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  1. Preview Production possibilities Changing the mix of inputs Relationships among factor prices and goods prices, and resources and output Trade in the Heckscher-Ohlin model Factor price equalization Trade and income distribution Empirical evidence

  2. Introduction In addition to differences in labor productivity, trade occurs due to differences in resources across countries. The Heckscher-Ohlin theory argues that trade occurs due to differences in labor, labor skills, physical capital, capital, or other factors of production across countries. Countries have different relative abundance of factors of production. Production processes use factors of production with different relative intensity.

  3. Two Factor Heckscher-Ohlin Model Two countries: home and foreign. Two goods: cloth and food. Two factors of production: labor and capital. The mix of labor and capital used varies across goods. The supply of labor and capital in each country is constant and varies across countries. In the long run, both labor and capital can move across sectors, equalizing their returns (wage and rental rate) across sectors.

  4. Production Possibilities With more than one factor of production, the opportunity cost in production is no longer constant and the PPF is no longer a straight line. Why? Numerical example: K = 3000, total amount of capital available for production L = 2000, total amount of labor available for production

  5. Production Possibilities Suppose use a fixed mix of capital and labor in each sector. aKC = 2, capital used to produce one yard of cloth aLC = 2, labor used to produce one yard of cloth aKF = 3, capital used to produce one calorie of food aLF = 1, labor used to produce one calorie of food

  6. Production Possibilities (cont.) Production possibilities are influenced by both capital and labor: aKCQC + aKFQF≤ K aLCQC+ aLFQF≤ L Total amount of capital resources Total amount of labor resources Capital used for each yard of cloth production Total yards of cloth production Capital used for each calorie of food production Total calories of food production Labor required for each calorie of food production Labor used for each yard of cloth production

  7. Production Possibilities (cont.) Constraint on capital that capital used cannot exceed supply: 2QC + 3QF≤ 3000 Constraint on labor that labor used cannot exceed labor supply: 2QC + QF≤ 2000

  8. Production Possibilities (cont.) Economy must produce subject to both constraints – i.e., it must have enough capital and labor. Without factor substitution, the production possibilities frontier can be derived using the two factor constraints.

  9. The Production Possibility Frontier Without Factor Substitution

  10. Production Possibilities (cont.) The opportunity cost of producing one more yard of cloth, in terms of food, is not constant: low (2/3 in example) when the economy produces a low amount of cloth and a high amount of food high (2 in example) when the economy produces a high amount of cloth and a low amount of food

  11. Production Possibilities (cont.) The above PPF equations do not allow substitution of capital for labor in production. Unit factor requirements are constant along each line segment of the PPF. If producers can substitute one input for another in the production process, then the PPF is curved (bowed). Opportunity cost of cloth increases as producers make more cloth.

  12. The Production Possibility Frontier with Factor Substitution

  13. Production Possibilities (cont.) What does the country produce? It depends on prices. The economy produces at the point that maximizes the value of production, V. An isovalueline is a line representing a constant value of production, V: V = PC QC + PF QF where PC and PF are the prices of cloth and food. The slope of isovalue line is – (PC /PF)

  14. Prices and Production

  15. Production Possibilities (cont.) The economy produces at the point Q, the point on the PPF that touches the highest possible isovalue line. At that point, the relative price of cloth equals the slope of the PPF, which equals the opportunity cost of producing cloth. The trade-off in production equals the trade-off according to market prices.

  16. Choosing the Mix of Inputs Producers may choose different amounts of factors of production. Their choice depends on the wage, and the rental rate. As the wage w increases relative to the rental rate r, producers use less labor and more capital in the production of both food and cloth.

  17. Choosing the Mix of Inputs The Key Assumption in the H-O Model: Assume that at any given factor prices, cloth production uses more labor relative to capital than food production uses: aLC/aKC > aLF/aKF or LC /KC > LF /KF Relative factor demand curve for cloth CC lies outside that for food FF.

