Resources, Comparative Advantage,

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Chapter 4

• Resources, Comparative Advantage,
• and Income Distribution

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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

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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

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

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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.

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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
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(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/aTCgtaLF/aTF
The ratio of land to labor used in the
production of cloth is higher than it is in the
production of food
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• 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 economys output of manufactures depends on
  how much capital and labor are used in that
  sector.

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• This relationship is summarized by a production
  function.
• The production 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).

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The production function for manufactures is given
by
QM QM (K, LM) (4-1)
where QM is the economys output of
manufactures K is the economys 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
economys output of food T is the economys
supply of land LF is the labor force employed in
food
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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
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Figure 4-2 The Production Possibility Frontier
With Factor Substitution

• Bowed shape - substitution

Where on the PPF does the economy produces?
QF
PP
QC
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• 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)

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Figure 4-3 Prices and Production
QF
Isovalue line
Q
PP
QC
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• In conlusion,The products mix the producers
  choose to produce depends on price (or relative
  price).
• Q
• What if the relative price changes?

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(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
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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.
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Figure 4-5 Factor Prices and Input Choices

w/r
CC
FF
T/L
Cloth production labor-intensive Food
production land-intensive
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(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 .

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(3).Factor Prices and Goods Prices

Figure 4-6 Factor Prices and Goods Prices
PC/PF
SS
w/r
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• 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)

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Figure 4-7 From Goods Prices to Input Choices


w/r
CC
w/r2
FF
w/r1
SS
TF/LF1
T/L
PC/PF
PC/PF2
PC/PF1
TC/LC1
TC/LC2
TF/LF2
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• 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.

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(4).Resources and Output
Figure 4-8 The Allocation of Resources

OF
LF
C
1
TC
TF
F
OC
LC
Why OfF is steeper?
Resources employed - production
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• How do output levels change when the economys
  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.

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Figure 4-9 An Increase in the Supply of Land

LF1
LF2
OF2
OF1
C
1
TC
TF1
2
TF2
F1
F2
OC
LC
T increases P L constant
Where do the reduced factors used in cloth
production go?
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• 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.

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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)
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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
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(1).Relative Prices and the Pattern of Trade

• Assumption Two countries
• ?The same relative demands
• Identical tasts for the same relative price.
• ?The same technology level
• Same factors yeilds same amount of goods.
• ?Factors can not move between countries
• ?Completely competition

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• ?Factor endowment (only difference)
• Home labor-abundant (L/T gt L/ T)
• Foreign land-abundant (L/T lt L/ T)

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• 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.

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• 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

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(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
QCQC
QFQF
Point 1 is lower than point 3, why? (factor
intensity)
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• How differences in relative prices be translated
  into a pattern of trade?
• Some basic relationships budget constraints in
  closed and open economy

PCDCPFDFPCQCPFQF
(4-5) Rearranging DF-QF(PC/PF)(QC-DC) (4-6)
Quantity of exports
Price of exports relative to imports
Quantity of imports
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• 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.

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Figure 4-12 The Budget Constraint for a
Trading Economy

• Two characters
• Slope
• tangency

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Figure 4-13 Trading Equilibrium

QF
QF
Homes budget constraint
Foreign's budget constraint
QFF
DFF
DFH
QFH
QC
DCH
QCH
QCF
DCF
QC
(a) Home
(b) Foreign
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(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

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• 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 countrys abundant factors gain
  from trade, but owners of a countrys scarce
  factors lose.
• The U.S. example

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Figure 4-3 Prices and Production
QF
Isovalue line
Q
PP
QC
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• In conlusion,The products mix the producers
  choose to produce depends on price (or relative
  price).
• Q
• What if the relative price changes?

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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.
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(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
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Figure 4-5 Factor Prices and Input Choices

w/r
CC
FF
T/L
Cloth production labor-intensive Food
production land-intensive
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Figure 4-7 From Goods Prices to Input Choices


w/r
CC
w/r2
FF
w/r1
SS
TF/LF1
T/L
PC/PF
PC/PF2
PC/PF1
TC/LC1
TC/LC2
TF/LF2
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• 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.

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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)
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(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 Homes exports than in
  its imports. So
• Home export labor, embodied in its
  labor-intensive exports.
• Foreign export land, embodied in its
  land-intensive exports.

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• In reality, factor prices are not equalized

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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
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• Three assumptions are in reality violated
  (untrue)
• ?.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.

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• ?.technologies are the same
• A country with superior technology might have
  both a higher wage rate and a higher rental rate.
• ?.trade actually equalize the prices of goods in
  the two countries
• Visible invisible barries (transportation
  costs, import quotas, tarriffs)

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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 countrys abundant factors gain from
  trade, but owners of a countrys scarce factors
  lose.

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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.

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

?Why has wage inequality increased?
North-South trade in manufactures fits to the
factor proportions model much better.
?Is it true that growing trade with low-wage
countries caused the inequality of income in
the United States?
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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
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• 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.

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• 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.

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• 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.

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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.

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• 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 countrys scarece factors lose
  from trade.
• Three questions
• How to measure the losses or gains?
• What should governments do?
• What are governments actually doing?s

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(1).The Gains from Trade, Revisited

Figure 4-14 Trade Expands the Economys
Consumption Possibilities
DF QF
2
Budget constraint
1
QF1
PP
QC1
DC QC
RETURN
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(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)

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• Three main reasons for not focusing on the income
  distribution effects of trade
• (1) Its not specific to trade.
• Changes in technology, changes in consumer
  preferences, exhaustion of resources and
  discovery of new ones all affect income
  distribution.
• (2) Its 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.

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(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.

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

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4.Empirical Evidence on the Heckscher-Ohlin Model

• ?.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.
• ?.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.
• ?.Tests on manufacturing data between low/middle
  income countries and high income countries.
• This data lends more support to the theory.

RETURN
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?.Tests on US data
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Year Factors Export Import Export/ Import
1947 Capital() 2,550,789 3,091339 1.30
1947 Labor(hours) 182 170 1.30
1947 K/L 14,100 18,180 1.30
1956 Capital() 2256,800 2,303,400 1.06
1956 Labor(hours) 174 168 1.06
1956 K/L 12,977 13,726 1.06
1971 (Baldwin) Capital() 1,876,000 2,132,000 1.27
1971 (Baldwin) Labor(hours) 131 119 1.27
1971 (Baldwin) K/L 14,200 18,000 1.27
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?.Tests on global data
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?.Tests on manufacturing data between low/middle
income countries and high income
countries.(North-South Trade)
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?.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.

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Whats the implications of the tests?
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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.

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• 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.

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• 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.

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