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Upcoming. PS #3 due now Office hours tomorrow cancelled PS #4 due next week (10/20) MT 2 on 11/3. The Heckscher-Ohlin-Samuelson Model. Factor Proportions Theory. Problems with the Generic Neoclassical Model.

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upcoming
Upcoming
  • PS #3 due now
  • Office hours tomorrow cancelled
  • PS #4 due next week (10/20)
  • MT 2 on 11/3
the heckscher ohlin samuelson model

The Heckscher-Ohlin-Samuelson Model

Factor Proportions Theory

problems with the generic neoclassical model
Problems with the Generic Neoclassical Model
  • What is the source of a country’s comparative advantage? Generic neoclassical theory doesn’t really say
  • Factors other than labor (especially capital) are not explicitly included
h o s in general
H-O-S In General
  • Heckscher, and his student Ohlin, worked in the early part of the 20th century
  • Samuelson refined their work after WWII
  • Closer attention is paid in this model to each country’s resource endowment
h o s assumptions
H-O-S Assumptions
  • 2 countries
  • 2 commodities
  • 2 factors (labor and capital)
  • Perfect competition exists in all markets
  • Each country’s endowment of factors is fixed
  • Factors are mobile internally, but immobile internationally
h o s assumptions cont d
H-O-S Assumptions (cont’d)
  • Each producer has a wide range of options as to how to produce X or Y
    • if K is cheap relative to labor, a relatively capital-intensive method will be adopted
    • if K is expensive relative to labor, a relatively labor-intensive method will be adopted
  • Each country has the same CRTS technology
h o s assumptions cont d7
H-O-S Assumptions (cont’d)
  • Tastes and preferences are the same for both countries
concepts and terminology
Concepts and Terminology
  • The capital-labor ratio for good X is simply KX/LX, and for Y is KY/LY
    • If KX/LX > KY/LY, production of good X is capital intensive relative to production of good Y
    • For example, the amount of capital per worker in the U.S. petroleum and coal industry is $468,000
    • The similar figure for apparel products is $8,274
    • Therefore, petroleum and coal is produced in a relatively capital-intensive manner
concepts and terminology9
Concepts and Terminology
  • Also, production of Y must be relatively labor intensive (If KX/LX > KY/LY, then LY/KY > LX/KX)
    • That is, apparel products are produced in a labor-intensive manner (as compared to petroleum and coal)
concepts and terminology11
Concepts and Terminology
  • Country A is said to be capital abundant relative to Country B if (K/L)A > (K/L)B
    • For example, if the U.S. has a capital stock of $4.3 trillion and a labor force of 121 million, then K/L is about $36,000.
    • K/L for India works out to $607 billion/$304 million = $2,000.
    • Therefore, the U.S. is capital abundant relative to India; India is relatively labor abundant.
concepts and terminology13
Concepts and Terminology

To summarize:

  • goods are produced relatively K or L intensively
  • countries are relatively K or L abundant
concepts and terminology14
Concepts and Terminology
  • The factor price of labor (the wage) is denoted w
  • The factor price of capital is denoted r
  • If labor is relatively expensive, w/r will be a relatively big number
  • If labor is relatively cheap, w/r will be a relatively small number
more on factor prices
More on Factor Prices
  • What makes labor relatively expensive?
    • If it is relatively scarce
  • What makes labor relatively cheap?
    • If it is relatively abundant
  • So: If (K/L)A is a relatively big number (that is, capital is relatively abundant), w/r will be a relatively big number, reflecting the relative scarcity of L and abundance of K
a review of trade in the neoclassical model
A Review of Trade in the Neoclassical Model
  • Suppose the U.S. is capital abundant relative to Mexico
  • This, of course, means that Mexico is relatively labor abundant
  • These differences affect the shape of each country’s PPF
  • Suppose that cars are produced rel. K-intensively, and textiles labor intensively
autarky in mexico and the u s
Autarky in Mexico and the U.S.

U.S.

Cars

Mexico

Cars

(PT/PC)Mex

E

e

Y1

Y4

(PT/PC)US

X1

Textiles

Textiles

X4

autarky in mexico and the u s18
Autarky in Mexico and the U.S.
  • The relative price of textiles in autarky is greater in the U.S. than in Mexico
  • That is, the U.S.’s autarky price line is steeper than Mexico’s
  • In symbols, (PT/PC)U.S. > (PT/PC)Mex.
  • This means thatMexico has the comparative advantage in textiles
autarky in mexico and the u s19
Autarky in Mexico and the U.S.

U.S.