  18. Factor Prices and Input Choices

  19. Factor Prices and Goods Prices The downward slope characterizes the substitution effect in the producers’ factor demand. Also: changes in w/r are tied to changes in PC /PF. In competitive markets, the price of a good should equal its cost of production, which depends on the factor prices. An increase in the rental rate of capital should affect the price of food more than the price of cloth since food is the capital intensive industry

  20. Factor Prices and Goods Prices

  21. Factor Prices and Goods Prices (cont.) Stolper-Samuelson theorem: If the relative price of a good increases, then the real wage or rental rate of the factor used intensively in the production of that good increases, while the real wage or rental rate of the other factor decreases. In other words: any change in the relative price of goods alters the distribution of income.

  22. From Goods Prices to Input Choices

  23. Factor Prices and Goods Prices (cont.) An increase in the relative price of cloth, PC /PF, is predicted to raise income of workers relative to that of capital owners, w/r. raise the ratio of capital to labor services, K/L, used in both industries. raise the real income (purchasing power) of workers and lower the real income of capital owners.

  24. Factor Prices and Goods Prices (cont.) Why? Workers are paid their Marginal Value Product=P*MPL=w P goes up, wage goes up But, MPL also goes up, as firms shift to using capital. So wage goes up more than P.

  25. Resources and Output How do levels of output change when the economy’s resources change? Suppose that a relative price (PC/PF) is given and associated with a fixed wage-rental ratio (w/r). That ratio, in turn, determines the ratios of labor to capital employed in both the cloth (LC/KC)1 and the food sectors (LF/KF)1. Now we assume that the economy’s labor force grows  L/K increases, but we know that at the given relative price of cloth the relative labor demanded in each sector remains constant at (LC/KC)1and (LF/KF)1. How does the economy employ the additional labor hours?

  26. Resources and Output The answer lies in the allocation of labor and capital across sectors: the Labor–Capital ratio in the cloth sector is higher than that in the food sector, so the economy can increase employment of labor to capital (holding the Labor-Capital ratio fixed in each sector) by allocating more labor and capital to the production of cloth (which is labor-intensive)  As labor and capital move from the food sector to the cloth sector, the economy produces more cloth and less food.

  27. Resources and Output: the PPF • TT1 represents the PPF before the increase in the Labor supply • Output is at point 1 where the slope of the PPF equals minus the relative price of cloth and the economy produces Q1C and Q2F • TT2 shows the PPF after an increase in the labor supply. The economy now can produce more than before of both goods. The outward shift of the frontier is much larger in the direction of cloth than of food: there is a biased expansion of production possibilities (the PPF shifts out morein one direction than in the other). • Production moves from point 1 to point 2  increase in cloth production and decrease in food production.

  28. Resources and Production Possibilities

  29. Resources and Output • Rybczynski theorem: If you hold output prices constant as the amount of 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. • 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.

  30. Trade in the Heckscher-Ohlin Model Now, focus on International Trade. Again, suppose that Home is relatively abundant in labor and Foreign in capital: L/K > L*/ K* Likewise, Home is relatively scarce in capital and Foreign in labor. Home will be relatively efficient at producing cloth because cloth is relatively labor intensive.

  31. Trade in the Heckscher-Ohlin Model (cont.) The countries are assumed to have the same technology and the same tastes ( same relative demand). With the same technology (No Ricardian Advantage!), each economy has a comparative advantage in producing the good that relatively intensively uses the factors of production in which the country is relatively well endowed. With the same tastes, the two countries will consume cloth to food in the same ratio when faced with the same relative price of cloth under free trade.

  32. Trade in the Heckscher-Ohlin Model (cont.) Home will have a larger relative supply of cloth to food than Foreign. Home’s relative supply curve lies to the right of Foreign’s.

  33. Trade Leads to a Convergence of Relative Prices

  34. Trade in the Heckscher-Ohlin Model (cont.) The Heckscher-Ohlin model predicts a convergence of relative prices with trade. The economy exports the good whose relative price increases: Home becomes an exporter of cloth because it is labor abundant (relative to Foreign), and an importer of food. Trade leads to a rise in the relative production of cloth and a fall in relative consumption of cloth.

  35. Trade in the Heckscher-Ohlin Model (cont.) Heckscher-Ohlin theorem: An economy has a comparative advantage in producing, and thus will export, goods that are relatively intensive in using its relatively abundant factors of production, and will import goods that are relatively intensive in using its relatively scarce factors of production.

