INTERNATIONAL TRADE LECTURE 8: The Basis For Trade Factor Endowments and the Heckscher-Ohlin Model

Contents To introduce the relationship between labor standards and comparative advantage To research the relevance of supply, demand, and autarky prices To explain the factor endowments and the Heckscher-Ohlin Theorem To understand the theoretical qualifications to Heckscher-Ohlin Thorem

Introduction The role of labor standards in fostering international trade is really important and attract interest widespread  Production of labor-intensive goods has continued to move to developing countries with increased globalization  Some economists believed that different categories of labor standards have an effect on comparative advantage in developing countries low labor standards  comparative advantage in unskilled labor intensive goods  increased export

Introduction They insist to built import barriers to ensure a more “level playing field”  Empirical work Focused on core labor standards rather than acceptable conditions of work  Core labor: elimination of discrimination against women; union rights; freedom from forced labor; abolition of child labor; equal opportunities  Acceptable conditions of work: minimum wages; safety and health standards

Introduction Hypothesize: lower core labor standards would lead to a relative increase in unskilled labor and thus increase relative exports of unskilled labor intensive goods Conclusions  greater discrimination against women weakened comparative advantage  Weaker union rights, greater child labor, and greater use of forced labor increased export share  The number of ratifications of the ILO conventions appeared to have no significant effect  Educational attainment and the overall relative labor endowment had relatively stronger influences on the trade patterns than did the labor standard variables

Introduction It is necessary to use a more formal structure to sort out the complexities of international comparative advantage What we discussed in last lecture is that a country will gain from trade any time that the terms of trade differ from its own relative prices in autarky (source of trade gain) This lecture we focus on differences in supply conditions and try to provide a deeper understanding of the critical factors underlying relative cost differences and therefore comparative advantage Quantities of factor of production  prices of factor of production  international trade International trade  prices of factor of production  comparative advantages

Supply, Demand, and Autarky Prices The source of difference in pretrade price ratios between countries lies in the interaction of aggregate supply and demand

Supply, Demand, and Autarky Prices It is clear that there is a basis for trade whenever supply conditions or demand conditions vary between countries This assumes there is no intervention in the markets to alter prices from these general equilibrium results Although taxes and subsidies can cause autarky prices to be more or less different prior to trade, we now only examined the role of factor availabilities in international trade

Factor Endowments and the Heckscher-Ohlin Theorem Simplifying assumptions of H-O Theorem  There are two countries, two homogeneous goods, and two homogeneous factors of production whose initial levels are fixed and assumed to be relatively different for each country (different factor endowment)  Technology is identical in both countries; that is, production functions are the same in both countries (fixed PPF)  Production is characterized by constant returns to scale for both commodities in both countries  The two commodities have different relative factor intensities, and the respective commodity factor intensities are the same for all factor price ratios

Factor Endowments and the Heckscher-Ohlin Theorem  Tastes and preferences are the same in both countries. Further, for any given set of product prices, the two products are consumed in the same relative quantities at all levels of income; that is, there are homothetic tastes and preferences (same IC and fixed slope)  Perfect competition exists in both countries (no invention)  Factors are perfectly mobile within each country and not mobile between countries (fixed and same domestic factor price)  There are no transportation costs  There are no policies restricting the movement of goods between countries or interfering with the market determination of prices and output (no invention from the government)

Factor Endowments and the Heckscher-Ohlin Theorem Factor Abundance and Heckscher-Ohlin  Factor endowments Different factor endowments refers to different relative factor endowments Relative factor abundance may be defined in two ways: the physical definition and the price definition  The physical definition (quantity conception): in terms of the physical units of two factors (K/L) I > (K/L) II focus on physical availability of supply (capital intensity)  The price definition (monetary conception): in terms of the relative scarcity prices (r/w) I < (r/w) II focus on factor price (capital intensity)  What is the link between above two?