Cars

Mexico

Cars

(PT/PC)Mex

E

e

Y1

Y4

(PT/PC)US

X1

Textiles

Textiles

X4

autarky in mexico and the u s20
Autarky in Mexico and the U.S.
  • This also means that the relative price of cars in autarky is lower in the U.S. than in Mexico
  • That is, (PC/PT)U.S. < (PC/PT)Mex.
  • This means thatthe U.S. has the comparative advantage in cars
autarky to trade
Autarky to Trade

U.S.

Cars

Mexico

Cars

(PX/PY)trade

E

e

Y1

Y4

X1

Textiles

Textiles

X4

production in trade
Production in Trade

U.S.

Cars

Mexico

Cars

(PX/PY)T

e'

Y5

E

e

Y1

Y4

E'

Y2

X1

X2

Textiles

Textiles

X5

X4

consumption in trade
Consumption in Trade

U.S.

Cars

Mexico

Cars

e'

Y5

C'

Y3

E

e

Y1

Y4

c'

Y6

E'

Y2

X1

X2

Textiles

Textiles

X5

X3

X4

X6

the result
The Result
  • The relatively capital abundant country (U.S.) exports the relatively capital intensive good (cars)
  • The relatively labor abundant country (Mexico) exports the relatively labor intensive good (textiles)
the heckscher ohlin theorem
The Heckscher-Ohlin Theorem
  • A country will export the commodity that uses relatively intensively the factor that country has in relative abundance
  • A country will import the commodity that uses relatively intensively the factor that is relatively scarce in that country
the source of comparative advantage
The Source of Comparative Advantage
  • If a country has a lot of labor relative to K, its wage rates will be relatively low, so
  • the product that uses a lot of labor in its production (relatively speaking) will be produced at a relatively low cost, so
  • the country should export the labor intensive good
the source of comparative advantage27
The Source of Comparative Advantage
  • If a country has a lot of capital relative to L, its capital price will be relatively low, so
  • the product that uses a lot of K in its production (relatively speaking) will be produced at a relatively low cost, so
  • the country should export the capital intensive good
the source of comparative advantage28
The Source of Comparative Advantage
  • So it is a country’s relative factor endowment that determines its comparative advantage
  • This is why the H-O-S model is also called the factor proportions theory
changes in relative commodity prices
Changes in Relative Commodity Prices
  • As we learned before,
    • (PT/PC)US falls as the U.S. moves to trade. That is, the international relative textile price is lower than the U.S.’s autarky price.
    • (PT/PC)Mex rises as Mexico moves to trade. That is, the international relative textile price is higher than Mexico’s autarky price.
changes in factor prices
Changes in Factor Prices
  • In autarky, the K-intensive product (cars) is less expensive to produce in the U.S. as compared to Mexico
    • this is because K is relatively abundant in the U.S., which makes the price of capital relatively low
  • As trade commences, r will rise since demand for capital will rise
changes in the price of capital in the u s32
Changes in the Price of Capital in the U.S.

r

SK

In autarky, the price of capital

(r1) is determined by supply of

and demand for capital in the U.S

r1

D1K

QK

changes in the price of capital in the u s33
Changes in the Price of Capital in the U.S.

r

SK

When trade starts, the U.S. increases

its production of the capital intensive

product, and therefore demand for

capital increases in the U.S.

r2

r1

D2K

D1K

QK

changes in factor prices34
Changes in Factor Prices
  • In autarky, the L-intensive product (textiles) is more expensive to produce in the U.S. as compared to Mexico
    • this is because L is relatively scarce in the U.S., which makes the price of labor relatively high.
  • As trade commences, w will fall since demand for labor will fall
changes in the price of labor in the u s36
Changes in the Price of Labor in the U.S.

w

SL

In autarky, the price of labor

(w1) is determined by supply of

and demand for labor in the U.S

w1

D1L

QL

changes in the price of labor in the u s37
Changes in the Price of Labor in the U.S.

w

SL

When trade starts, the U.S. decreases

its production of the labor intensive

product, and therefore demand for

labor decreases in the U.S.

w1

w2

D1L

QL

commodity and factor prices in trade a summary
Commodity and Factor Prices In Trade: A Summary
  • When trade begins, the relative price of the good intensive in the abundant factor rises (e.g., (PC/PT)US rises)
  • The relative price of the good intensive in the scarce factor falls (e.g., (PT/PC)US falls)
  • Also, the price of the abundant factor rises, and the price of the scarce factor falls (i.e., w falls, r rises in the U.S.)
commodity and factor prices in trade a summary39
Commodity and Factor Prices In Trade: A Summary
  • In our example, (PT/PC)US falls as trade commences
  • (w/r)US also falls
  • In Mexico, the opposite is happening:
    • (PT/PC)Mex rises
    • (w/r)Mex also rises
  • Therefore relative commodity and factor prices move together as trade commences
the relative cost curve
The Relative Cost Curve
  • Since relative factor and commodity prices move together as countries move from autarky to trade, we can look at a picture of these two sorts of prices
  • We also know that in autarky (PT/PC)Mex is lower than (PT/PC)US
  • (w/r)Mex is also lower in autarky than (w/r)US since Mexico is relatively labor abundant
the relative cost curve41
The Relative Cost Curve

