1. Slide 4-1Copyright © 2003 Pearson Education, Inc. RD RS RS * 1 2 3 Effects of International Trade Between Two-Factor Economies Figure 4-8: Trade Leads to a Convergence of Relative Prices Relative price of cloth, P C /P F Relative quality of cloth, Q C + Q * C Q F + Q * F

2. Slide 4-2Copyright © 2003 Pearson Education, Inc. When Home and Foreign trade with each other, their relative prices converge. The relative price of cloth rises in Home and declines in Foreign. –In Home, the rise in the relative price of cloth leads to a rise in the production of cloth and a decline in relative consumption, so Home becomes an exporter of cloth and an importer of food. –Conversely, the decline in the relative price of cloth in Foreign leads it to become an importer of cloth and an exporter of food. Effects of International Trade Between Two-Factor Economies

3. Slide 4-3Copyright © 2003 Pearson Education, Inc.  Trade and the Distribution of Income Trade produces a convergence of relative prices. Changes in relative prices have strong effects on the relative earnings of labor and land in both countries: –In Home, where the relative price of cloth rises: – Laborers are made better off and landowners are made worse off. –In Foreign, where the relative price of cloth falls, the opposite happens: – Laborers are made worse off and landowners are made better off. Owners of a country’s abundant factors gain from trade, but owners of a country’s scarce factors lose. Note: Home-labor abundant/ foreign-land abundant Effects of International Trade Between Two-Factor Economies

4. Slide 4-4Copyright © 2003 Pearson Education, Inc. FF CC SS Land- labor Ratio, T/L Relative price of cloth, P C /P F Wage-rental ratio, w/r (P C /P F ) 1 (T C /L C ) 2 (T C /L C ) 1 (T F /L F ) 2 (T F /L F ) 1 (w/r) 2 (w/r) 1 Increasing A Model of a Two-Factor Economy Figure 4-4: From Goods Prices to Input Choices (P C /P F ) 2

5. Slide 4-5Copyright © 2003 Pearson Education, Inc.  Factor Price Equalization In the absence of trade: labor would earn less in Home than in Foreign, and land would earn more. Factor-Price Equalization Theorem: –International trade leads to complete equalization in the relative and absolute returns to homogeneous factors across countries. –It implies that international trade is a substitute for the international mobility of factors. Effects of International Trade Between Two-Factor Economies

6. Slide 4-6Copyright © 2003 Pearson Education, Inc. Has international trade equalized the returns to homogeneous factors in different countries in the real world? –Even casual observation clearly indicates that it has not. –Example: Wages are much higher for doctors, engineers, technicians, mechanics and laborers in the United States and Germany than in Korea and Mexico. –Under these circumstances, it is more realistic to say that international trade has reduced, rather than completely eliminated, the international difference in the returns to homogeneous factors. Effects of International Trade Between Two-Factor Economies

7. Slide 4-7Copyright © 2003 Pearson Education, Inc. Effects of International Trade Between Two-Factor Economies Table 4-1: Comparative International Wage Rates (United States = 100)

8. Slide 4-8Copyright © 2003 Pearson Education, Inc. Three assumptions crucial to the prediction of factor price equalization are in reality untrue: –Both countries produce both goods –Both countries have the same technologies in production –Both countries have the same prices of goods due to trade One thing the factor-price equalization theorem does not say is that international trade will eliminate or reduce international differences in per capita incomes. Effects of International Trade Between Two-Factor Economies

9. Slide 4-9Copyright © 2003 Pearson Education, Inc.  Implications of the Tests Empirical evidence on the Heckscher-Ohlin model has led to the following conclusions: –It has been less successful at explaining the actual pattern of international trade. –It has been useful as a way to analyze the effects of trade on income distribution. Empirical Evidence on the Heckscher-Ohlin Model

10. Slide 4-10Copyright © 2003 Pearson Education, Inc. Summary  The owners of a country’s abundant factors gain from trade, but the owners of scarce factors lose.  In reality, complete factor price equalization is not observed because of wide differences in resources, barriers to trade, and international differences in technology.  Empirical evidence is mixed on the Heckscher- Ohlin model. Most researchers do not believe that differences in resources alone can explain the pattern of world trade or world factor prices.

11. Slide 4-11Copyright © 2003 Pearson Education, Inc.  Assumptions of the Heckscher-Ohlin model: There are two countries (Home and Foreign) that have: –Same tastes –Same technology –Different resources –Home has a higher ratio of labor to land than Foreign does Each country has the same production structure of a two-factor economy. Effects of International Trade Between Two-Factor Economies

12. Slide 4-12Copyright © 2003 Pearson Education, Inc. Introduction  This chapter is focused on the following questions: What are the effects of various trade policy instruments? –Who will benefit and who will lose from these trade policy instruments? What are the costs and benefits of protection? –Will the benefits outweigh the costs? What should a nation’s trade policy be? –For example, should the United States use a tariff or an import quota to protect its automobile industry against competition from Japan and South Korea?

13. Slide 4-13Copyright © 2003 Pearson Education, Inc. Classification of Commercial Policy Instruments Introduction Commercial Policy Instruments Trade Contraction Trade Expansion Tariff Export tax Import quota Voluntary Export Restraint (VER) Import subsidy Export subsidy Voluntary Import Expansion (VIE) PriceQuantity PriceQuantity

14. Slide 4-14Copyright © 2003 Pearson Education, Inc. Basic Tariff Analysis  Tariffs can be classified as: Specific tariffs –Taxes that are levied as a fixed charge for each unit of goods imported –Example: A specific tariff of $10 on each imported bicycle with an international price of $100 means that customs officials collect the fixed sum of $10. Ad valorem tariffs –Taxes that are levied as a fraction of the value of the imported goods –Example: A 20% ad valorem tariff on bicycles generates a $20 payment on each $100 imported bicycle.

15. Slide 4-15Copyright © 2003 Pearson Education, Inc. A compound duty (tariff) is a combination of an ad valorem and a specific tariff. Modern governments usually prefer to protect domestic industries through a variety of nontariff barriers, such as: –Import quotas –Limit the quantity of imports –Export restraints –Limit the quantity of exports Basic Tariff Analysis