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PPT – ECW3121 International Trade and Finance Lecture 3 PowerPoint presentation | free to view - id: c1b50-ZDc1Z

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ECW3121International Trade and FinanceLecture 3

Heckscher-Ohlin

Stolper-Samuelson

Factor Price Equalisation

Comparative Advantage

Trade Theory Study Guide 1

Rybzcynski

Absolute Advantage

Immiserising Growth

Mercantilism

International Trade and Finance

Balance Of Payments

Foreign Exchange Markets

Non Tariff Barriers

Interest Arbitrage

TradeBlocs

Tariffs

Finance Study Guide 3

Trade Policy Study Guide 2

International Resource Movements

Tools of the Trade Policy Analysis

Exchange rate theorems

Heckscher-Ohlin

Stolper-Samuelson

Factor Price Equalisation

Comparative Advantage

Trade Theory Study Guide 1 Weeks 1-5

Last Lecture

Trade Theory Study Guide 1

Rybzcynski

Absolute Advantage

Immiserising Growth

Mercantilism

Heckscher-Ohlin

Stolper-Samuelson

This week

Comparative Advantage

Factor Price Equalisation

Trade Theory Study Guide 1 Weeks 1-5

Trade Theory Study Guide 1

Rybzcynski

Absolute Advantage

Immiserising Growth

Mercantilism

Assumptions

Trade Theory

Why do Nations Trade?

- Perfect Competition in Product and Factor Markets

(PMC) - Each Country has a fixed endowment of resources

that are fully used and are homogeneous - Technology is Unchanging
- No Transportation Costs or barriers to trade
- Factors of Production are perfectly mobile

between industries but are immobile between

countries - 2x2x1 or 2x2x2

Trade Theory

Why do Nations Trade?

- Mercantilism - zero sum game - one nation gains

at the expense of the other. - Absolute Advantage - each nation should

specialise in production of the good which it is

most efficient at producing. - Comparative advantage - A nation should

specialise in the good in which it enjoys a

comparative advantage. - Fixed costs - complete specialisation
- Variable costs - incomplete specialisation

Trade Theory

Comparative Advantage

Why do Nations Trade?

To increase in welfare of nations

What are the gains from trade?

Increase in consumption of both (all) tradables

Who gains from trade?

Both (all) nations participating in trade

Key points

Trade Theory

Comparative Advantage

Increasing cost PPF (Standard Theory of

International Trade)

- A nation should specialise in the good in which

it enjoys a comparative advantage. - Incomplete specialisation required for maximum

world welfare. - Optimal specialisation occurs at the amount of

production of two commodities, by both nations,

corresponding to equal price ratios

Reminder Production Possibility Frontier

Trade Theory

Comparative Advantage

Increasing cost PPF

x

x

Y

Y

Variable (increasing) opportunity cost

Constant opportunity cost

Trade Theory

Comparative Advantage

Specialisation

Increasing cost PPF

Televisions

Pw Pt

(Singapore)

Singapore

Pw Pt

(Australia)

Australia

0

Wine

Trade Theory

Comparative Advantage

Free trade

Increasing cost PPF

Televisions

Singapore

C

Pw/Pt (Singapore)

Pw/Pt (Australia)

C

Australia

0

Wine

Trade Theory

Comparative Advantage

Free trade

Increasing cost PPF

Televisions

Pw/Pt (Singapore) Pw/Pt (Australia)

Australia - Free Trade

Produces Te of televisions We of

wine. Exchanges We - Wec of wine for Tec -

Te of televisions Increase in production We -

Wa of wine Decrease in production Te - Ta of

televisions Increase in consumption Tec - Ta

of televisions Wec - Wa of wine

Australia - Autarky

Produces and consumes Ta of televisions Wa

of wine

Eec

Tec

A

Ta

E

Te

Wa

Wec

0

Wine

We

Trade Theory

Comparative Advantage

Free trade

Increasing cost PPF

Televisions

Pw/Pt (Singapore) Pw/Pt (Australia)

Singapore - Free Trade

Produces Te of televisions We of

wine. Exchanges Te - Tec of televisions for Wec

- We of wine Increase in production Te - Ta of

televisions Decrease in production We - Wa of

wine Increase in consumption Tec - Ta of

televisions Wec - Wa of wine

E

Te

Singapore - Autarky

Produces and consumes Ta of televisions Wa

of wine

Tec

Eec

A

Ta

Wa

We

Wec

0

Wine

Trade Theory

Heckscher-Ohlin theorem

Reminder Isoquants, Isocosts, Equilibrium

K

Isoquant - Various combinations

of factors K and L that a firm can use to

produce a specific level of

output

Isocost

- Various amounts of K and L that a firm

can hire with a given total outlay

Isocost

Isoquant

0

L

Trade Theory

Heckscher-Ohlin theorem

Reminder Isoquants, Isocosts, Equilibrium

K

Producers equilibrium points when

she maxi- mises output for a given

cost outlay.