PT/PC

(PT/PC)US

(PT/PC)Mex

(w/r)Mex

(w/r)US

w/r

the relative cost curve42
The Relative Cost Curve

PT/PC

(PT/PC)US

(PT/PC)Mex

(w/r)Mex

(w/r)US

w/r

the relative cost curve43
The Relative Cost Curve

PT/PC

(PT/PC)US

As trade commences, (PT/PC)US

falls, and (PT/PC)Mex rises

(PT/PC)Mex

(w/r)Mex

(w/r)US

w/r

the relative cost curve44
The Relative Cost Curve

PT/PC

(PT/PC)US

In addition, as trade commences

(w/r)US falls, and (w/r)Mex rises

(PT/PC)Mex

(w/r)Mex

(w/r)US

w/r

factor price equalization
Factor Price Equalization
  • In fact, each country moves along the relative cost curve to a common point
  • We know this because there is only one international price
  • If the countries wind up with a common international price, they must also wind up with a common set of relative factor prices
the relative cost curve46
The Relative Cost Curve

PT/PC

(PT/PC)US

(PT/PC)Int

Both relative commodity and

factor prices equalize in trade

(PT/PC)Mex

(w/r)Mex

(w/r)US

(w/r)Int

w/r

the factor price equalization theorem
The Factor Price Equalization Theorem

In equilibrium, with both countries facing the same relative product prices, relative costs will be equalized. This can only happen if relative factor prices are equalized between countries.

h o s and the distribution of income
H-O-S and the Distribution of Income
  • The H-O theorem, together with the FPE theorem, also tell us about how the incomes of different groups within a country change as trade starts
  • This provides insight into the politics of free trade
the stolper samuelson theorem
The Stolper-Samuelson Theorem

As trade commences, the owners of the relatively abundant factor will find their real incomes rising; the owners of the relatively scarce factor will find their real incomes falling.

h o s and the distribution of income50
H-O-S and the Distribution of Income
  • According to the S-S theorem, if the U.S. is a relatively K-abundant country, who in America should favor free trade?
  • Who in America should favor protectionism?
theoretical qualifications to h o s
Theoretical Qualifications to H-O-S
  • Suppose we relax some of the many assumptions. Will the implications of the H-O-S model still be the same?
qualification 1 demand reversal
Qualification #1: Demand Reversal
  • Normally, the relative price of the commodity that uses intensively the abundant factor will be lower
  • In our example, (PC/PT)US < (PC/PT)Mex
  • Or, (PT/PC)US > (PT/PC)Mex
  • What causes this difference in autarky prices? Differences in supply conditions
qualification 1 demand reversal53
Qualification #1: Demand Reversal
  • Suppose we let demand conditions differ
  • Suppose domestic demand for the good that uses relatively intensively the relatively abundant factor is very strong in each country
  • That is, suppose demand for cars is very strong in the U.S., and that demand for textiles is very strong in Mexico
qualification 1 demand reversal54
Qualification #1: Demand Reversal
  • Such strong demand makes the autarky car price in the U.S. higher, and the textile price in Mexico higher
  • In the extreme, demand reversal could occur: (PC/PT)US> (PC/PT)Mex, and
  • (PT/PC)US< (PT/PC)Mex
  • So what?
qualification 1 demand reversal55
Qualification #1: Demand Reversal
  • When trade begins, as usual the int’l price will lie between the two countries’ APRs
  • Therefore (PC/PT) for Mexico will rise as it moves to trade
  • Mexico, then, would export cars
  • Meanwhile, (PT/PC) for the U.S. will rise as it moves to trade
  • The U.S., then, would export textiles
bottom line on demand reversals
Bottom Line on Demand Reversals
  • If demand reversals occur, the H-O theorem no longer holds: the K-abundant country is exporting the L-intensive good, and the L-abundant country is exporting the K-intensive good
  • If demand reversals are common in the real world, we’d better find a new theory
qualification 2 factor intensity reversal
Qualification #2: Factor Intensity Reversal
  • Implicitly, we’ve assumed that if good X is K-intensive relative to good Y at one factor price ratio, it will be K-intensive at all factor prices
  • A FIR is when a good is relatively K-intensive at one set of factor prices, but relatively labor intensive at another
qualification 2 factor intensity reversal58
Qualification #2: Factor Intensity Reversal
  • FIRs occur when capital and labor can be substituted more easily in the production of one good than another
  • Example:
    • Suppose butane production is very inflexible: 1K + 1L = 1 butane, and if you want more butane you must add more of both K and L
    • Suppose apple production is much more flexible
qualification 2 factor intensity reversal59
Qualification #2: Factor Intensity Reversal
  • If w/r is very high, apple producers will choose a relatively K-intensive method (as compared with butane makers)
  • If w/r starts to fall, apple producers will start substituting L for K
  • Eventually, it’s possible that apples might be produced in a relatively L-intensive manner (as compared with butane)
factor intensity reversal implications for trade
Factor Intensity Reversal: Implications for Trade
  • Suppose France is K-abundant relative to Germany (that is (K/L)F > (K/L)G)
  • This means that (w/r)F > (w/r)G
  • Suppose further that there is a FIR: in France, at (w/r)F apples are produced relatively K-intensively but in Germany at (w/r)G apples are produced in a relatively L-intensive way
factor intensity reversal implications for trade61
Factor Intensity Reversal: Implications for Trade
  • If trade begins, according to the H-O theorem the relatively K-abundant country (France) will export the rel. K-intensive good (apples) and the rel. L-abundant country will export the rel. L-intensive good (also apples)
  • This can’t work
factor intensity reversal the bottom line
Factor Intensity Reversal: The Bottom Line
  • If FIRs are present, the H-O theorem breaks down
  • If FIRs are common, we’d better find a new theory
qualification 3 transportation costs
Qualification #3: Transportation Costs
  • In the real world, it is costly to transport goods internationally
  • How do the implications of our model change if we allow for transportation costs?
  • Consider the supply and demand curves for textiles in Mexico and the U.S.:
basic set up
Basic Set-Up

