1. Comparative Advantage II: Factor Endowments and the Neoclassical Model
Chapter Three
Comparative Advantage II: Factor Endowments and the Neoclassical Model
Copyright © 2003 South-Western/Thomson Learning

2. Chapter Three Outline Introduction Neoclassical World without Trade
Neoclassical World with Trade
Major Sources of Comparative Advantage

3. Introduction
Another implication of Ricardian constant-cost model – complete productive specialization – fails to match empirical observations in today’s global economy.
Economists now think the opportunity costs of production increase with output rather than remain constant.
We observe partial rather than complete specialization.
There are more sources of comparative advantage other than Ricardo's differences in relative labor productivity.

4. Introduction Why should opportunity costs differ?
If relative labor productivity were the same in all countries, the opportunity costs and autarky relative prices would also be the same, and there would be no potential gains from trade.
Second advantage for increasing-cost model:
Its ability to explain why international trade policy is so controversial.
Certain groups in certain countries always advocate unrestricted trade, while others strongly support protectionist policies.

5. Neoclassical World without Trade
Continue to use simplifying assumptions of last chapter.
Goal is to compare availability of goods in autarky with that under unrestricted trade.
In autarky, each country must decide the allocation of resources between production and consumption of two goods.

6. Production in Autarky
The Neoclassical or increasing-cost model incorporates two factors of production:
Labor (L)
Capital (K)
When used in trade theory this refers to durable inputs such as machines, buildings, iron mines, and tools.
These factors are not equally effective in producing goods X and Y.
Most production processes offer a wide range of opportunities for substituting one input for another.
Graphs of production functions and isoquants depict them.

7. Production Functions and Isoquants
For each industry, this function is the recipe specifying the maximum output firms can produce with given quantities of inputs.
Producers can generate a given quantity of output using a variety of combinations of labor and capital, because the inputs are substitutes for each other.
Graphical technique for showing all possible combinations is an isoquant (same-quantity) map.
Fig. 3.1 shows production of X in Country A.

8. Figure 3.1: Isoquant Map for an X Firm in Country AK A X
Slope =  K A /  L A
= MRTS A X X X X A 1 X A L A X

9. Production Functions and Isoquants
Each isoquant is downward sloping and convex.
Negative slope represents the fact that the two inputs are substitutes.
Using less of one requires using more of the other.
Slope represents the rate at which producers can substitute one input for the other
Rate is called Marginal Rate of Technical Substitution (MRTS)
Convexity implies this rate changes along the curve.
Higher isoquants correspond to higher levels of output.

10. Production Functions and Isoquants
Assuming there are only two inputs, an X-producing firm's total costs equal the wage rate paid to labor in A multiplied by the quantity of labor employed, plus the rental rate for capital multiplied by the quantity of capital employed.
The wage rate and the rental rate for capital are called Factor Prices or Factor Rewards.

11. Production Functions and Isoquants
By using the expression for total cost, one can draw a line (an isocost) representing all the different combinations of L and K a firm could hire for a given level of costs (Fig. 3.2).
The slope of each isocost equals the (negative) ratio of the input prices.
Higher isocost lines correspond to higher levels of total costs.

12. Figure 3.2: Costs of Different Input Combinations for an X Firm in Country AK A K A X X
Slope = – (w A /r A )
Slope = –
($10/$15) = –
(2/3)
C/r A
$60/$15
$45/$15
C/w A L A
$45/$10
$60/$10 L A X X
(a) General Case
(b) Numerical Example

13. Capital-Labor Ratio
Firms produce their outputs at the minimum possible costs (Fig. 3.3).
Point of tangency of an isoquant with an isocost line represents this decision.
The slope of the straight line from the origin through the production point equals the Capital-Labor Ratio.
If (aKX/aLX) > (aKY/aLY), good X is said to be the Capital-Intensive Good.

14. Figure 3.3: How Will a Firm in Country A Produce Good X?K A X
Slope = – (w A /r A )
Slope = MRTS A C * /r A X
(K/L) A X
Firm ’
s choice K A * X X A L A * C * /w A L A X X

15. Capital-Labor Ratio
As long as there are two goods and two factors of production, the statement that good X is capital-intensive is equivalent to the statement that good Y is Labor-Intensive.
In Fig. 3.4, steel is the capital-intensive industry and textiles the labor-intensive one.
Although industries face the same relative factor prices, they generally choose different capital-labor ratios.

