2. 1 Dr. Bill W. S. Hung

3. 2 Neoclassical Trade Theory: The Heckscher-Ohlin Theorem Basic Assumptions: 1. Two countries, two goods, two factors -- 2x2x2 mode 2. Identical technological in two countries Production functions are same in two countries 3. Constant returns to scale The sharp of PPC is unchanged 4. Two different factor abundance countries: Labor-abundant and capital-abundant And Two factor intensities commodities: Labor-intensive and Capital-intensive

4. 3 5. Identical preference and tastes Two countries are facing the same utility functions 6. Perfect competition Goods market and factors market 7. Factors are perfectly mobile only within a country Factors are restricted to move across countries 10. Increasing opportunity costs: The PPF curve is concave but not a straight line. 8. No transportation costs 9. No restriction on trade

5. 4 Factor abundance: Definition: Suppose: Country 1 is relative abundance of capital Country 2 is relative abundance of labor Factor Price definition: w:labor wage r:rental rate of capital OR The greater the relative abundance of a factor, the lower its relative price. Since Country 1 has relative abundance of capital, thus its rental rate of capital is relatively lower than its wage. 21 ) K L () K L (  or

6. 5 Relative Factor Intensity: CS ) L K () L K (  Definition: OR Commodity S (steel) is a capital- intensive goods. Commodity C( clothes) is a labor-intensive goods. Similarly in terms of factor prices: rr ( w ) c >( w ) S OR ww ( r ) c <( r ) S

7. 6 The Edgeworth Box: K 0c L C1 C2 C3 C4 C5 L 0s K S1 S2 S3 S4 S5 Contract curve: production efficiency locus (Increasing opportunity cost)

8. 7 Country I:Capital abundant country K2K2 L2L2 Steel Clothes S3S3 S2S2 S1S1 S0S0 C3C3 C2C2 C1C1 C0C0 steel clothes o PPF I

9. 8 KIKI LILI Clothes Steel S3S3 S2S2 S1S1 S0S0 C3C3 C2C2 C1C1 C0C0 Country II:Labor-abundant country steel clothes o PPF 1I

10. 9 0 X - Clothes Y- Steel PPF PXPYPXPY E (autarky price) Marginal rate of transformation (MRT) Marginal rate Of substitution (MRS) CI 0 The shape or pattern of CICs represent the aggregate consumers’ taste or preference

11. 10 K L PPF I I S 0 C PPF I P II CI 0 II LKLK or KLKL I* PIPI I LKLK I or KLKL Combining two countries input space, output space and consumer preference:

12. 11 Increasing opportunity cost  incomplete specialization Different demand condition  different autarky price ratio Classical analysis: Two countries with identical PPF or production condition are the same, there is no incentive for trade and of course no gains from trade. Neoclassical analysis Even two countries have the same production condition, but when the demand conditions are different the increasing opportunity costs would drive the two countries to trade. The different prices in autarky indicates that there is a basis for gainful trade between two countries.

13. 12 Trade direction, incomplete specialization, and consumption PIPI CI 0 A S 0 C CI 1 P PWPW C Only when P W > P I, Country-I has incentive to reallocate the production from point A to point P and to trade with other country (world), and through exchange (import) to consume at point C.

14. 13 The Heckscher-Ohlin Theorem A country will have comparative advantage in, and therefore, will export, that good whose production is relatively intensive in the factor with which that country is relatively well endowed. Labor abundant country Exports (i.e., China)Labor-intensive products Imports Capital-intensive products Capital abundant country Exports (i.e., U.S.A.) Capital-intensive goods Imports Labor-intensive goods

15. 14 (A) Trade between two countries with Identical Demand & Different Production Structures: Country I: capital abundant Country II: labor abundant Good X-clothes: labor-intensive Good Y-steel: capital-intensive The H -O Model 0 PPF I PPF II Good X-Clothes Good Y-Steel e1e1 E II C0C0 (P X /P Y ) 1 (P X /P Y ) 2 (P X /P Y ) 3 C1C1 C II ’, c I ’ I’s imports (X) I’s exports (Y) e’ y3y3 x3x3 II’s exports (X) II’s imports (Y) E’ y1y1 x1x1 x 2,x 4 y 4,y 2