Isocost

Equilibrium

Isoquant

0

L

Trade Theory

Heckscher-Ohlin theorem

Reminder Isoquants, Isocosts, Equilibrium

Slope of Isocost Rise / Run Amount of Capital

/ Amount of Labour

K

Amount of Capital Budget / r Amount of Labour

Budget / w

Budget / r

Budget w r

Slope of Isocost

x

Budget / w

Budget

Isocost

0

L

Trade Theory

Heckscher-Ohlin theorem

Reminder Isoquants, Isocosts, Equilibrium

K

A? B MRTS change K/change L MPL/MPK

A

B

Isoquant

0

L

Trade Theory

Heckscher-Ohlin theorem

Reminder Isoquants, Isocosts, Equilibrium

A? B MRTS change K/change L MPL/MPK

Trade Theory

Heckscher-Ohlin theorem

Reminder Isoquants, Isocosts, Equilibrium

Slope of Isocost w/r Slope of Isoquant

MRTS Therefore w/r MRTS in equilibrium

K

Isocost

Isoquant

0

L

Trade Theory

Heckscher-Ohlin theorem

Reminder Isoquants, Isocosts, Equilibrium

K

K/L Ratios

w/r ratios

Q4

Q3

Q2

Q1

0

L

Main points

Trade Theory

Heckscher-Ohlin theorem

- Explains why nations have a comparative

advantage. - Examines what lies behind a production

possibilities frontier. - A nation will have a comparative advantage in the

good that uses its abundant factor intensively.

Main points

Trade Theory

Heckscher-Ohlin theorem

- Each nation will export the good which uses its

abundant factor intensively and will import the

good which uses its scarce factor intensively. - Factor abundance refers to a comparison of the

two nations. - Factor intensity compares the two goods.

Assumptions

Trade Theory

Heckscher-Ohlin theorem

- As for the standard theory of trade, and
- Two factors - labour and capital
- Isoquants are homothetic.
- Homothetic isoquants have the same slope along

any given capital / labour ratio. - If the proportion of capital and labour remains

the same, so will the MRTS.

Trade Theory

Derivation of the Edgeworth Box Diagram

Heckscher-Ohlin theorem

130X

50X

95x

K

O

x

L

Factor diagram for the product X.

- isoquants for the product X

Trade Theory

Derivation of the Edgeworth Box Diagram

Heckscher-Ohlin theorem

60Y

K

Factor diagram for the product Y.

45Y

- isoquants for the product Y

20Y

Y

O

O

L

Trade Theory

Derivation of the Edgeworth Box Diagram

Heckscher-Ohlin theorem

L

L

O

O

Y

Factor diagram for the product Y.

20Y

45Y

- isoquants for the product Y

K

60Y

Trade Theory

Derivation of the Edgeworth Box Diagram

Heckscher-Ohlin theorem

L

L

L

L

O

O

O

O

Y

130X

Factor diagram for the product Y.

50X

20Y

95x

45Y

- isoquants for the product Y

K

K

60Y

O

x

L

Factor diagram for the product X.

- isoquants for the product X

Trade Theory

Derivation of the Edgeworth Box Diagram

Heckscher-Ohlin theorem

L

O

O

O

O

Y

- The length of the horizontal sides L of the

rectangular corresponds to the total amount of

factor L available in the economy - The length of the vertical sides K of the

rectangular corresponds to the total amount of

factor K available in the economy - Each tangent point of two isoquants reflects

factor utilisation for a feasible combination of

products X and Y - Kx and Lx - the amount of factors used for the

production of X - (K- Kx) and (L-Lx ) - the amount of factors

used for the production of Y..

XE

K

YE

E

K

Kx

O

x

Lx

L

Trade Theory

Derivation of the Edgeworth Box Diagram

Heckscher-Ohlin theorem

L

L

L

L

L

L

O

O

O

O

Y

130X

Factor diagram for the product Y.

50X

20Y

95x

45Y

- isoquants for the product Y

K

K

60Y

O

x

L

The contract curve of Nation 1 - Efficient

combinations of factors and products Eficient

means the factors are fully utilised.

Factor diagram for the product X.

