Chapter 4:
Trade: Factor Availability and Factor Proportions
Are Key
Four Fundamental Questions About Trade
• What is the basis for trade?
• What are the gains from trade?
• What are the effects of trade on production
and consumption in each country?
• What are the distributional effects of trade in
each nation?
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Production with Increasing Marginal Costs
• Increasing marginal costs: As one industry
expands at the expense of others, increasing
amounts of the other products must be given up
to get each extra unit of the expanding industry’s
product.
• A country’s production-possibilities curve (ppc)
shows the combinations of amounts of different
products that a country can produce, given the
country’s available factor resources and
maximum feasible productivities.
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Production Possibilities under Increasing Costs
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What’s Behind the Bowed-Out
Production Possibilities Curve?
• Why are increasing-cost curves (bowed-out in
shape) more realistic than constant-cost
(straight-line) production possibility curves?
• A country’s ppc is derived from information on
both total factor (resource) supplies and the
production functions that indicate how factor
inputs can be used to produce outputs in
various industries.
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What’s Behind the Bowed-Out
Production Possibilities Curve?
• The explanation for the realism of increasing
costs (and the bowed-out shape)
– There are several kinds of factor inputs (land,
skilled labor, unskilled labor, capital, etc.)
– Different products use factor inputs in different
proportions
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What Production Combination Is
Actually Chosen?
• It depends on the price ratio that competitive
firms face.
• Suppose that the market price of cloth in
terms of wheat is 2 W / C . If you are a
competitive firm vying with other firms
around you, you will see one of these three
conditions at any production point:
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What Production Combination Is
Actually Chosen?
If the opportunity cost of producing another unit of cloth
is….
• less than the 2 W / C that you can sell it for, then try to
make more cloth (and take resources away from
wheat). The opportunity cost is less (the slope of the
ppc is flatter) than 2 W / C .
• more than the 2 W / C that you can sell it for, then try
to make less cloth (and shift resources into growing
wheat). The opportunity cost is greater (the slope of
the ppc is steeper) than 2 W / C .
• equal to the 2 W / C that you can sell it for, then you
are producing the right amount. There is no reason to
shift any production between cloth and wheat.
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Community Indifference Curves
Indifference curves show the various
combinations of consumption quantities that
lead to the same level of well-being or
happiness (utility).
Community indifference curves purport to show
how the economic well-being of a whole group
depends on the whole group’s consumption of
products.
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Indifference Curves Relating an Individual’s Levels
of Well-Being to Consumption of Two Goods
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Indifference Curves
Indifference curves are:
• individual specific
• downward sloping
• concave to the origin
• There are infinite indifference curves
(indifference map)
• Indifference curves cannot intersect
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Community Indifference Curves
Community indifference curves are useful. Still,
economic theory raises difficult questions about
community indifference curves:
• The shapes of individual indifference curves differ
from person to person. There is no clear way to
“add up” individuals’ indifference curves to
obtain community indifference curves.
• The concept of national well-being or welfare is
not clearly defined.
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Production and Consumption Together
• Without trade the US must be self-sufficient
and find the combination of domestically
produced wheat and cloth that will maximize
community well-being.
• With trade the US imports cloth from the rest
of the world and exports wheat to the rest of
the world.
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Indifference Curves and Production
Possibilities without Trade
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Two Views of Free Trade and Its Effects
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Gains from Trade
• Trade allows both countries to reach a higher
level of economic well-being than before
trade.
• A country’s gain depends on the price ratios
before trade (autarky price) and after trade
• Trade affects both production and
consumption patterns in both countries
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Trade Affects Production
The opening up of trade has two types of
implications for production
1. Within each country output expands for the
product in which the country has a comparative
advantage. The expanding industry (export
sector) acquires factor resources from other
industries in the economy. The importcompeting sector reduces its domestic
production (the shrinking sector)
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Trade Affects Production and Consumption
2. The shift from autarky to free trade results in
more efficient world production as each country
expands output of the product in which it is
initially the lower cost producer.
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Trade Affects Consumption
• Substitution effect: In each country the
relative price of the importable product
declines, so consumers tend to buy more of
the importable product and less of the
exportable product.
• Real income effect: In each country real
incomes rise, so consumers have more buying
power and tend to buy more of both products.
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Trade Affects Consumption
Opening up of trade alters the quantities
consumed of each product.
• In each country the quantity consumed of the
importable product will increase.
• In each country the quantity consumed of the
exportable product can decrease, stay the
same, or increase. (It depends on the sizes of
the negative substitution effect and the
positive income effect.)
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What Determines the Trade Pattern?
The immediate basis for the pattern of international
trade is that the relative product prices differ
between the two countries if there were no trade.
But why do product prices differ?
Possible causes for relative price differences are:
• Production conditions differ (supply-side factors)
• Demand conditions differ (demand-side factors)
• Some combination of these factors may cause
price differences(supply and demand side factors)
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Heckscher-Ohlin (H-O) Theory of Trade
• Predicts that a country exports product (or products)
that uses its relatively abundant factor(s) intensively
and imports the product (or products) that uses its
relatively scarce factor(s) intensively.
• A country is relatively labor-abundant if it has a
higher ratio of labor to other factors than does the
rest of the world.
• A product is relatively labor-intensive if labor costs
are a greater share of its value than they are of the
value of other products.
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Heckscher-Ohlin (H-O) Theory of
Trade
• H-O comparative advantage is actually a triple
comparison:
across countries
across products
across factors of production
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The Heckscher-Ohlin Model: The
Setting for the H-O Theory of Trade
• There are two factors of production, labor and
land.
• Factors of production can freely move between
industries in a country (perfect factor mobility
within each country).
• The owners of land are paid rent (r), and the
reward to workers is wage rate (w).
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Heckscher-Ohlin (H-O) Model
• Countries differ in their relative endowment of
factors of production. In our example, U.S. is
assumed to be relatively land abundant, while ROW
is assumed to be relatively labor abundant. This
𝐿𝑎𝑛𝑑
𝐿𝑎𝑛𝑑
implies that: (
) US > (
)ROW
Alternatively,
𝐿𝑎𝑏𝑜𝑟
𝑅𝑒𝑛𝑡
(
𝑊𝑎𝑔𝑒
) US <
𝐿𝑎𝑏𝑜𝑟
𝑅𝑒𝑛𝑡
(
)ROW
𝑊𝑎𝑔𝑒
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Heckscher-Ohlin (H-O) Model
• Production technologies used to produce goods are
identical across countries. In this example we
assume that in both countries, the production of
wheat is more land intensive than the production of
𝐿𝑎𝑛𝑑
𝐿𝑎𝑛𝑑
cloth so that: (
) Wheat > (
)Cloth
𝐿𝑎𝑏𝑜𝑟
𝐿𝑎𝑏𝑜𝑟
• Identical demand conditions: Consumer tastes are
the same across countries
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