Factor Endowments and the Heckscher-Ohlin Theorem The factor price reflects not only the supply of available factors but also the demand  The demand for a factor of production is a derived demand  Factor prices reflect not only the physical availability of the factors in question but also the structure of final demand and the production technology employed  Assumption of H-O theorem: technology and tastes and preferences are the same in both countries  Conclusion: the country with the relatively larger K/L ratio also will have the relatively smaller r/w ratio with technology and demand influences neutralized between the two countries, no matter which definition we take

Factor Endowments and the Heckscher-Ohlin Theorem Commodity Factor Intensity and Heckscher- Ohlin (with physical definition)  A factor-x-intensive commodity: the ratio of factor x to a second factor y is larger when compared with a similar ratio of factor usage of a second commodity  H-O assumes not only that the two commodities have different factor intensities at common factor prices but also that the difference holds for all possible factor price ratios in both countries  This is a strong assumption and it is critical to the H-O analysis and it does not preclude substituting effect  Example: two country, two factors, two commodities

Factor Endowments and the Heckscher-Ohlin Theorem

The Heckscher-Ohlin Theorem  The PPF will differ between two countries solely as a result of their differing factor endowments With identical technology, constant returns to scale, and a given factor intensity relationship between final products, the country with abundant capital will be able to produce relatively more of the capital intensive good, vice versa The shape and position of the PPF is determined by the factor intensities of the two goods and the amount of each factor available

Factor Endowments and the Heckscher-Ohlin Theorem Considering K/L （ r/w ） Capital intensive Labor intensive Country I’s PPF is oriented more toward steel, and Country II’s PPF is oriented more toward cloth

Factor Endowments and the Heckscher-Ohlin Theorem  Combined the two PPF above and the same set of tastes and preferences, two different sets of relative prices will emerge in autarky, thus trade basis  The trade implications P s1 <P s2 P c1 >P c2 Country I is capital abundant, and country II is labor abundant Country I export steel, and country II export cloth

Factor Endowments and the Heckscher-Ohlin Theorem A similar discussion in terms of the price definition  (r/w) I < (r/w) II With identical technology and constant returns to scale, country I will be able to produce steel relatively more cheaply than country II, and country II can produce cloth relatively more cheaply than country I  Relationship between relative factor prices and relative product prices can be developed through isoquant-isocost analysis

Factor Endowments and the Heckscher-Ohlin Theorem  (r/w) I (w/r) II  For country I, MN, (w/r) I, X and Y, S 1 and C 1  For country II M’N’, (w/r) II, Q and T, S 1 and C 2, C 2 >C 1 Cloth in country II is cheaper, and steel in country I is cheaper Conclusion: a higher w/r leads to a higher relative price of cloth

Factor Endowments and the Heckscher-Ohlin Theorem  Different relative factor prices will generate different relative commodity prices in autarky, each country expanded production of and exported the good that made the more intensive use of its relatively abundant factor of production

Factor Endowments and the Heckscher-Ohlin Theorem Heckscher-Ohlin theorem  A country will export the commodity that uses relatively intensively its relatively abundant factor of production, and it will import the good that uses relatively intensively its relatively scarce factor of production

Factor Endowments and the Heckscher-Ohlin Theorem The Factor Price Equalization Theorem  After participate in the trade, prices adjust until both countries face the same set of relative prices (before trade: (w/r) I > (w/r) II )  In H-O framework, this convergence of product prices takes place as the price of the product using the relatively abundant factor increases with trade and the price of the product using the country’s relatively scarce factor falls  Note: under perfect competition, production will shift along the PPF and resources must be shifted from one to another  The adjustment of commodity price will affect the price of factor. Considering Country II, labor abundant country  After participate in the trade, what will happen to country II? P c rise, P s fall Resources shift -> D L rise, D K fall P L rise, P K fall w/r rise -> K/L rise due to substitution effect

Factor Endowments and the Heckscher-Ohlin Theorem Capital Labor

Factor Endowments and the Heckscher-Ohlin Theorem  The change of factor prices will cause the factor prices ratio, (w/r) II, to rise and induce producers to move to a different equilibrium point on each respective isoquants (C decrease and S increase). the K/L will rise  Similar adjustment take place in Country I while the w/r decrease and K/L decrease

Factor Endowments and the Heckscher-Ohlin Theorem  The Factor Price Equalization Theorem Prior to trade (w/r) I > (w/r) II After trade (w/r) I = (w/r) II In equilibrium, with both countries facing the same relative (and absolute) product prices, with both having the same technology, and with constant returns to scale, relative (and absolute) costs will be equalized. The only way this can happen is if, in fact, factor prices are equalized.