- isoquants for the product X

Trade Theory

Derivation of the Edgeworth Box Diagram

Heckscher-Ohlin theorem

L

L

L

L

L

L

O

O

O

O

130X

Y

The contract curve for Nation 1 - efficient

combinations of factors and products A, F, B -

efficient points

20Y

50X

95x

B

45Y

F

K

K

60Y

A

O

x

L

Edgeworth Box Diagram for Nation 1

Y

A

60Y

F

45Y

B

20Y

X

50X

95x

130X

Trade Theory

Derivation of the Edgeworth Box Diagram

Heckscher-Ohlin theorem

L

L

L

L

L

L

O

O

O

O

130X

Y

The contract curve for Nation 1 - efficient

combinations of factors and products A, F, B -

feasible and efficient points What means

infeasible point? What means feasible but

inefficient point?

20Y

50X

95x

B

45Y

F

K

K

60Y

A

O

x

L

Edgeworth Box Diagram for Nation 1

Y

A

60Y

F

45Y

B

20Y

Production possibility frontier for Nation 1

X

50X

95x

130X

Trade Theory

Derivation of the Edgeworth Box Diagram

Heckscher-Ohlin theorem

L

L

L

L

L

L

O

Y

Y

Edgeworth Box Diagram for Nation 2 Nation 2 has

a relative abundance of K compare with Nation 1.

K

80X

40Y

40

(A)

65x

A

K

85Y

85

F

40X

(F)

120Y

120

(B)

B

L

O

x

65

80

40

x

(B)

(F)

(A)

Factor Abundance

Trade Theory

Heckscher-Ohlin theorem

L

0Y

Need to Compare Two Nations

Capital Abundant

K

0Y

L

K

Labour Abundant

K

K

0X

L

L

0X

Factor Abundance

Trade Theory

Heckscher-Ohlin theorem

Need to Compare Two Nations

0Y

L

K

Labour Abundant

K

0X

L

Factor Intensity

Trade Theory

Heckscher-Ohlin theorem

- Factor Intensity refers to the proportion of each

factor used in the production of the goods. - Good X is labour intensive if it uses more labour

per unit of capital than Good Y.

Trade Theory

Heckscher-Ohlin theorem

Edgeworth Box Diagram for Nation 1

L

O

Y

- Labour Abundant
- Has comparative advantage in producing labour

intensive good X - Good X requires more labour per unit of capital

than Good Y.

130X

20Y

50X

G

95x

B

45Y

K

F

K

60Y

A

O

x

L

Y

A

60Y

F

45Y

B

G

20Y

X

0

130X

50X

95x

Trade Theory

Heckscher-Ohlin theorem

Edgeworth Box Diagram for Nation 2

L

L

L

L

- Capital abundant
- Has comparative advantage in producing the

capital intensive good Y - Good Y requires more more capital per unit of

labour than Good X.

Trade Theory

Heckscher-Ohlin theorem

Autarky

O

L

L

L

Y

Nation 2

A and A - Autarky

Nation 2 - steep w/r ratio Nation 1 - flat w/r

ratio

K

A

K

L

O

Y

F

B

Nation 1

B

F

K

A

L

Ox

Trade Theory

Heckscher-Ohlin theorem

Free trade/specialisation

O

L

L

L

Y

- Production possibility frontier
- Nation 2 - steep (capital abundant)
- Nation 1 - flat (labour abundant)

Y

Nation 2

B

Nation 2

K

80X

40Y

F

A

K

65x

L

A

O

85Y

F

F

Y

130X

A

B

20Y

40X

95x

B

B

120Y

45Y

Nation 1

K

A

50X

0

60Y

X

L

Nation 1

- The labour abundant nation 1 specialises in

producing the labour intensive good X - The capital abundant nation 2 specialises in

producing the capital intensive good Y

Trade Theory

Stolper- Samuelson theorem

- Explains the impact of free trade on the returns

to factors. - The increase in the relative price for a

commodity raises the return or earnings of the

factor used intensively in the production of the

commodity.

