McGraw-Hill/Irwin Copyright  2009 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 4: Trade: Factor Availability and Factor Proportions Are Key

4-2 Figure Production Possibilities under Increasing Costs

4-3 Production possibilities with increasing costs Why is the PPC bowed out? – law of increasing opportunity cost Why is the PPC bowed out? – law of increasing opportunity cost The slope of the PPC increases as we move to the right The slope of the PPC increases as we move to the right Why? Wheat and cloth use factors in different proportions (even with CRS industries) Why? Wheat and cloth use factors in different proportions (even with CRS industries) Readjustment causes effects similar to the law of diminishing returns Readjustment causes effects similar to the law of diminishing returns

4-4 Why choose to produce at S 0 ? Why choose to produce at S 0 ? If at S1, producing an extra unit of cloth costs only 1W/C, therefore produce more cloth If at S1, producing an extra unit of cloth costs only 1W/C, therefore produce more cloth If at S3, producing an extra unit of cloth costs 3W/C, therefore produce less cloth If at S3, producing an extra unit of cloth costs 3W/C, therefore produce less cloth If a S 0, the opportunity cost of cloth is the same as the price – no reason to adjust production If a S 0, the opportunity cost of cloth is the same as the price – no reason to adjust production

4-5 Figure 4.2 – Indifference Curves Relating an Individual’s Utility Levels to Consumption of Two Goods

4-6 Review of consumer theory Indifference curves – meaning, shape Indifference curves – meaning, shape Budget line Y=PwQw+PcQc and Budget line Y=PwQw+PcQc and Qw=Y/Pw – (Pc/Pw)Qc The optimal point is where the budget constraint is tangent to the indifference curve The optimal point is where the budget constraint is tangent to the indifference curve At that point the slope of the indifference curve is equal to Pc/Pw At that point the slope of the indifference curve is equal to Pc/Pw We apply the same theory using community indifference curves and the PPC We apply the same theory using community indifference curves and the PPC

4-7 Figure 4.3 – Indifference Curves and Production Possibilities without Trade

4-8 Production and consumption with trade The free-trade equilibrium is at a price ratio of 1W/C – this is the slope of the price line The free-trade equilibrium is at a price ratio of 1W/C – this is the slope of the price line Production is at S1 Production is at S1 Consumption is at C1 – the tangent point of the price line and the highest community indifference curve Consumption is at C1 – the tangent point of the price line and the highest community indifference curve

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4-10 US US Exports: 40 billion units of wheat (80-60) Exports: 40 billion units of wheat (80-60) Imports: 40 billion units of cloth (60-20) Imports: 40 billion units of cloth (60-20) Trade triangle: S 1 TC 1 Trade triangle: S 1 TC 1 ROW ROW Exports: 40 billion units of cloth (100-60) Exports: 40 billion units of cloth (100-60) Imports: 40 billion units of wheat (55-15) Imports: 40 billion units of wheat (55-15) Trade triangle: C 1 TS 1 Trade triangle: C 1 TS 1

4-11 Derive D and S curves for cloth in US Derive D and S curves for cloth in US At 1W/C US consumes 60 units of cloth (point C1) At 1W/C US consumes 60 units of cloth (point C1) At 2W/C US consumes (and produces) 40 units of cloth (market equilibrium) (point So) At 2W/C US consumes (and produces) 40 units of cloth (market equilibrium) (point So) At 1W/C US produces 20 units of cloth (point S1) At 1W/C US produces 20 units of cloth (point S1)

4-12 Derive demand and supply curves for cloth in ROW Derive demand and supply curves for cloth in ROW At 1W/C ROW consumes 60 units of cloth (point C1) At 1W/C ROW consumes 60 units of cloth (point C1) At 2W/C ROW consumes (and produces) 80 units of cloth (market equilibrium) (point So) At 2W/C ROW consumes (and produces) 80 units of cloth (market equilibrium) (point So) At 1W/C ROW produces 100 units of cloth (point S1) At 1W/C ROW produces 100 units of cloth (point S1)