16. 15 Country I: capital abundant Country II: labor abundant Good X: labor-intensive Good Y: capital-intensive The H-O Model: alternative case: (different consumption level ) Good Y-Steel Good X-Clothes 0 PPF I PPF II (P X /P Y ) 1 e E (P X /P Y ) II (P X /P Y )3 I C’ I e’ I’s exports I’s imports C’ II E’ II II’s imports II’s exports C1C1 C2C2 C3C3 C4C4

17. 16 (B) Trade between two countries with Identical PPFsDifferent Demand Conditions Identical PPFs & Different Demand Conditions: e (P X /P Y ) 2 W1W1 x4x4 y4y4 (P X /P Y ) 3 E I ’, e I ’ c’ W2W2 S2S2 C’ II’s imports (X) y3y3 x3x3 x5x5 y5y5 II’s exports (Y) y2y2 I’s imports (Y) I’s exports (X) x2x2 Good Y-Steel Good X-Cloth 0 PPF II E1E1 S1S1 (P X /P Y ) 1 y1y1 x1x1 PPF I

18. 17 0 X - Clothes Y-Steel PPF I,II (C) No Trade between two countries with Identical PPFs & identical Demand Conditions: CI 2 CI 0 A B (autarky price) PXPYPXPY CI 1 Community Indifferent utility curves E No Incentive to trade Why?

19. 18 Gains From Trade PWPW C I1I1 P PWPW I1*I1* C* P* 3 important assumptions 3 important assumptions : 1. No costs of factor mobility 2. Full employment of factors 3. No redistribution of income once trade open (the different curves can show welfare changes) A I0I0 Good Y Good X0 I0*I0* A* Good X Good Y 0

20. 19 Gains from trade and specialization Good Y Good X 0 E CI 1 Autarky price PXPYPXPY C CI 2 ( )’ PXPYPXPY PXPYPXPY consumption gains gains from exchange E  C: consumption gains (or gains from exchange) E’ C’ CI 3 World trade price ( )’ PXPYPXPY production gains gains from specialization E  E’ and C  C’: production gains (or gains from specialization)

21. 20 Concept Check Concept Check: Can you show that the production at less than complete specialization leads to a lower level of welfare than at complete specialization.

22. 21 The Leontief Paradox Leontief statistic is defined as (K/L) M (K/L) X Leontief’s result were startling. He found that the hypothesized reduction of US export would release $2.25 Million worth of capital And 182.3 year of labor-time, for a (K/X)x of approximately $14,000 Per labor-year. On the import side, to produce the foregone import would require $3.09 million worth of capital and 170,0 years of Labor-time, yielding a (K/L)M of approximately $18,200 per labor-year. Thus, the Leontief statistic for the US was 1.3 (= $18,200/$14,000), Unexpected for a relatively capital-abundant country. What are the implications of the Leontief Paradox?

23. 22 Invalid assumptions to Heckscher-Ohlin Model 1. Demand reversal 2. Factor-intensity reversal 3. Transportation costs 4. Imperfect competition 5. Immobile or commodity-specific factors 6. US tariff structure 7. Different skill levels of labor 8. The role of natural resources others 9. Income inequality

24. 23 1. The Factor Price Equalization Theorem: Given all the assumptions of the H-O model, free trade will lead to the international equalization of individual factor prices.(The impact of trade on factor prices) 2. The Stolper-Samuelson Theorem: Free trade benefits the abundant factor and harms the scarce factor.(The impact of trade on income distribution) 3. The Rybczynski Theorem : At constant world prices, if a country experiences an increase in the supply of one factor, it will produce more of the product intensive in that factor and loss of the other.(The effect of economic growth on trade)

25. 24 Factor price equalization theorem When home and foreign country trade with each other, the relative prices of goods converge. This convergence, in turn, causes convergence of the relative prices of factors. Before trade: (w/r) II > (w/r) world > (w/r) I (Country-I wage is lower) After trade: (w/r) I = world factor price = (w/r) II because the goods prices are equalized in two countries Example: When trade open between China and Hong Kong, Wages increase in China, Wage decline in Hong Kong

26. 25 (w/r) 0   (w/r) 1 When r , w  In Country II : (labor-abundant) Increase produce c lothes i.e., I c 0  I c 1 Decrease produce s teel i.e., I s 0  I s 1 ( K/L) c 0 ( w/r) 0 K L Clothes IC0IC0 Steel K (w/r) 0 L (K/L) S 0 IS0IS0 (w/r) 1 IC1IC1 (K/L)c 1 (w/r) 1 IS1IS1 (K/L) s 1 After trade adjustment in Country II (labor-abundant) case: Producer adjusts output due to relative factor prices changes. Both industries now employ more capital

27. 26 0 w/r Pc/Ps ( Pc/Ps ) I <(w/r) I Capital abundant country (w/r) I (Pc/Ps) I ( Pc/Ps ) II (w/r) II < Labor abundant country (w/r) II (Pc/Ps) II < < Trade Condition ( Pc/Ps ) (w/r) world trade price w/r Pc/Ps One important assumption is market perfect competition But in real world it seems FPE theorem does not work well.

