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Chapter 4. Resources, Comparative Advantage, and Income Distribution. Outline. 1 .A Model of Two-Factor Economy 2 .Effects of International Trade Between Two-Factor Economies Case Study: North South Trade and Income Inequality 3 .The Political Economy of Trade: A Preliminary View

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Chapter 4

Chapter 4

Resources, Comparative Advantage,

and Income Distribution


Outline

Outline

1.A Model of Two-Factor Economy

2.Effects of International Trade Between Two-Factor Economies

Case Study: North South Trade and Income Inequality

3.The Political Economy of Trade: A Preliminary View

4.Empirical Evidence on the Heckscher-Ohlin Model

5. Summary

1


Introduction

Introduction

  • Ricardian Model – labor

    • differences in productivity

  • In reality – labor, land, natural resources…

  • Main foucus: resources differences

  • Nations’ resources

    • The relative abundance of factor of production

  • Technology of production

    • Relative intensity with which different factors of production are used in the production of goods


Chapter 4

  • Hecksher – Ohlin theory or factor – propotions theory

  • Model : from simple (closed economy) to complexed (open economy)

  • Empirical evidence : for or against?


Learning goals

Learning Goals

  • Explain how differences in resources cause international trade.

  • Discuss why there are losers and winners as a result of trade.

  • Understand the meaning of gains as a whole.

  • Discuss the reasons why trade is a politically important issue and the arguments for free trade.


1 a model of a two factor economy

1.A Model of a Two-Factor Economy

(1).Prices and Production

(2).Choosing the Mix of Inputs

(2).Factor Prices and Goods Prices

(3).Resources and Output

RETURN

2


1 prices and production

(1). Prices and Production

  • The economy we studied

    produce two goods: cloth (C) and food (F)

    two inputs: labor (L) and land (T)

    labor and land are in limited supply

    then, define: aTC, aLC, aTF, aLF, L, F

  • We assume:

aLC/aTC>aLF/aTF

The ratio of land to labor used in the production

of cloth is higher than it is in the production of food

3


Chapter 4

  • Food is produced using land and labor (but not capital).

    • Labor is therefore a mobile factor that can be used in either sector.

    • Land and capital are both specific factors that can be used only in the production of one good.

  • Perfect Competition prevails in all markets.

  • How much of each good does the economy produce?

    • The economy’s output of manufactures depends on how much capital and labor are used in that sector.


Chapter 4

  • This relationship is summarized by a production function.

  • Theproduction function for good X gives the maximum quantities of good X that a firm can produce with various amounts of factor inputs.

    • For instance, the production function for manufactures (food) tells us the quantity of manufactures (food) that can be produced given any input of labor and capital (land).


Chapter 4

  • The production function for manufactures is given by

  • QM = QM (K, LM) (4-1)

  • where:

    • QM is the economy’s output of manufactures

    • K is the economy’s capital stock

    • LM is the labor force employed in manufactures

  • The production function for food is given by

  • QF = QF (T, LF) (4-2)

  • where:

    • QF is the economy’s output of food

    • T is the economy’s supply of land

    • LF is the labor force employed in food


  • Figure 4 1 the production possibility frontier without factor substitution

    Figure 4-1 The Production Possibility Frontier Without Factor Substitution

    QF

    L/aLF

    Labor constraint

    T/aTF

    Land constraint

    L/aLC

    QC

    T/aTC

    4


    Figure 4 2 the production possibility frontier with factor substitution

    Figure 4-2 The Production Possibility Frontier With Factor Substitution

    • Bowed shape - substitution

    Where on the PPF does the economy produces?

    QF

    PP

    QC

    5


    Chapter 4

    • In general, the economy should produce at the point that maximizes the value of production, V:

      V = PCQC + PFQF

    • Define an isovalue line as a line representing a constant value of production.

      • V = PCQC + PFQF

      • PFQF = V – PCQC

      • QF = V/PF – (PC /PF)QC

      • The slope of an isovalue line is – (PC /PF)

    13


    Figure 4 3 prices and production

    Figure 4-3 Prices and Production

    QF

    Isovalue line

    Q

    PP

    QC

    14


    Chapter 4

    • In conlusion,The products mix the producers choose to produce depends on price (or relative price).

    • Q:

    • What if the relative price changes?