Factor Endowments and the Heckscher-Ohlin Theorem  Trade in final goods essentially substitutes for movement of factors between countries, leading to an increase in the price of the abundant factor and a fall in the price of the scarce factor among participating countries until relative factor prices are equal

Factor Endowments and the Heckscher-Ohlin Theorem  We do not observe factor price equalization theorem in practice for its assumptions are not realized or not realized as fully as stated in the model Transportation cost Tariffs and subsidies, and economic policies Imperfect competition Nontraded goods Unemployed resources Factor of production are not homogeneous Technology is not identical …

Factor Endowments and the Heckscher-Ohlin Theorem  Despite the limitations, the H-O model provides some helpful insights into the likely impact of trade on relative factor prices Trade based on comparative advantage should tend to increase the demand for the abundant factor and ultimately exert some upward pressure on its price With earning from trade, countries can import needed goods The same result would obtain with respect to commodity prices and factor prices if factors were mobile between countries and final products were immobile internationally Conclusion: goods movements and factor movements are indeed substitutes for each other

Factor Endowments and the Heckscher-Ohlin Theorem The Stolper-Samuelson Theorem and Income Distribution Effects of Trade in the Heckscher- Ohlin Model  It explains that with international trade, changes of factor price will have income distribution effects in general Assume a labor abundant country participate the trade Its labor price will increase and capital price will decrease Thus, its labor’s total nominal income will increase and capital’s total nominal income will decrease Real income is not the same as nominal income, it depends not only on changes in income, but also on changes in product prices

Factor Endowments and the Heckscher-Ohlin Theorem If workers only consume labor intensive export good, whether their real income increase or decrease?  Depends on which increased relatively more than others, income and commodity price  Wage = MP L X P  Both wage and P is increase  With trade, because wage rate increase, then less labor will be used in production, thus increase the productivity of labor at the margin, that is to say, MP L increase  Conclusion: wage rate in the labor abundant country will rise relatively more than the price of the export good. Similarly, the real income of the owners of the scarce factor is decreasing with trade

Factor Endowments and the Heckscher-Ohlin Theorem  Stolper-Samuelson theorem: with full employment both before and after trade takes place, the increase in the price of the abundant factor and the fall in the price of the scarce factor because of trade imply that the owners of the abundant factor will find their real incomes rising and the owners of the scarce factor will find their real incomes falling  Owners of the relatively abundant resources tend to be “free traders” while owners of relatively scarce resources tend to favor trade restrictions

Factor Endowments and the Heckscher-Ohlin Theorem  In real world, we may not see the clear-cut income distribution effects with trade Personal income distribution also depends on ownership of the factors of production Individuals or households often own several factors of production Thus, the final impact of trade on personal income distribution is far from clear  Concept Check on P139

Theoretical Qualifications to Heckscher-Ohlin We need to examine strict assumptions of H-O and to determine the impact of their absence Demand Reversal  H-O: tastes and preferences are identical in the trading countries  Real world: each country may value the products in very different ways and extreme example is referred to as demand reversal

Theoretical Qualifications to Heckscher-Ohlin  Country I: capital abundant, but (P C /P S ) I <(P C /P S ) II  After trade, country I will export cloth and import steel from country II  It will cause the relative price of capital to fall in country I and that of labor to fall in country II  It could interfere with factor price equalization

Theoretical Qualifications to Heckscher-Ohlin Factor-Intensity Reversal  H-O: a commodity is always relatively intensive in a given factor regardless of relative factor prices (the strong-factor- intensity assumption)  In real world: the degree of substitution between the two factors is sufficiently different between industries so that we cannot guarantee that a given product will always be relatively intensive in the same factor

Theoretical Qualifications to Heckscher-Ohlin  L and K can be substituted for each other more easily in cloth production  At (w/r) 1, capital is relatively expensive, the K/L ratio represents that steel is the capital-intensive product  At (w/r) 2, cloth is the capital intensive product (w/r) 1 < (w/r) 2 Capital is more expensive (in one country ) Labor is more expensive (in another country)

Theoretical Qualifications to Heckscher-Ohlin  If (w/r) 1 applies to country I (labor abundant) and (w/r) 2 to country II (capital abundant), what will happen? Both export cloth……???  Factor-intensity reversal occurs when a commodity has a different relative factor intensity at different relative factor prices  Factor-intensity reversal could also interfere with factor price equalization One of the country can end up exporting the good that intensively uses its relatively scarce factor For country I, if it import cloth, labor price will decrease and capital price will increase just like country II, so (w/r) will move in the same direction instead of converging toward each other

Theoretical Qualifications to Heckscher-Ohlin Transportation Costs  H-O: no transportation costs  In real world: definitely has transportation costs  Assume two country: Norway and France; two autarky price for corn: P F <P N ; France attempts to pass the entire transportation cost on to Norway

