US Isoquant line A B Iso-cost line for China C D L

Factor Intensive K KS /LS Isoquant line Iso-cost line Kc /Lc L

Basis for Trade factor endowments, technology and tastes The structure of trade, in general, can be traced back to differences in factor endowments, technology and tastes Since Heckscher-Ohlin theory assumes that technology and tastes are similar between countries, it attributes the comparative advantage to differences in factor endowments

Basis for Trade Different relative factor endowments different relative factor prices different relative production cost different relative prices of products Comparative advantage in producing and exporting the product that uses its abundant recourse intensively (lower relative cost)

Pattern of production and trade The capital-abundant country exports the capital-intensive commodity, and the labor-abundant country exports the labor-intensive commodity. In this case, US should export steel and China should export cloth.

Numerical example One country Required inputs per unit of output

Derivation of PPF (one country) Cloth 600 • M Capital Constraint If the economy had an unlimited supply of capital (labor), it would be able to produce along the labor constraint JG (capital constraint MH). When the supplies of both factors are limited, both constraints become binding and the production frontier coincides with the heavy kinked line JEH. Because steel is capital intensive relative to cloth, the capital constraint is steeper than the labor frontier. J 225 • E • Labor constraint 150 G H • • 150 200 450 Steel

Derivation of PPF (two countries)

Graphical Presentation

Effects of Trade To relative price of goods To Factor Prices Trade increase the relative price of goods for export, while decrease that for import. To Factor Prices To production More resources are used in the productions for export. To consumption Comparing with close economy state, the consumptions possibility rise, but the consumptions for both goods need not rise. It depend on the relative price change and community preferences

Effects of Trade on Factor Prices Short-Run (no factors are mobile among sectors) Long-Run (all factors are able to move among sectors ) The Factor Price Equalization Theorem & Stopler - Samuelson theorem

Short-Run Effect Return to factors w = P x MPL r = P x MPK （No changes in marginal productivity of factor ，so w&r are determined by changes in Product Price） Price of export product , both factors in the export sector gain Price of import-competing product , both factors in the import-competing sector loss

Long-run Effect 1. The Stolper-Samuelson (S-S) Theorem Free trade raises the return to the factor used intensively in the rising-price sector (export sector) and lowers the return to factor used intensively in the falling-price (import competing sector) 2. Effect on distribution of income Owners of a country’s abundant factors gain from trade,but owners of scarce factors lose.