    2 choosing the mix of inputs

    (2).Choosing the Mix of Inputs

    What input choice will producers actually make?

    The input choice will depend on the ratio of these

    Two factor prices, w/r

    16


    Figure 4 4 input possibilities in food production

    Figure 4-4 Input Possibilities in Food Production

    aTF

    Input combinations that produce one calorie of food

    II

    aLF

    (1)Negative slope;

    (2)Convex to the origin.

    17


    Figure 4 5 factor prices and input choices

    Figure 4-5 Factor Prices and Input Choices

    w/r

    CC

    FF

    T/L

    Cloth production: labor-intensive

    Food production: land-intensive

    18


    3 factor prices and goods prices

    (3).Factor Prices and Goods Prices

    • Under competition, the price of a good equals the cost of production, and the cost of production depends on the wage rate and the rental rate.

    • The effect of the rental rate of land (r) on the price of cloth (PC) depends on the intensity of land usage in cloth production.(So does food production)

      • However, an increase in the rental rate of land will affect the price of food more than the price of cloth.

    • Under competition, changes in w/r are therefore directly related to changes in PC /PW .

    19


    3 factor prices and goods prices1

    (3).Factor Prices and Goods Prices

    Figure 4-6 Factor Prices and Goods Prices

    PC/PF

    SS

    w/r

    20


    Chapter 4

    • We have a relationship among factor prices and good prices and the levels of factors used in production:

    • Stolper-Samuelson theorem: 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.

      • Under competition, the real wage/return is equal to the marginal productivity of the factor. (zero profit under perfect competition)

      • Marginal productivity of a factor increases as the level of that factor used in production decreases. (marginal productivity theory)

    21


    Figure 4 7 from goods prices to input choices

    Figure 4-7 From Goods Prices to Input Choices

    w/r

    CC

    FF

    T/L

    w/r

    CC

    w/r2

    FF

    w/r1

    SS

    TF/LF1

    PC/PF

    PC/PF2

    PC/PF1

    TC/LC1

    TC/LC2

    TF/LF2

    T/L

    22


    Chapter 4

    • We have a theory that predicts changes in the distribution of income when the relative price of goods changes, say because of trade.

    • An increase in the relative price of cloth, PC /PF , will:

      • raise income of workers relative to that of landowners, w/r. (w? r?)

      • raise the ratio of land to labor, T/L, in both industries and raise the marginal product of labor in both industries and lower the marginal product of land in both industries. (factors of production are paid by their marginal product)

      • raise the real income of workers and lower the real income of land owners.

    23


    4 resources and output

    (4).Resources and Output

    Figure 4-8 The Allocation of Resources

    LF

    OF

    C

    1

    TC

    TF

    F

    OC

    LC

    Why OfF is steeper?

    Resources employed - production

    24


    Chapter 4

    • How do output levels change when the economy’s resources change?

    • If we hold output prices constant as a factor of production increases, then the supply of the good that uses this factor intensively increases (more than proportionately )and the supply of the other good decreases.

      • This proposition is called the Rybczynski theorem.

    25


    Figure 4 9 an increase in the supply of land

    Figure 4-9 An Increase in the Supply of Land

    LF2

    LF1

    OF2

    OF1

    C

    1

    TF1

    TC

    2

    TF2

    F2

    F1

    OC

    LC

    T increases

    P & L constant

    Where do the reduced factors used in cloth production go?

    26


    Chapter 4

    • A economy with a high ratio of land to labor is predicted to have a high output of food relative to cloth and a low price of food relative to cloth.

      • It will be relatively efficient at (have a comparative advantage in) producing food.

      • It will be relatively inefficient at producing cloth.

    27


    Figure 4 10 resources and production possibilities

    Figure 4-10 Resources and Production Possibilities

    QF

    QF2

    2

    Slope=-PC/PF

    Generally, an economy will tend to be relatively effective at producing goods that are intensive in the factors with which the country is relatively well-endowed.

