Chapter 4: Trade: Factor Availability and Factor Proportions Are Key

1. Chapter 4: Trade: Factor Availability and Factor Proportions Are Key

2. Figure 4.1 - Production Possibilities under Increasing Costs

3. Production possibilities with increasing costs Why is the PPC bowed out? – law of increasing opportunity cost The slope of the PPC increases as we move to the right Why? Wheat and cloth use factors in different proportions (even with CRS industries) Readjustment causes effects similar to the law of diminishing returns

4. Why choose to produce at S0? If at S1, producing an extra unit of cloth costs only 1W/C, therefore produce more cloth If at S3, producing an extra unit of cloth costs 3W/C, therefore produce less cloth If a S0, the opportunity cost of cloth is the same as the price – no reason to adjust production

5. Figure 4.2 –Indifference Curves Relating an Individual’s Utility Levels to Consumption of Two Goods

6. Review of consumer theory Indifference curves – meaning, shape Budget line Y=PwQw+PcQc and Qw=Y/Pw – (Pc/Pw)Qc The optimal point is where the budget constraint is tangent to the indifference curve At that point the slope of the indifference curve is equal to Pc/Pw We apply the same theory using community indifference curves and the PPC

7. Figure 4.3 – Indifference Curves and Production Possibilities without Trade

8. Production and consumption with trade The free-trade equilibrium is at a price ratio of 1W/C – this is the slope of the price line Production is at S1 Consumption is at C1 – the tangent point of the price line and the highest community indifference curve

10. US Exports: 40 billion units of wheat (80-60) Imports: 40 billion units of cloth (60-20) Trade triangle: S1TC1 ROW Exports: 40 billion units of cloth (100-60) Imports: 40 billion units of wheat (55-15) Trade triangle: C1TS1

11. Derive D and S curves for cloth in US At 1W/C US consumes 60 units of cloth (point C1) At 2W/C US consumes (and produces) 40 units of cloth (market equilibrium) (point So) At 1W/C US produces 20 units of cloth (point S1)

12. Derive demand and supply curves for cloth in ROW At 1W/C ROW consumes 60 units of cloth (point C1) At 2W/C ROW consumes (and produces) 80 units of cloth (market equilibrium) (point So) At 1W/C ROW produces 100 units of cloth (point S1)

13. Gains from trade with variable costs Trade allows a country to consume at a point above its PPC Trade allows each country to achieve a higher community indifference curve Distribution of benefits??? Which country gains more? The higher its export prices (compared to equilibrium before trade) the more a country gains The lower its import prices (compared to pre-trade) the more a country gains Terms of trade – the price of exports relative to the price of imports

14. Gains from trade with variable cost ROW will have better terms of trade if the price of cloth (its export product) is higher the international price line will be steeper leading to a higher community indifference curve US will have better terms of trade if the price of wheat (its export product) is higher The international price line will be flatter leading to a higher community indifference curve

15. Gains from trade with variable cost Increased production of the export product (wheat in US; cloth in ROW) Reduced production of the import competing product (cloth in US;wheat in ROW) Resource re-allocation from import-competing to export product Countries do not specialize completely in producing their export product

16. Gains from trade with variable cost More efficient world production From 50+30=80 units of wheat (S0 in US and ROW) To 80+15=95 units of wheat (S1 in US and ROW) Cloth production unchanged at 120 units Increased consumption of the imported product (cloth in US, wheat in ROW) Increase in real income (income effect) Consumption of exported product can decrease or increase depending on the strength of income and substitution effects

17. Trade patterns and the Heckscher-Ohlin Theory of Trade The patterns of trade are determined by production differences – different shapes of PPC demand differences – differences in community indifference curves The Heckscher-Ohlin theory: A country will export products that use relatively intensively those production factors found relatively abundantly in the country Wheat is land-intensive Land is relatively cheaper in US (land is abundant in US) The US has a comparative advantage and exports wheat

18. Trade patterns and the Heckscher-Ohlin Theory of Trade A country will import products that use relatively intensively those production factors that are relatively scarce in the country. Cloth is labour-intensive Labour is more expensive in the US (scarce) The US imports cloth

23. Heckscher-Ohlin Theory of Trade • A country will export products that use relatively intensively those production factors found relatively abundantly in the country, and import products that use relatively intensively those production factors that are relatively scarce in the country. • H-O comparative advantage is actually a triple comparison: • across countries • across products • across factors of production

24. Summary • The Neo-Classical Model • The Heckscher-Ohlin Theory