4-13 Gains from trade with variable costs Trade allows a country to consume at a point above its PPC Trade allows a country to consume at a point above its PPC Trade allows each country to achieve a higher community indifference curve Trade allows each country to achieve a higher community indifference curve Distribution of benefits??? Distribution of benefits??? Which country gains more? Which country gains more? The higher its export prices (compared to equilibrium before trade) the more a country gains The higher its export prices (compared to equilibrium before trade) the more a country gains The lower its import prices (compared to pre-trade) the more a country gains The lower its import prices (compared to pre-trade) the more a country gains Terms of trade – the price of exports relative to the price of imports Terms of trade – the price of exports relative to the price of imports

4-14 Gains from trade with variable cost ROW will have better terms of trade if the price of cloth (its export product) is higher will have better terms of trade if the price of cloth (its export product) is higher the international price line will be steeper leading to a higher community indifference curve the international price line will be steeper leading to a higher community indifference curve US US will have better terms of trade if the price of wheat (its export product) is higher will have better terms of trade if the price of wheat (its export product) is higher The international price line will be flatter leading to a higher community indifference curve The international price line will be flatter leading to a higher community indifference curve

4-15 Gains from trade with variable cost Increased production of the export product (wheat in US; cloth in ROW) Increased production of the export product (wheat in US; cloth in ROW) Reduced production of the import competing product (cloth in US;wheat in ROW) Reduced production of the import competing product (cloth in US;wheat in ROW) Resource re-allocation from import-competing to export product Resource re-allocation from import-competing to export product Countries do not specialize completely in producing their export product Countries do not specialize completely in producing their export product

4-16 Gains from trade with variable cost More efficient world production More efficient world production From 50+30=80 units of wheat (S 0 in US and ROW) From 50+30=80 units of wheat (S 0 in US and ROW) To 80+15=95 units of wheat (S 1 in US and ROW) To 80+15=95 units of wheat (S 1 in US and ROW) Cloth production unchanged at 120 units Cloth production unchanged at 120 units Increased consumption of the imported product (cloth in US, wheat in ROW) Increased consumption of the imported product (cloth in US, wheat in ROW) Increase in real income (income effect) Increase in real income (income effect) Consumption of exported product can decrease or increase depending on the strength of income and substitution effects Consumption of exported product can decrease or increase depending on the strength of income and substitution effects

4-17 Trade patterns and the Heckscher-Ohlin Theory of Trade The patterns of trade are determined by The patterns of trade are determined by production differences – different shapes of PPC production differences – different shapes of PPC demand differences – differences in community indifference curves demand differences – differences in community indifference curves The Heckscher-Ohlin theory: The Heckscher-Ohlin theory: A country will export products that use relatively intensively those production factors found relatively abundantly in the country A country will export products that use relatively intensively those production factors found relatively abundantly in the country Wheat is land-intensive Wheat is land-intensive Land is relatively cheaper in US (land is abundant in US) Land is relatively cheaper in US (land is abundant in US) The US has a comparative advantage and exports wheat The US has a comparative advantage and exports wheat

4-18 Trade patterns and the Heckscher- Ohlin Theory of Trade A country will import products that use relatively intensively those production factors that are relatively scarce in the country. A country will import products that use relatively intensively those production factors that are relatively scarce in the country. Cloth is labour-intensive Cloth is labour-intensive Labour is more expensive in the US (scarce) Labour is more expensive in the US (scarce) The US imports cloth The US imports cloth

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4-23 Heckscher-Ohlin Theory of Trade A country will export products that use relatively intensively those production factors found relatively abundantly in the country, and import products that use relatively intensively those production factors that are relatively scarce in the country. A country will export products that use relatively intensively those production factors found relatively abundantly in the country, and import products that use relatively intensively those production factors that are relatively scarce in the country. H-O comparative advantage is actually a triple comparison: H-O comparative advantage is actually a triple comparison:  across countries  across products  across factors of production

4-24 Summary Summary The Neo-Classical Model The Neo-Classical Model The Heckscher-Ohlin Theory The Heckscher-Ohlin Theory