U.S.

SText

PT

PT

Mexico

SText

PAUS

PAMex

DText

DText

QT

QT

basic set up65
Basic Set-Up

U.S.

SText

PT

PT

Mexico

SText

PAUS

PIntl

PIntl

PAMex

DText

DText

q1

q2

QT

q1

q2

QT

basic set up66
Basic Set-Up

U.S.

SText

PT

PT

Mexico

SText

PAUS

Exp.

PIntl

PIntl

Imp.

PAMex

DText

DText

q1

q2

QT

q1

q2

QT

adding transportation costs
Adding Transportation Costs
  • Suppose Mexico tries to pass along 100% of the transportation costs to the U.S. consumers
  • In this case, the U.S. textile price will rise, and the quantity of imports demanded will fall
  • Mexico will have a surplus, and will eventually lower their domestic price
adding transportation costs68
Adding Transportation Costs

U.S.

SText

PT

PT

Mexico

SText

Exp.

t-costs

PIntl

PIntl

Imp.

DText

DText

q1

q2

q1

q2

QT

QT

adding transportation costs69
Adding Transportation Costs
  • Therefore, unless Mexico is the only seller in the world, transportation costs will be borne by both the consumer (the U.S.) and the seller (Mexico).
  • How does this look on the graph?
adding transportation costs70
Adding Transportation Costs

U.S.

SText

PT

PT

Mexico

SText

Exp.

PIntl

PIntl

Imp.

DText

DText

q1

q2

q1

q2

QT

QT

adding transportation costs71
Adding Transportation Costs

U.S.

SText

PT

PT

Mexico

SText

Exp.

PIntl

PIntl

t-costs

Imp.

DText

DText

q1

q2

q1

q2

QT

QT

adding transportation costs72
Adding Transportation Costs
  • Notice: there is no longer a single international textile price, but rather two different ones
  • That is, transportation costs drive a wedge between the two countries’ prices
adding transportation costs the bottom line
Adding Transportation Costs: the Bottom Line
  • In general, the H-O theorem will still hold
  • The FPE theorem breaks down, since factor prices only equalize if the commodity prices do
  • Therefore, in the presence of transportation costs, factor prices have a tendency to move towards each other, but we should not expect equalization
relaxing other assumptions
Relaxing Other Assumptions
  • One can relax many other assumptions and examine how the implications of the model change:
    • perfect competition
    • CRTS
    • identical production technologies
    • lack of policy obstacles
    • factors being perfectly transferable
relaxing other assumptions75
Relaxing Other Assumptions
  • These issues have involved many researchers for many years
  • You can read a bit about this research in your text, but we have other fish to fry
  • Suffice it to say that relaxing these assumptions can modify the basic H-O-S model, but doesn’t lead us to scrap the model