Trade Theory

Stolper- Samuelson theorem

O

L

L

L

Y

Nation 2

K

A

K

L

O

Y

F

B

Nation 1

B

F

A

K

L

Ox

Trade Theory

Stolper- Samuelson theorem

O

L

L

L

Y

Nation 2

K

A

K

L

O

F

Y

B

Nation 1

F

B

K

A

L

Ox

Trade Theory

Stolper- Samuelson theorem

O

L

L

L

Y

Nation 2

K

A

K

L

O

Y

F

B

Nation 1

B

F

K

A

L

Ox

Trade Theory

Stolper- Samuelson theorem

L

O

Y

Nation 1

K

K

A

Ox

L

Trade Theory

Stolper- Samuelson theorem

Ly

O

Y

Nation 1

A

Kx

Ky

Ox

Lx

Trade Theory

Stolper- Samuelson theorem

Ly

O

Y

Nation 1

A

Kx

Ky

Ox

Lx

Trade Theory

Stolper- Samuelson theorem

Ly

O

Y

Nation 1

A

Kx

Ky

Ox

Lx

Trade Theory

Stolper- Samuelson theorem

L

O

Y

Nation 1

K

K/L

K

A

Ox

L

Trade Theory

Stolper- Samuelson theorem

L

O

Y

Nation 1

K

F

K

A

Ox

L

Trade Theory

Stolper- Samuelson theorem

LyA

O

Y

Nation 1

F

K

A

KxA

KyA

Ox

LA1

Trade Theory

Stolper- Samuelson theorem

LyF

LyA

O

Y

Nation 1

F

KyF

KxF

A

KxA

KyA

Ox

LA1

LF2

Trade Theory

Stolper- Samuelson theorem

L

O

Y

Nation 1

K

F

K

A

Ox

L

Trade Theory

Stolper- Samuelson theorem

L

O

Y

Nation 1

K

F

K

A

Ox

L

Trade Theory

Stolper- Samuelson theorem

L

O

Y

Nation 1

K

F

K

A

Ox

L

Trade Theory

Stolper- Samuelson theorem

L

O

Y

Nation 1

K

F

K

A

Ox

L

Trade Theory

Stolper- Samuelson theorem

O

L

Y

Nation 2

K

K

A

F

Ox

L

Trade Theory

Stolper- Samuelson theorem

O

LyA

Y

Nation 2

KyA

KxA

A

F

Ox

LxA

Trade Theory

Stolper- Samuelson theorem

O

LyA

LyF

Y

Nation 2

KyA

KxA

A

F

KyF

KxF

Ox

LxF

LxA

Trade Theory

Stolper- Samuelson theorem

O

Y

Nation 2

A

F

Ox

Trade Theory

Stolper- Samuelson theorem

O

Y

Nation 2

A

F

Ox

Trade Theory

Stolper- Samuelson theorem

O

Y

Nation 2

A

F

Ox

Trade Theory

Stolper- Samuelson theorem

O

Y

Nation 2

A

F

Ox

Trade Theory

Stolper- Samuelson theorem

O

Y

Nation 2

L

A

O

Y

Nation 1

K

F

F

K

A

Ox

L

Ox

Trade Theory

Stolper- Samuelson theorem

O

Y

Nation 2

L

A

O

Y

Nation 1

K

F

F

K

A

Ox

L

Ox

Trade Theory

Stolper- Samuelson theorem

O

Y

Nation 2

L

A

O

Y

B

Nation 1

K

F

F

K

A

B

Ox

L

Ox

Trade Theory

Stolper- Samuelson theorem

O

Y

Nation 2

A

L

O

Y

B

Nation 1

K

A

B

Ox

L

Trade Theory

Stolper- Samuelson theorem

O

L

L

L

Y

Labour Abundant Nation 1 has comparative

advantage in producing labour intensive good X

Nation 2

- Capital abundant Nation 2 has comparative

advantage in producing the capital intensive good

Y

K

A

K

L

O

Y

F

B

B

F

A

K

L

Nation 1

Ox

Trade Theory

Stolper- Samuelson theorem

O

L

L

L

Y

Increase in the price for X causes increase in

the production of X by the labour abundant Nation

1. This will cause increase in w/r ratio (or

increase in wage in the units of capital

rent) Specialisation of nation 2 in good Y

causes increase of r/w ratio.

Nation 2

K

A

K

L

O

F

Y

B

Nation 1

F

B

K

A

L

Ox

Trade Theory

Stolper- Samuelson theorem

- In a Labour Abundant Nation, which exports a

Labour Intensive Commodity, - wages will increase relative to rental and the

Labour force will be the winners...... - capital owners the losers when free trade is

opened. - In a Capital Abundant Nation, which exports a

Capital Intensive Commodity, - rental will increase relative to wages and the

Capital Owners will be the winners...... - labour owners the losers when free trade is

opened. - Because Each Nation gains from free trade, the

winner will gain enough to fully compensate the

losers...... - the result being a net gain

DONT FORGET

- Reading Salvatore Chapter 7 before next lecture.
- Tutorial Exercise