    Slope=-PC/PF

    1

    QF1

    TT1

    TT2

    QC2

    QC1

    QC

    RETURN

    (disproportionately) biased expansion of production possibilities (towards food production)

    28


    2 effects of international trade between two factor economies

    2.Effects of International Trade Between Two-Factor Economies

    (1).Relative Prices and the Pattern of Trade

    (2).Trade and the Distribution of Income

    (3).Factor Price Equalization

    (4). Case Study: North-South Trade and Income Inequality

    RETURN

    29


    1 relative prices and the pattern of trade

    (1).Relative Prices and the Pattern of Trade

    Assumption: Two countries

    ①The same relative demands

    Identical tasts for the same relative price.

    ②The same technology level

    Same factors yeilds same amount of goods.

    ④Factors can not move between countries

    ⑤Completely competition

    30


    Chapter 4

    ③Factor endowment (only difference)

    Home: labor-abundant(L/T > L*/ T*)

    Foreign: land-abundant (L/T < L*/ T*)


    Chapter 4

    Abundant vs. intensive

    • Abundance is defined in relative terms, by comparing the ratio of labor to land in the two countries.

      • Eg. The U.S. is land abundant & Britain is labor abundant.

  • Intensive is also defined in relative terms, by comparing the ratio of labor to land used in two goods production.

    • Eg. Cloth is labor-intensive & food is land-intensive.


  • Chapter 4

    • eg. Cloth : labor-intensive

      • PPF shift out more in this direction

      • Home tends to produce a higher ratio of cloth to food

  • One effect of trade – convergence in prices


  • 1 relative prices and the pattern of trade1

    (1).Relative Prices and the Pattern of Trade

    Figure 4-11 Trade Leads to a Convergence of Relative Prices

    PC/PF

    RS*

    RS

    .

    3

    .

    .

    2

    1

    RD

    QC+QC*

    QF+QF*

    Point 1 is lower than point 3, why?

    (factor intensity)

    34


    Chapter 4

    • How differences in relative prices be translated into a pattern of trade?

    • Some basic relationships & budget constraints in closed and open economy

    PC×DC+PF×DF=PC×QC+PF×QF (4-5)

    Rearranging: DF-QF=(PC/PF)×(QC-DC) (4-6)

    Quantity of imports

    Price of exports relative to imports

    Quantity of exports


    Chapter 4

    • Result:

      Countries tend to export goods whose production is intensive in factors with which they are abundantly endowed (home: labor-abundant)

    • Heckscher-Ohlin Theorem:

      A country will export that commodity which uses intensively its abundant factor and import that commodity which uses intensively its scarce factor.

    36


    Figure 4 12 the budget constraint for a trading economy

    Figure 4-12 The Budget Constraint for a Trading Economy

    DF

    QF

    Budget constraint(slope)

    1

    QF1

    PP

    QC1

    DC

    QC

    • Two characters:

    • Slope

    • tangency

    37


    Figure 4 13 trading equilibrium

    Figure 4-13 Trading Equilibrium

    QF

    QF

    Home’s budget constraint

    Foreign's budget constraint

    QFF

    DFF

    DFH

    QFH

    DCH

    QCH

    QCF

    DCF

    QC

    QC

    (a) Home

    (b) Foreign

    38


    2 trade and the distribution of income

    (2) Trade and the Distribution of Income

    In Home:

    Relative price of cloth rises

    People get income from labor gain from trade

    People get income from land are worse off

    In Foreign:

    Relative price of cloth rises

    Laborers are made worse off

    Landowners are made better off


    Chapter 4

    • Abundant factor (factor of relative large supply)

      • Home: Labor ; Foreign: Land

    • Scarce factor (factor of relative small supply)

      • Home: land ; Foreign: labor

    • Effects of trade on income distribution:

      Owners of a country’s abundant factors gain from trade, but owners of a country’s scarce factors lose.

    • The U.S. example


    Figure 4 3 prices and production1

    Figure 4-3 Prices and Production

    QF

    Isovalue line

    Q

    PP

    QC

    42


    Chapter 4

    • In conlusion,The products mix the producers choose to produce depends on price (or relative price).

    • Q:

    • What if the relative price changes?


    Figure 4 4 input possibilities in food production1

    Figure 4-4 Input Possibilities in Food Production

    aTF

    Input combinations that produce one calorie of food

    II

    aLF

    (1)Negative slope;

    (2)Convex to the origin.

    44


    2 choosing the mix of inputs1

    (2).Choosing the Mix of Inputs

    What input choice will producers actually make?