16. Figure 3.4: Industries Differ in Their Capital-Labor RatiosK A
(K/L) A
steel
(K/L) A
textiles K A s
Steel A K A t
Textiles A L A L A L A s t

17. Capital-Labor Ratio
What can a country do under increasing costs (Fig. 3.5)?
With two factors of production unequally suited for the production of the two outputs, the production possibilities frontier bows out from the origin.
Reduced production of good Y releases resources in the “wrong” proportion for the X industry.
Adjustment becomes increasingly difficult as more and more X is produced, causing X’s opportunity cost to rise.

18. Figure 3.5: What Can a Country Produce Under Increasing Costs?1 Y A 1 2 Y A 2 X A X A X A 1 2

19. Equilibrium in Autarky
What would Country A do in autarky with increasing costs (Fig. 3.6)?
Country A chooses to locate at the tangency of the highest attainable indifference curve and the production possibilities frontier (PPF).
The absolute slope of the PPF at A* gives the opportunity cost and the relative price of good X.
In autarky, B produces and consumes at B*.
They achieve the highest level of utility attainable given the constraint imposed by the availability of resources and technology.

20. Figure 3.6: What Would Country A Do in Autarky with Increasing Costs?B
Slope = MRT A
Slope = MRT B
Slope = – (P /P ) A
Slope = – (P /P ) B X Y X Y
Slope = MRS A
Slope = MRS B A * Y A* U A B * Y B* U B X A* X A X B* X B
(a) Country A
(b) Country B

21. The Neoclassical World with Trade
In autarky, the production opportunity set for each country coincides with its consumption opportunity set.
Opening up the possibility of trade between countries A and B creates an opportunity for residents of each country to consume combinations of the two goods that lie outside the respective production possibilities frontiers.
The key to increased consumption with trade is found in the difference between the autarky relative prices in the two countries.

22. Productive Specialization
In the Neoclassical model, A has a comparative advantage in production of X if the relative price of X in A, (PX/PY)A, is lower than that in B, (PX/PY)B.
Implies that the opportunity cost of X is lower in A than in B.
From Fig. 3.6, A has comparative advantage in X if the slope of the relative price line representing A’s autarky equilibrium is flatter than that representing B’s.

23. Productive Specialization
Assume that each of the two countries begins to produce more of the good in which it has a comparative advantage and less of the good in which it has a comparative disadvantage.
Each additional unit of X produced in A requires fewer units of Y than when that unit of X was produced in B.
Similarly, each additional unit of Y produced in B requires forgoing fewer units of X than when that unit of Y was produced in A.
Therefore, specialization according to comparative advantage allows total output to expand – more of the good can be produced without producing less of the other good.

24. Productive Specialization
How do countries specialize with increasing costs (Fig. 3.7)?
From the autarky equilibrium, A*, country A specializes in its good of comparative advantage, X.
As A produces more X and less Y, the opportunity cost (its relative price of X) rises while that of Y falls.
From the autarky equilibrium, B*, country B increases production of Y until the opportunity cost of the two goods equalizes with that in A.
Specialization continues until point AP.

25. Figure 3.7: How Do Countries Specialize with Increasing Cost?Y A Y B B Y B p p A * Y A* A B * Y A p Y B* p X A* X A X A X B X B* X B p p
(a)
Country A
(b)
Country B

26. International Equilibrium with Trade
Once productive specialization has occurred so that the two goods’ opportunity costs are equalized between the two countries, the goods’ relative prices also will be equal in A and B.
Equilibrium Price of any good: the price at which quantity demanded equals quantity supplied.

27. International Equilibrium with Trade
In Fig. 3.8, A specializes in its comparative advantage good, X, until the opportunity cost of X equalizes in the two countries.
Trade occurs along the terms-of-trade line until A reaches its highest attainable indifference curve at point AC.
The trade triangle is AACAP.

28. Figure 3.8: What Do Countries Do Under Free Trade with Increasing Cost?Y A Y B
Slope = – (P /P ) tt
Slope = – (P /P ) tt X Y X Y A B Y A c Y B p c p U A 1 A * A B B Y A p Y B c p A c B * U B 1 X A X A X A X B X B X B c p p c
(a) Country A
(b) Country B

29. More Sources of Comparative Advantage
To locate the sources of comparative advantage, it is necessary to examine the determinants of relative prices.
Differences in relative prices can originate from differences in resource availability, technology, tastes, or some combination thereof.
Assuming that the two countries have access to the same technology, it is time to investigate the possible effects of differences in resource endowments and tastes in determining comparative advantage.

