1. Slides prepared by Thomas Bishop Chapter 4 Resources, Comparative Advantage and Income Distribution

2. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 4-2 Introduction While trade is partly explained by differences in labor productivity, it also can be explained by differences in resources across countries. The Heckscher-Ohlin model shows that comparative advantage is influenced by the interaction between nations’ resource endowment and the technology of production (how to use resources in production of each product).  Countries have relative abundance of factors of production.  Production processes use factors of production differently in relative intensity.

3. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 4-3 A Model of a Two Factor Economy - This chapter introduces the simplest version of the Heckscher-Ohlin Model (factor-proportions model). - This model assumes there exist two countries, two goods, two factors of production (2 by 2 by 2 model). Home and Foreign, food and cloth, labor and land -At first, we discuss the characteristics of one economy (namely, Home) of this model. - Later, we discuss the two economies together and their trade.

4. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 4-4 Production Possibilities When there is more than one factor of production, the PPF is no longer a straight line. Why?  Opportunity cost is not constant. Let’s expand the previous chapter’s model to include two factors of production, labor and land.  a TC = hectares of land used to produce one unit of cloth  a LC = hours of labor used to produce one unit of cloth  a TF = hectares of land used to produce one unit of food  a LF = hours of labor used to produce one unit of food <cf: unit labor requirement (of Ch 3).  L = total amount of labor available for production  T = total amount of land (terrain) available for production

5. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 4-5 Production Possibilities (cont.) Let’s assume that ratio of labor to land in cloth production is higher than that in food production :  a LC /a TC > a LF /a TF  (at any level of factor price).  We may interpret this as cloth production is labor intensive (food production is land intensive). (This assumption influences the slope of the production possibility frontier)

6. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 4-6 Production Possibilities (cont.) First, consider special case, where a TC, a LC, a FC, a LF are fixed: no substitution between labor and land. Production possibilities are influenced by both land and labor constraints (two resource constraints). a TF Q F + a TC Q C ≤ T a LF Q F + a LC Q C ≤ L Total amount of land resources Land required for each unit of food production Total units of food production Land required for each unit of cloth production Total units of cloth production Total amount of labor resources Labor required for each unit of food production Labor required for each unit of cloth production

7. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 4-7 Production Possibilities (cont.)

8. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 4-8 Production Possibilities (cont.) The economy must produce subject to both constraints.  The PPF becomes the kinked line (in red) of the graph. The opportunity cost of producing cloth (in terms of food) is not constant in this model:  it’s low when the economy produces a low amount of cloth (and a high amount of food).  it’s high when the economy produces a high amount of cloth (and a low amount of food).

9. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 4-9 Production Possibilities (cont.) The above PPF do not allow substitution of land for labor in production or vice versa.  Unit factor uses (a TC, a LC, a FC, a LF ) are constant along each line segment of the PPF. If we allow substitution of inputs (generalize the situation), then the PPF becomes smoothly curved.  That is, many laborers could work on a small plot of land or a few labors could work on a large plot of land to produce the same amount of output.  Unit factor requirements vary, as cloth and food production quantities change.

10. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 4-10 Production Possibilities (cont.)

11. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 4-11 Production and Prices The PPF describes what an economy can produce, but to determine what the economy does produce (on the PPF), we must know the prices of goods. In general, the economy should produce at the point that maximizes the value of production, V: V = P C Q C + P F Q F  where P C is the price of cloth and P F is the price of food.  Isovalue line is defined for any given value of V.

12. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 4-12 Production and Prices (cont.) Define an isovalue line as a line representing a constant value of production.  V = P C Q C + P F Q F  Rearranging the above, P F Q F = V – P C Q C  Q F = V/P F – (P C /P F )Q C  That is, isovalue line is a straight line with slope of – (P C /P F ) and vertical intercept of V/P F.

13. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 4-13 Production and Prices (cont.)

14. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 4-14 Production and Prices (cont.) Given prices of output, one isovalue line represents the maximum value of production, say at a point Q. At that point, the slope of the PPF equals – (P C /P F ), so the opportunity cost of cloth equals the relative price of cloth.

15. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 4-15 Input Possibilities: Isoquant (Curve) In the production of each unit of food, unit factor uses of land and labor are not constant in the Heckscher-Ohlin model

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17. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 4-17 Choosing the Mix of inputs: Factor Prices, Goods Prices and Factor Use Producers may choose different amounts of factors of production used to make cloth or food. Their choice depends on the relative cost of land and labor (namely w/r, where w is wage rate and r is rental rate of the land). As the wage rate increases relative to the rental rate (i.e., w/r increases), producers are willing to use more land and less labor in the production of food and cloth.

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19. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 4-19 Choosing the Mix of inputs (cont’d) There is a corresponding relationship between (w/r) and the land-labor ratio in cloth (food) production.  This relation is shown as the CC for cloth, and FF for food in the following graph.  CC lies to the left of FF, because a LC /a TC > a LF /a TF  That is, food production will have higher (T/L) than cloth production for any given factor prices. We say that food production is land intensive, and cloth production is labor intensive

20. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 4-20 Factor Prices, Goods Prices and Factor Use (cont.)

21. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 4-21 Factor Prices, Goods Prices and Factor Use (cont.) Under mkt competition, the price of a good equals the cost of production, and the cost of production depends on the factor prices (w and r). The effect of the change in factor prices on the price of cloth (food) depends on the intensity of land (T/L) for cloth (food) production.  An increase in the rental rate of land (wage rate) will affect the price of food (cloth) more than the price of cloth (food). There is a one-to-one relationship between the relative factor price (w/r) and the relative price between cloth and food (P C /P F ).  See Figures in Appendix for more close examination.

22. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 4-22 Factor Prices, Goods Prices and Factor Levels (cont.)

23. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 4-23 Factor Prices, Goods Prices and Factor Levels (cont.) We have a relationship among factor prices and good prices and the factor use in production:  Now, let us combine the above two figures.

24. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 4-24 Factor Prices, Goods Prices and Factor Levels (cont.)

25. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 4-25 Factor Prices, Goods Prices and Factor Uses (cont.) An increase in the relative price P C /P F will :  Raise the wage of workers relative to rent of landowners, w/r.  Raise the ratio of land to labor, T/L, in both cloth and food production and thus raise MPL in terms of both goods.  Raise the purchasing power of workers and lower the purchasing power of landowners, by raising real wages (w/P f = MPL f or w/P c = MPL c ) and lowering real rents in terms of both goods.

26. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 4-26 Factor Prices, Goods Prices and Factor Uses (cont.) Now we have a theory that predicts changes in the income distribution when the relative price of goods changes.  potentially, because of trade. (Stolper-Samuelson Theorem ): If the relative price of a good increases, then the nominal and real return to the factor used intensively in production of that good increases, while the nominal and real return to the other factor decreases.  Distributional effect of international trade.

27. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 4-27 Factor Prices, Goods Prices, Factor Use and Output Levels Complete the model, by looking at the relation among goods price, factor price, factor supplies, factor proportion, and output. Given the relative price and the supplies of land and labor, how much of each resource will be devoted to producing each good?  It would decide the output level at the economy’s PPF.  Use a ‘ box diagram ’. The width & height represent the given total supply of labor and land, respectively. Any single point in the box represents a specific resource allocation.

28. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 4-28 Factor Prices, Goods Prices, Factor Uses and Output Levels (cont.)

29. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 4-29 Factor Prices, Goods Prices, Factor Levels and Output Levels (cont.) How do output levels change when the economy’s resources change? As a factor of production increases, then the supply of the good that uses this factor intensively increases and the supply of the other good decreases (assuming output prices constant).  If L (total labor supply) increase, cloth production increase, while food production decrease.  This proposition is called the Rybczynski theorem.

30. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 4-30 Factor Prices, Goods Prices, Factor Levels and Output Levels (cont.)

31. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 4-31 Factor Prices, Goods Prices, Factor Levels and Output Levels (cont.) An increase in the supply of land (labor) leads to a biased expansion of production possibilities toward food (cloth) production.  An increase in land (labor) supply expands PPF disproportionately to the direction of food (cloth) production (see the next graph). The biased effect of increases (decreases) in resources on production possibilities is the key to understanding how differences in resources give rise to international trade.

32. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 4-32 Factor Prices, Goods Prices, Factor Levels and Output Levels (cont.)

33. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 4-33 Factor Prices, Goods Prices, Factor Levels and Output Levels (cont.) A economy with a high ratio of land to labor is predicted to have a high output of food relative to cloth.  It will be relatively efficient at (have a comparative advantage in) producing food. (Generalization) an economy is relatively efficient at producing goods that are intensive in the factors of production which the country is relatively abundantly endowed with.

34. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 4-34 Trade in the Heckscher-Ohlin Model : Now Two Countries model. Suppose that the Home has an abundant amount of labor relative to the amount of land.  The Home is abundant in labor and the Foreign is abundant in land: L/T > L*/ T*  Eg. If US has 8 million workers and 20 million acres, while UK has 2 million workers and 2 million acres, then UK is labor-abundant and US is land- abundant.  However, the countries are assumed to have the same technology and same consumer tastes.

35. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 4-35 Trade in the Heckscher-Ohlin Model (cont.) Because the Home is abundant in labor, it will be relatively efficient at producing cloth, because cloth is labor intensive.  The Home’s PPF will allow a higher ratio of cloth to food relative to the Foreign’s PPF.  At each relative price, the Home will produce a higher ratio of cloth to food than the Foreign. The Home will have a higher relative supply of cloth than the Foreign (for any relative prices).

36. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 4-36 Trade in the Heckscher-Ohlin Model (cont.)

37. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 4-37 Trade in the Heckscher-Ohlin Model (cont.) Like the Ricardian model, the Heckscher-Ohlin model predicts a convergence of relative prices after trade. With trade, the relative price of cloth will rise in the Home and fall in the Foreign.  In the Home, the rise in the relative price of cloth leads to a rise in the relative production of cloth and a fall in relative consumption of cloth; Home becomes exporter of cloth and importer of food.  The decline in the relative price of cloth in the Foreign leads it to become an importer of cloth and an exporter of food.  Also, the change in relative price due to trade would affect income distribution within the two countries. (refer to slide 25)

38. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 4-38 Trade in the Heckscher-Ohlin Model (cont.) (Summary of the previous discussion) An economy will be relatively efficient at (or, have a comparative advantage in) producing goods that are intensive in its abundant factors of production. An economy will export goods that are intensive in its abundant factors of production and import goods that are intensive in its scarce factors of production.  This proposition is called the Heckscher-Ohlin theorem

39. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 4-39 Trade in the Heckscher-Ohlin Model (cont.) The value of goods consumed is constrained to equal the value of goods produced for each country. P C D C + P F D F = P C Q C + P F Q F where D C represents domestic consumption demand for cloth and D F represents domestic consumption demand for food (D F – Q F ) = (P C /P F )(Q C – D C ) Quantity of exports Price of exports relative to imports Quantity of imports

40. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 4-40 Trade in the Heckscher-Ohlin Model (cont.) This equation is the budget constraint for an economy, and it has a slope of – (P C /P F ) Note the budget constraint touches the PPF: a country can always afford to consume what it produces.  However, a country need not consume only the goods and services that it produces with trade.  Exports and imports can be greater than zero. Furthermore, a country can afford to consume more of both goods with trade, with production change.

41. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 4-41 Trade in the Heckscher-Ohlin Model (cont.)

42. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 4-42 Trade in the Heckscher-Ohlin Model (cont.)

43. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 4-43 Trade in the Heckscher-Ohlin Model (cont.)

44. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 4-44 Trade and the Distribution of Income Because an economy can afford to consume more with trade, the country as a whole is made better off. But not everybody will gain from trade, unless there will be some redistribution of income. Trade changes relative prices of goods, which have effects on the relative earnings of labor and land.  A rise in the price of cloth raises the purchasing power of domestic laborers, but lowers the purchasing power of domestic land owners. (refer to slide 25 & slide 37). The model predicts that with trade opened, owners of abundant factor gain, but owners of scarce factor lose.

45. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 4-45 Factor Price Equalization The Heckscher-Ohlin model predicts that factor prices will be equalized among countries that trade.  In the absence of trade, labor would earn less in Home (labor-abundant) than Foreign, and land-owner earn more. Home has lower (Pc/Pf) and lower (w/r) than Foreign.  International trade leads to convergence of (Pc/Pf), again leading to convergence of (w/r) due to 1-1 correspondence. Then even w=w*, r=r* follows (MPL or MPT converge between the countries using the same technology, due to the same K/L).  Trade increases demand for goods produced by abundant factor, indirectly increasing the demand for the abundant factor itself, raising the factor price of the abundant factor (which used to be low before trade) in all the countries. Trade of goods are indirect trade of factors of production.

46. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 4-46 Factor Price Equalization (cont.) But factor prices are not actually equal across the countries. Three assumptions crucial to the prediction of factor price equalization are in reality not valid:  Both countries produce both goods  Both countries have the same technologies in production  Both countries have the same prices of goods due to trade (no barriers to trade & transportation cost).

47. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 4-47 Trade and Income Distribution in the SR and the LR. After an economy liberalizes trade, factors of production may not quickly move to the industries that intensively use the abundant factors (in real world, where mobility is limited).  In the short run, the productivity of factors will be determined by their use in their current industry. If trade leads to fall in (Pc/Pf), then (w/r) will decrease in the LR, and land (labor) will be better off (worse off). In the SR, owner of land currently used in cloth production will be worse off & labor in food better off.

48. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 4-48 Political Economy of Trade: A Preliminary View In the H.-O. model, there are typical losers and winners from trade. <cf: Ricardian Model  In the LR, scarce factor lose from trade.  In the SR, factors that are specific (fixed) to the industries competing with imports are losers. Three questions arise.  In what sense, we can talk about gains from trade  What should government do, considering losers from trade  What gov’t does in practice?

49. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 4-49 Gains from Trade, revisited

50. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 4-50 Optimal Trade Policy Gov’t must weigh one’s gain against other’s loss.  There are some reasons why one group (eg. poor) matter more than others (at least in political sense). Changes in income distribution occur with every economic change, not only international trade.  Changes in technology, changes in consumer preferences, exhaustion of resources etc, all affect income distribution.  Economists put most of the blame on technological change as the major cause of increasing income inequality in the US. It would be better to compensate the losers from trade than prohibit trade.  The economy as a whole does gain from trade.

51. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 4-51 Income Distribution and Trade Politics There is a political bias in trade politics: potential losers from trade are better politically organized than the winners from trade.  Losses are usually concentrated among a few, but gains are usually dispersed among many (like consumers).  Example: protection of sugar industry in US Each pays about $8/year to restrict imports of sugar, and the total cost of this policy is about $2 billion/year. The benefits of this program total about $1 billion, but this amount goes to relatively few sugar producers.

52. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 4-52 Empirical Evidence of the Heckscher-Ohlin Model Tests on US data  Leontief found that US exports were less capital-intensive than US imports, even though the US is the most capital- abundant country in the world: Leontief paradox. Tests on global data  Bowen, Leamer, and Sveikauskas tested the Heckscher- Ohlin model on data from 27 countries and confirmed the Leontief paradox on an international level. Tests on manufacturing trade between low/middle income countries and high income countries.  This data lends more support to the theory.

53. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 4-53 Empirical Evidence of the Heckscher-Ohlin Model (cont.)

54. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 4-54 Empirical Evidence of the Heckscher-Ohlin Model (cont.)

55. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 4-55 Empirical Evidence of the Heckscher-Ohlin Model (cont.)

56. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 4-56 Summary 1.Substitution of factors in the production process generates a curved PPF.  When an economy produces a low level of a good, the opportunity cost of producing that good is low.  When an economy produces a high level of a good, the opportunity cost of producing that good is high. 2.When an economy produces on its PPF, the opportunity cost of producing a good equals the relative price of that good.

57. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 4-57 Summary (cont.) 3.If the relative price of a good increases, then the real wage or rate of return of the factor used intensively in the production of that good increases, while the real wage or rate of return of the other factor decreases. 4.If we hold output prices constant as a factor of production increases, then the supply of the good that uses this factor intensively increases, and the supply of the other good decreases.

58. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 4-58 Summary (cont.) 5.An economy will export goods that are intensive in its abundant factors of production and import goods that are intensive in its scarce factors of production. 6.The Heckscher-Ohlin model predicts that relative output prices and factor prices will equalize, neither of which occurs in the real world. 7.The model predicts that owners of abundant factors gain, but owners of scarce factors lose with trade.

59. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 4-59 Summary (cont.) 8.A country as a whole will be better off with trade, even though the model predicts that owners of scarce factors will be worse off without compensation. 9.Empirical support of the Heckscher-Ohlin model is weak except for cases involving trade between high income countries and low/middle income countries.

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