    The input choice will depend on the ratio of these

    Two factor prices, w/r

    45


    Figure 4 5 factor prices and input choices1

    Figure 4-5 Factor Prices and Input Choices

    w/r

    CC

    FF

    T/L

    Cloth production: labor-intensive

    Food production: land-intensive

    46


    Figure 4 7 from goods prices to input choices1

    Figure 4-7 From Goods Prices to Input Choices

    w/r

    CC

    FF

    T/L

    w/r

    CC

    w/r2

    FF

    w/r1

    SS

    TF/LF1

    PC/PF

    PC/PF2

    PC/PF1

    TC/LC1

    TC/LC2

    TF/LF2

    T/L

    47


    Chapter 4

    • A economy with a high ratio of land to labor is predicted to have a high output of food relative to cloth and a low price of food relative to cloth.

      • It will be relatively efficient at (have a comparative advantage in) producing food.

      • It will be relatively inefficient at producing cloth.

    48


    Figure 4 10 resources and production possibilities1

    Figure 4-10 Resources and Production Possibilities

    QF

    QF2

    2

    Slope=-PC/PF

    Generally, an economy will tend to be relatively effective at producing goods that are intensive in the factors with which the country is relatively well-endowed.

    Slope=-PC/PF

    1

    QF1

    TT1

    TT2

    QC2

    QC1

    QC

    RETURN

    (disproportionately) biased expansion of production possibilities (towards food production)

    49


    3 factor price equalization

    (3).Factor Price Equalization

    • In the absence of trade, price of goods and factors are different between countries.

    • Trade leads to (complete) equalization of factor prices.

    • Because relative goods prices are equalized and because of the direct relationship between relative goods prices and factor prices, factor prices are also equalized.

    • Goods trade means indirect trade of factors.

      • More labor is embodied in Home’s exports than in its imports. So…

      • Home: export labor, embodied in its labor-intensive exports.

      • Foreign: export land, embodied in its land-intensive exports.

    51


    Chapter 4

    • In reality, factor prices are not equalized

    52


    Table 4 1 comparative international wage rates

    Table 4-1 Comparative International Wage Rates

    Hourly compensation of production workers,2000

    Country

    United States

    Germany

    Japan

    Spain

    South Korea

    Portugal

    Mexico

    Sri Lanka*

    100

    121

    111

    55

    41

    24

    12

    2

    53


    Chapter 4

    • Three assumptions are in reality violated (untrue):

      ①.both countries produce both goods

      • Factor-price equalization occurs only if the countries involved are sufficiently similar in their relative factor endowments.

      • Countries with radically different ratios of capital to labor or skilled to unskilled labor – Not necessarily true.


    Chapter 4

    ②.technologies are the same

    • A country with superior technology might have both a higher wage rate and a higher rental rate.

      ③.trade actually equalize the prices of goods in the two countries

    • Visible & invisible barries (transportation costs, import quotas, tarriffs…)


    Trade and income distribution in the short run

    Trade and Income Distribution in the Short Run

    • 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:

    • Owners of a country’s abundant factors gain from trade, but owners of a country’s scarce factors lose.

    56


    Trade and income distribution in the short run1

    Trade and Income Distribution in the Short Run

    • Difference between the specific factors model and the Heckscher-Ohlin model in terms of income distribution effects:

      • The specificity of factors to particular industries is often only a temporary problem.

      • In contrast, effects of trade on the distribution of income among land, labor, and capital are more or less permanent.

    57


    4 case study north south trade and income inequality

    (4). Case Study: North-South Trade and Income Inequality

    ①Why has wage inequality increased?

    North-South trade in manufactures fits to the

    factor proportions model much better.

    ②Is it true that growing trade with low-wage

    countries caused the inequality of income

    in the United States?

    59


    Table 4 c1 composition of developing country exports

    Table 4-C1 Composition of Developing-Country Exports

    Manufactures Goods

    Agricultural Products

    Mining Products

    30

    24

    47.5

    22.5

    22

    62.5

    1973

    1995

    60


    Chapter 4

    • The Heckscher-Ohlin model predicts that owners of abundant factors will gain from trade and owners of scarce factors will lose from trade.

    • But little evidence supporting this prediction exists.

    • According to the model, a change in income distribution occurs through changes in goods prices, but there is no evidence of a change in the prices of skill-intensive goods relative to prices of unskilled-intensive goods.