30. Role of Factor Endowments
Heckscher and Ohlin (Swedish economists) asserted the importance of differences between countries’ endowments of various factors of production in determining patterns of opportunity costs.
Made three further assumptions:
Tastes and technology did not differ between countries;
Countries differed in factor abundance; and
Goods differed in factor intensity.

31. Factor Abundance Abundance defined in two ways:
First definition is based on relative factor quantities.
Country A is capital abundant if it has more capital per unit of labor than does country B.
If A is capital abundant, then B must be labor abundant.
This definition is used in the textbook.
Second definition is based on factor prices.
Country A is capital abundant if the relative rental rate for capital in A is lower than in B.

32. Heckscher-Ohlin Theorem
In Fig. 3.9, the U.S. has a resource endowment well suited to wheat production.
Abundant in farmland. Wheat is a farmland-intensive good.
Hong Kong has a resource endowment well suited to clothing production.
Abundant in labor. Clothing is labor-intensive good.

33. Heckscher-Ohlin Theorem
Production possibilities frontiers of U.S. and Hong Kong reflect a Production Bias toward the good of comparative advantage.
If tastes were identical in each country, Heckscher and Ohlin asserted that the autarky price of wheat would be lower in U.S., and the price of clothing lower in Hong Kong.
Each country then would be the low-cost producer of the good that used its abundant factor intensively.
Under unrestricted trade, each country would specialize in and export the good that used the abundant factor intensively due to the good’s low autarky price (Heckscher-Ohlin Theorem).

34. Figure 3.9: How Do Differences in Factor Abundance Affect What Countries Can Produce?
Apparel US
Apparel C
Slope = – (P /P ) C W C
Slope = – (P /P ) US W C U C U US
Wheat US
Wheat C
(a) United States
(b) China

35. The Role of Tastes
If tastes differ between countries A and B (Fig. 3.10), the autarky price ratios will differ even if production possibilities are identical, and a basis for mutually beneficial trade will exist.
Residents of A have tastes biased towards consumption of Y, and residents of B have tastes biased towards consumption of X.
This Taste Bias gives A a comparative advantage in production of X.

36. Figure 3.10: How Can Taste Differences Create a Basis for Trade?Y A Y B
Slope = – (P /P ) A
Slope = – (P /P ) B X Y X Y U A U B X A X B
(a) Country A
(b) Country B

37. Can Heckscher-Ohlin Explain China’s Trade?
Consistent with the predictions of the Heckscher-Ohlin theory of trade, reform in China has reduced the export share of food and agricultural products (intensive in the country’s scarce arable farmland) and increased the export share of manufacturers (intensive in the country’s abundant factor…labor).

38. Figure 3.11: How Have China’s Exports Changed, 1975–1990?
Year
1975
1980
1985
1990 20 40 60 80
100
Percent of total exports
All manufactures
Food and agricultural raw materials

39. Can Heckscher-Ohlin Explain China’s Trade?
With its reforms since 1975, China has shifted its exports from areas of factor scarcity (physical-capital and resource-intensive products) into areas of factor abundance (labor-intensive manufacturers).

40. Figure 3.12: How Have the Factor Intensities of China’s Exports Changed, 1965–1990?
Year
1975
1980
1985
1990 20 40 60 80
100
Share of total exports
Resource-based products
Human capital-intensive goods
Physical capital-intensive goods
Skilled labor-intensive goods
Unskilled labor-intensive goods

41. Summary
When goods are produced using two inputs that are not perfect substitutes for each other, the opportunity cost of producing each good rises as more of the good is produced.
A country has a comparative advantage in production of a good when the opportunity cost of that good is lower there than in the trading partner.
When trade is possible, each country will specialize in and export the good in which it has a comparative advantage.

42. Summary
We now know three bases for comparative advantage and mutually beneficial trade:
Differences in technology or labor productivity;
Differences in factor endowments; and
Differences in tastes under increasing costs.

43. Appendix A: The Edgeworth Box
In Figure 3A.1, the country’s resource endowment defines the length of each axis.
LA determines the lengths of the horizontal axes, and KA the lengths of the vertical axes.

44. Appendix 3A.1: Isoquant Maps for X and Y in Country AK A K A X Y Y A 3 X A Y A 3 2 X A 2 Y A 1 X A 1 Y A X A L A L A X Y
(a) X Industry
(b) Y Industry

45. Appendix A: The Edgeworth Box
In Figure 3A.2, each point in the box describes an allocation of the total available labor and capital between the X and Y industries.
Industry X values are read from left to right and bottom to top from the bottom-left origin.
Industry Y values are read from right to left and top to bottom from the upper-right origin.

