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Chapter 4

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  1. Chapter 4 Resources, Comparative Advantage, and Income Distribution

  2. 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

  3. 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

  4. Hecksher – Ohlin theory or factor – propotions theory • Model : from simple (closed economy) to complexed (open economy) • Empirical evidence : for or against?

  5. 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.

  6. 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

  7. (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

  8. 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.

  9. 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).

  10. 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

  11. 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

  12. 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

  13. 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

  14. Figure 4-3 Prices and Production QF Isovalue line Q PP QC 14

  15. In conlusion,The products mix the producers choose to produce depends on price (or relative price). • Q: • What if the relative price changes?

  16. (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

  17. 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

  18. Figure 4-5 Factor Prices and Input Choices w/r CC FF T/L Cloth production: labor-intensive Food production: land-intensive 18

  19. (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

  20. (3).Factor Prices and Goods Prices Figure 4-6 Factor Prices and Goods Prices PC/PF SS w/r 20

  21. 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

  22. 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

  23. 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

  24. (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

  25. 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

  26. 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

  27. 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

  28. 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

  29. 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

  30. (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

  31. ③Factor endowment (only difference) Home: labor-abundant(L/T > L*/ T*) Foreign: land-abundant (L/T < L*/ T*)

  32. 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.

  33. 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

  34. (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

  35. 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

  36. 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

  37. 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

  38. 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

  39. (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

  40. 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

  41. Figure 4-3 Prices and Production QF Isovalue line Q PP QC 42

  42. In conlusion,The products mix the producers choose to produce depends on price (or relative price). • Q: • What if the relative price changes?

  43. 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

  44. (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

  45. Figure 4-5 Factor Prices and Input Choices w/r CC FF T/L Cloth production: labor-intensive Food production: land-intensive 46

  46. 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

  47. 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

  48. 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