  36. Trade and the Distribution of Income • A rise in the price of cloth raises the purchasing power of labor in terms of both goods. A rise in the price of food has the reverse effect  International trade can have a powerful effect on the distribution of income. • Owners of a country’s abundant factors gain from trade, but owners of a country’s scarce factors lose. • Gain from trade: Opening to trade expands an economy’s consumption possibilities (the same argument of the specific factors case)

  37. Factor Price Equalization Unlike the Ricardian model, the Heckscher-Ohlin model predicts that factor prices will be equalized among countries that trade. Free trade equalizes relative output prices. Due to the connection between output prices and factor prices, factor prices are also equalized (note: this is the difference between H-O and Ricardian Models).

  38. Factor Price Equalization (cont.) • In other words: when Home and Foreign trade with each other, in an indirect way, they trade factors of production. • The goods that Home sells require more labor to produce than the goods it receives in return: more labor is embodied in Home’s exports than in its imports  Home’s exports its labor, embodied in its labor-internsive exports.  Foreign’s exports embody more capital than its imports, thus Foreign is indirectly exporting its capital.

  39. Factor Price Equalization (cont.) BUT…in the real world, factor prices (wage rate and the capital rent) are not equal across countries.

  40. Example: Comparative International Wage Rates (United States = 100)

  41. Factor Price Equalization (cont.) We need to look at the assumptions! The model assumes that trading countries have the same technology, but different technologies could affect the productivities of factors and therefore the wages/rates paid to these factors (Ricardo!). The model also ignores trade barriers and transportation costs, which may prevent output prices and thus factor prices from equalizing. After an economy liberalizes trade, factors of production may not quickly move to the industries that intensively use abundant factors.

  42. Empirical Evidence on the Heckscher-Ohlin Model Tests on US data Leontief found that U.S. exports were less capital-intensive than U.S. imports, even though the U.S. is the most capital-abundant country in the world: Leontief paradox.

  43. Factor Content of U.S. Exports and Imports for 1962

  44. Empirical Evidence of the Heckscher-Ohlin Model (cont.) A solution to the paradox: The US are a country with high technology and highly educated labor forces  it has a comparative advantage in producing goods made with innovative technologies (e.i.aircraft and sophisticated computer chips). Such products may well be less capital-intensive than products whose technology has had time to mature and become suitable for mass production techniques “Effective” endowments of labor may differ from observed endowments due to technologies.

  45. Empirical Evidence on the Heckscher-Ohlin Model (cont.) • Tests on global data • Bowen, Leamer, and Sveikauskas tested the Heckscher-Ohlin model on data from 27 countries and 12 factors of production and confirmed the Leontief paradox on an international level. • Based on the factor content of exports and imports, a country should be a net exporter of a factor of production with which it is relativeley abundantly endowed. • Findings: for two-thirds of the factors of production, trade ran in the predicted directions less than 70 percent of time

  46. Testing the Heckscher-Ohlin Model

  47. Empirical Evidence on the Heckscher-Ohlin Model: The case of missing trade • Daniel Trefler: H-O model can be used to derive predictions for a country’s volume of trade based on differences in that country’s factor abundance with the rest of the world (since in the model trade in goods substitute trade in factors). Findings: Factor trade turns out to be substantially smaller than the H-O model predicts. Allowing for technology differences helps to resolve this puzzle of “missing trade”! • Large technology differences are an explanation of the discrepancies between the observe volumes of trade and those predicted by the H-O model.

  48. Empirical Evidence on the Heckscher-Ohlin Model: The case of missing trade (cont.) • Example: if workers in the US are much more efficient than those in China, then the “effective” labor supply in the US is much larger compared with that of China than the raw data suggest  the expected volume of trade between labor-abundant China and labor-scarce America is correspondingly less. Trefler estimated technology efficiency for a sample of countries. They suggest that technology differences are, in fact, very large.

  49. Estimated Technological Efficiency, 1983 (United States = 1)

  50. Empirical Evidence of the Heckscher-Ohlin Model: Patterns of Trade Between Developed and Developing Countries Looking at changes in patterns of exports between developed (high income) and developing (low/middle income) countries supports the theory. US imports from Bangladesh (low educated work force) are high in “low-skill-intensity industries”, while US imports from Germany (high educated work force) are high in “high- skill-intensity industries”.