46. Appendix 3A.2: Edgeworth Box for X and Y Production in Country AL A L A A Y Y0 Y K A X Y A Y A I K A 1 K A X0 Y0
III X A Y A 3 K A 2 X A II 2 Y A 3 X A 1 X A K A Y A L A L A X X0 X L A

47. Appendix A: The Edgeworth Box
In Figure 3A.3, points I, II, and III correspond to the matching points from Figure 3A.2.
All points on the production possibilities frontier correspond to the points of tangency between an X isoquant in the Edgeworth box.
All points inside the production possibilities frontier correspond to nontangency points in the Edgeworth box.

48. Appendix 3A.3: Country A’s Production Possibilities FrontierII Y A 2
III Y A 1 I X A X A X A 1 2

49. Appendix A: The Edgeworth Box
In Figure 3A.4, production at the autarky production points A* and B* defines the dimensions of the box in panel (a).
The larger dimensions of the box in panel (b) reflect increased production brought about by productive specialization according to comparative advantage.

50. Appendix 3A.4: Edgeworth Box Showing Total World Production of Goods X and YB X B X B B p Y A Y A Y A* Y B*
YW = YA + YB
YW = YA + YB Y A Y B p p Y B A X A* X A Y B X W
= X A
+ X B A X A X A p
(a) Autarky X W
= X A
+ X B
(b) With Trade

51. Appendix A: The Edgeworth Box
In Figure 3A.5, beginning from the point of productive specialization (p), residents of both countries can better themselves through trade, which occurs at the international terms of trade to consumption point C.
There it becomes impossible to improve the welfare of the residents of one country without reducing the welfare of the residents of the other.
The two countries’ trade triangles comprise the shaded triangle.

52. Appendix 3A.5: Edgeworth Box Depiction of Trade Between Countries A and BB c p Y A c Y A Y B c c U A 1 p Y A Y B p U A p U B U B 1 Y B A X A X A X A c p

53. Appendix B: Offer Curves
In Figure 3B.1, each country’s offer curve illustrates the quantities of the two goods it would want to export and import at different terms of trade, represented by the slopes of rays from the origin.
Offer Curve: refers to the curve’s illustration of the “offer” one country would make for trade with another at any given terms of trade.

54. Appendix 3B.1: Offer Curves for Countries A and B
Imports
Exports
of Y by A
of Y by B (P /P ) tt (P /P ) tt X Y X Y A (P /P )
tt* (P /P )
tt* X Y X Y Y A (P /P ) tt (P /P ) tt X Y 1 X Y 1 Y B B 1 Y B* Y A* Y B Y A 1 A X A X A* X A
Exports B X B X B* X B
Imports 1 1
of X by A
of X by B
(a) Trade by A
(b) Trade by B

55. Appendix B: Offer Curves
In Figure 3B.2, at the equilibrium terms of trade, (PX/PY)tt*, the quantity of good X that country A wants to export equals the quantity country B wants to import (and vice versa).
At any other terms of trade, there is excess supply of one good and excess demand for the other.
The shaded rectangle combines the two countries’ trade triangles from Figure 3.8.

56. Appendix 3B.2: Equilibrium Terms of Trade
Imports of Y by A,
Exports of Y by B
Excess demand
for Y at ( P /P ) tt X Y (P /P ) tt X Y A (P /P )
tt* X Y Y A (P /P ) tt X Y 1 B Y B 1 Y A*
= Y B*
Excess supply of
Y at (P /P ) tt Y B X Y 1
Excess supply of Y A 1
X at (P /P ) tt X Y X B X A X A X B
Exports of X by A, 1 1
Imports of X by B X A*
= X B*
Excess demand for
X at (P /P ) tt X Y 1

57. Key Terms in Chapter 3 Neoclassical (increasing-cost) model
Fixed proportions
Production function
Isoquant
Marginal rate of technical substitution (MRTS)
Factor prices (factor rewards)
Isocost line

58. Key Terms in Chapter 3 Capital-labor ratio Capital-intensive good
Labor-intensive good
Comparative advantage
Equilibrium price
Factor abundance
Labor abundance

59. Key Terms in Chapter 3 Production bias Heckscher-Ohlin theorem
Taste bias
Home bias