28. 27 The Stolper-Samuelson Theorem With full employment both before and after trade, the increase in the price of the abundant factor and the fall in the price of the scare factor because of trade imply that the owners of abundant factor will find their real incomes rising and the owners of scarce factor will find their real incomes falling. In labor-abundant country: if price of labor-intensive goods  ---> wage  ---> producer of labor-intensive goods and labor income  In capital-abundant country: if price of capital-intensive goods  ---> capital rent  ---> producer of capital-intensive goods and capital owner income 

29. 28 Steel 0 Clothes Example: Tariffs can increase the trade prices. (From red to green line) i.e., production point shifts from P point to T point Policy implication: Producer of steel and the capital owner will gain from the tariff. (Pro-tariff or welcome any protection). Producer of clothes and the labor will loss from the tariff. (Against tariff or reject any protection) PCPSPCPS ( ) II A Country II’s PPF PCPSPCPS ( ) II P C   W  P S   r  A to P : T [Pc/(Ps+ tariff )] w P C   W  (P S + t)   r  P to T : PCPSPCPS ( ) <World price P PCPSPCPS ( ) World price

30. 29 Rybczynski Theorem: The effect of factor endowment change Autos a0a0 t0t0 Textiles 0 (P T /P A ) Migration Example: The Growth Effects of Labor-Market Adjustment and Migration ---Labor Endowment moves out, PPF shifts in. (P T /P A ) a1a1 t1t1

31. 30 Autos (P T /P A ) a0a0 t0t0 Textiles 0 Rybczynski Theorem: a1a1 t1t1 (P T /P A ) Labor endowment increases, PPF shifts out

32. 31 Exercise: One of the important changes in the world economy over the past three decades has been the rapid increase in capital investment in the countries of the Pacific Basin (notably Japan, Korea). What are the implications of this investment for the commodity patterns of trade of these two countries, say, with respect to the United States? Explain. (Hint: Think about Rybczynski theorem)

33. 32 Invalid assumptions to Heckscher-Ohlin Model Case of Demand Reversal Demand Reversal outcome: Country 2: now exports S and imports C Country 1: now exports C and imports S P2 Country 2’s imports of C Country 2’s exports of S P1 Country 1’s imports of S Country 1’s exports of C Prediction of trade pattern from H-O model Country 2: exports C and imports S Country 1: exports S and imports C (Pc/Ps) world price C1 CI 1 1 C2 CI 2 1 A1 CI 1 0 A2 CI 2 0 Now Country-1 prefers more steel But Countyr-2 prefers more clothes Steel Cloth PPF 2 PPF 1 Steel: capital-intensive Clothes: labor-intensive Country-1: capital abundant Country-2: labor abundant

34. 33 K 0 Labor W r ( ) 1 A B Cloth Steel Case of Factor-intensity: No matter factor prices change, factor relative requirement ratio is always unchanged. If steel is capital-intensive, cloth is labor-intensive,then at any factor prices ratio, the factor input ratio is always (K/L)s > (K/L)c KLKL ( ) S1 KLKL ( ) C1 At (w/r) 1 : KK ( L ) S1 >( L ) C1 KLKL ( ) S2 KLKL ( ) C2 W r ( ) 2 F G At (w/r) 2 : KK ( L ) S2 >( L ) C2 Steel: capital-intensive Clothes: labor-intensive

35. 34 Invalid assumptions to Heckscher-Ohlin Model Case of Factor intensity Reversal K 0 L Steel At (w/r) 1 : KK ( L ) C1 <( L ) S1 (k/L) S1 (k/L) C1 Clothes (w/r) 1 B A (k/L) C2 (k/L) S2 (w/r) 2 F G At (w/r) 2 : KK ( L ) C2 >( L ) S2

36. 35 Question: Can you give any example of tradable goods that may have such factor-intensity-reversal problem? Exercise: Show in a graph to illustrate that factor- intensity reversal can also occur of the two industry isoquants do not cross each other but are tangent to one another.