Theoretical Qualifications to Heckscher-Ohlin  Without transportation cost, the quantity for trade should be Q 1 Q 2 and q 1 q 2  With transportation cost, P N rise and imports fall thus France export fall, P F fall. Consequently the quantity move to Q 1 ’Q 2 ’ or q 1 ’q 2 ’  The difference between the price of corn in the two countries will equal exactly the transportation costs involved

Theoretical Qualifications to Heckscher-Ohlin  The participating countries will not necessarily share the transportation costs equally The incidence of the transportation cost will depend on the elasticities of supply and demand in each country Conclusion: Who inelastic, who pay more transportation cost  Transportation costs had demonstrated a downward trend because of new transport technologies and emerging marketing concerns  Transport time is important as well as distance  The implications of transportation costs do not alter H-O conclusions about the composition of trade, although the amount of trade and specialization of production will be reduced  Under this situation, relative factor prices will not equalize and complete factor price equalization cannot be attained.  If transportation costs are sufficiently large, they can prevent trade from taking place and lead to the presence of nontraded goods

Theoretical Qualifications to Heckscher-Ohlin Imperfect Competition  H-O: perfect competition  In the real world: imperfect competition, eg. Monopoly  Example I: the monopolist maintains the monopoly position at home (price setter) but at some point chooses to export at world prices (price taker) For production: MR=MC P 0 and Q 0 In the world market: MR=MC P INT and Q 1 Sold in the domestic market: Q 2 and P 2 and Q 1 Q 2 export International trade leads to an increased difference between the domestic price and the world price, not a convergence to a single commodity price

Theoretical Qualifications to Heckscher-Ohlin  Example 2: pure monopolistic price discrimination to international trade Single world supplier and the markets in the various countries can be kept separate and elasticities of demand differ between the various markets Assume: two markets, MC constant MR=MC, a higher price will be charged in the market where demand is less elastic More elasticLess elastic

Theoretical Qualifications to Heckscher-Ohlin Pure price discrimination leads to the charging of different prices in different markets and tends to reduce the degree of factor price equalization that takes place Several major suppliers may band together and form a cartel (as only supplier in the market)

Theoretical Qualifications to Heckscher-Ohlin Immobile or Commodity-Specific Factors  H-O: factors are completely mobile between different uses in production within a country (permit production adjustments move smoothly along the PPF according to product price changes)  In real world: it is not easy or even possible for factors to be moved from the production of one product to another  Analyze adjustment in short run through the specific- factors model

Theoretical Qualifications to Heckscher-Ohlin  SF model: an attempt to explore the implications of short-run factor immobility between sectors in an H-O context Three factors: labor (mobile), capital in industry X, and capital in industry Y Assume: in short time, it is not possible for K X moved to K Y In the SF model, the contract curve is the horizontal line point A

Theoretical Qualifications to Heckscher-Ohlin The different contract curves will be associated with different PPFs RA’S and TA’V Considering A to B, and A to C The SF PPF will lie inside the normal PPF except at point A (compare B and C point)

Theoretical Qualifications to Heckscher-Ohlin  Implications for trade: Suppose country located A and labor intensive in autarky In H-O model  after trade, move from A to B and result in labor price increase and K/L increased in each industry, and thus productivity and wages rise  The flip side of the rise in wages is the fall in the real return to capital  Policy implications: the country’s abundant factor prefers free trade to autarky and the country’s scarce factor prefers autarky to free trade

Theoretical Qualifications to Heckscher-Ohlin In SF model, move from A to C  The increased demand for labor will increase the money wage of all labor  However, the increased demand for capital will face fixed capital supply which result in the return to capital rises in X (specialize in X production). Similarly, the return to capital decreased in Y  Policy implication: owners of capital in industry Y will argue against free trade, while those in industry X will argue in favor of it  About return to labor, the money wage for labor rises does not mean its real wage rises Consider money wage in industry X, W=P X MP LX MP LX decreased (more labor with same capital) thus w/P x fall which means money wages haven’t risen as much as the price of good X The direction of the real return for a worker therefore depends on the bundle of goods being consumed  Concept Check on P149

Summary To introduce the relationship between labor standards and comparative advantage To research the relevance of supply, demand, and autarky prices To explain the factor endowments and the Heckscher-Ohlin Theorem To understand the theoretical qualifications to Heckscher-Ohlin