    61


    Chapter 4

    • According to the model, wages of unskilled workers should increase in unskilled labor abundant countries relative to wages of skilled labor, but in some cases the reverse has occurred:

      • Wages of skilled labor have increased more rapidly in Mexico than wages of unskilled labor.

    • Even if the model were exactly correct, trade is a small fraction of the US economy, so its effects on US prices and wages prices should be small.

    62


    Chapter 4

    • Changes in income distribution occur with every economic change, not only international trade.

      • Changes in technology, changes in consumer preferences, exhaustion of resources and discovery of new ones all affect income distribution.

      • Economists put most of the blame on technological change and the resulting premium paid on education as the major cause of increasing income inequality in the US.

    • It would be better to compensate the losers from trade (or any economic change) than prohibit trade.

      • The economy as a whole does benefit from trade.

    63


    3 the political economy of trade a preliminary view

    3.The Political Economy of Trade: A Preliminary View

    (1).The Gains from Trade, Revisited

    (2).Optimal Trade Policy

    (3).Income Distribution and Trade Politics

    Box: Income Distribution and the Beginnings of Trade Theory

    Short-run gains & loses often determine political positions in debates over trade policy.

    64


    Chapter 4

    • There are losers & winners from trade.

      • In the short run, factors specific to industries that have to compete with imports lose from trade.

      • In the long run, a country’s scarece factors lose from trade.

    • Three questions:

      • How to measure the losses or gains?

      • What should governments do?

      • What are governments actually doing?s


    1 the gains from trade revisited

    (1).The Gains from Trade, Revisited

    Figure 4-14 Trade Expands the Economy’s Consumption Possibilities

    DF

    QF

    2

    Budget constraint

    1

    QF1

    PP

    QC1

    DC

    QC

    RETURN

    66


    2 optimal trade policy

    (2).Optimal Trade Policy

    Trade – expansion of choices

    • Theoretically, everyone can gain from trade.

    • In practice?

      Homogeneous economy? Actually not.

      • Who nees special treatment?

      • eg. The U.S. manufactures (producers of garments, shoes…)

    67


    Chapter 4

    Three main reasons for not focusing on the income distribution effects of trade:

    (1) It’s not specific to trade.

    • Changes in technology, changes in consumer preferences, exhaustion of resources and discovery of new ones all affect income distribution.

      (2) It’s always better to allow trade and compensate those who are hurt by it.

    • Cusions like “safety net” of income support programme

    • The economy as a whole does benefit from trade.


    3 income distribution and trade politics

    (3).Income Distribution and Trade Politics

    (3) Those who stand to lose are typically better organized.

    • eg. the U.S. sugar industry

  • 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.

    • Each of you 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.

  • 69


    Chapter 4

    Typically, those who gain from trade in any particular product are a much less concentrated, informed, and organized group than those who lose.

    70


    4 empirical evidence on the heckscher ohlin model

    4.Empirical Evidence on the Heckscher-Ohlin Model

    ①.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.

      ②.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.

      ③.Tests on manufacturing data between low/middle income countries and high income countries.

    • This data lends more support to the theory.

    RETURN

    71


    Tests on us data

    ①.Tests on US data

    72


    Tests on global data

    ②.Tests on global data

    74


    Chapter 4

    ③.Tests on manufacturing data between low/middle income countries and high income countries.(North-South Trade)

    75


    The case of the missing trade

    ④.The Case of the Missing Trade.

    • But because factor prices are not equalized across countries, the predicted volume of trade is much smaller than actually occurs.

      • A result of “missing trade” discovered by Daniel Trefler.

    • The reason for this “missing trade” appears to be the assumption of identical technology among countries.

      • Technology affects the productivity of labor and therefore the value of labor services.

      • A country with high technology and a high value of labor services would not necessarily import a lot from a country with low technology and a low value of labor services.

    76


    Chapter 4

    What’s the implications of the tests?

    77


    5 summary

    5. Summary

    1 Substitution of factors in the production process generates a curved PPF.

    2 When an economy produces on its PPF, the opportunity cost of producing a good equals the relative price of that good.

    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.

    78


    Chapter 4

    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.

    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.

    79


    Chapter 4

    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.

    80


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