Ch. 4: Resources, Comparative
Advantage, and Income Distribution
1
Evolution of Trade Theories
Adam Smith used differences in labor
productivity to explain why trade occurs.
 Ricardo extended the productivity
differences idea to show why trade benefits
both the more productive and the less
productive countries.

2
Evolution of Trade Theories

While trade is partly explained by differences in
labor productivity, it also can be explained by
differences in resources across countries.

The Heckscher-Ohlin theory argues that
international differences in labor, labor skills,
physical capital or land (factors of production)
create productive differences that explain why
trade occurs.
3
Evolution of Trade Theories
Heckscher-Ohlin theory allows for all the
factors to be freely employed in every
industry.
 H-O theory is also called “factor-proportions”
theory because it allows different
proportions of K/L ratio to be used in the
production process.
 As new theories are developed, old theories
become a special case of the new theory.

4
Neoclassical Production
In H-O, labor and capital can be substituted
to produce a constant unit of output.
 Each firm will try produce the highest output
with given amount of outlay by changing the
proportions of capital and labor used.
 Typically, technologies in different industries
employ different ratios of capital and labor in
spite of the fact that the prices of inputs they
face are the same.

5
Typical Firm Behavior
Terrain
Terrain
Q=3
w/r
Q=2
Q=3
Q=2
Q=1
Q=1
FOOD
Labor
CLOTH
Labor
6
Factor Prices, Factor Proportions
In the previous example, the ratio of wages
to rental rate of territory is the same for all
the firms in clothing and food.
 Firms in food industry use a higher
land/labor ratio than firms in clothing.

aLC /aTC > aLF/aTF
 Or aLC /aLF > aTC /aTF
 Considering the total resources used in each
industry, cloth production is labor intensive
and food production is land intensive if LC /TC
> LF /TF.

7
Output Prices

Assuming that all the firms operate in
competitive environment, their unit cost
will be equal to the price they charge.
8
Increase in r (Cost of Land)
T
T
w/r1
Q=3
w/r2
Q=3
Q=1
Q=1
FOOD
L
CLOTH
9
L
Increase in r (Cost of Land)
All the firms react to an increase in cost
of land the same way: substitute more
labor for capital.
 Because land is the intensive factor in
food, higher cost of land will raise the
price of food compared to cloth.
 Or labor is relatively cheaper so cloth
will be relatively cheaper.

10
Expansion Path
T
T
Q=3
Q=2
Q=3
Q=2
Q=1
Q=1
FOOD
L
CLOTH
11
L
PPF
If more food is to be produced, both land
and labor will be taken away from cloth.
 First, excess land will be taken, resulting in
a small drop of cloth production.
 As more and more resources are taken
away, opportunity cost of food (cloth
sacrificed) rises.

12
PPF
13
What to Produce
PPF shows options given “technology.”
 Any point on the PPF is efficient.
 How to choose “the” point?
 What is the meaning of the slope of PPF?
 How to draw a budget line and what does
the slope show?

14
PPF
FOOD
PC/PF
Y/PF
Y/PC
CLOTH
15
Change in r
If r increases, w/r falls.
 Both industries prefer to lower their
Land/Labor ratios (increase L/T ratios).
 Since food is land intensive, PF will go up.
 What happened to price ratios? Where are
we on the PPF?
 Why did Food production INCREASE?

16
Change in r
Why did Food production INCREASE?
 What happens to the Marginal Product of
Labor if less Land is used (remember
Land/Labor (T/L) ratios fell)?
 What happens to the Marginal Product of
Land if more labor is employed?
 What happens to the earnings of labor and
landowners?

17
Allocation of Land and Labor
Given the prices of cloth and food, the
competitive economy will choose the point
on the PPF where the opportunity cost of
cloth in terms of food is Pc/Pf.
 Given the price ratios, the relative factor
prices are also determined, indicating a
specific choice of land/labor ratio for each
industry.

18
Allocation of Labor and Land
L
0
Labor in Cloth
T
C
l
o
t
h
F
o
o
d
The slope is the
Land/Labor ratio
for Food.
T
0
Labor in Food
L
19
Increase in Land
L
0
Labor in Cloth
T
C
L
O
T
H
F
O
O
D
T
0
Labor in Food
L
20
Increase in Land
More land in this country will make food
industry employ both more labor and land.
 If prices of food relative to cloth remained
the same, keeping factor prices and factor
proportions the same, food sector (landintensive) will expand and cloth sector
(labor-intensive) will shrink.

21
Increase in Land in PPF
C
F
22
Relative Product Prices and
Relative Factor Prices
A sudden increase in land, ceteris paribus,
will make land relatively cheaper than labor.
 More land will make labor more productive
and hence raise wages.
 Higher w/r ratio will raise the prices of cloth
relative to food.
 Income distribution will change in favor of
labor.

23
Two Countries
C
C
Foreign
Home
F
F
Given the same prices, which country produces RELATIVELY
more cloth and which one relatively more food?
As a result, which country’s relative supply curve (F/C) would
be further to the right? Price is (PF/PC).
24
Supply, Demand, Prices
Pf/Pc
Home
Foreign
F/C
If tastes and incomes were the
same in both countries, price of
food would be relatively
higher in Home and relatively
lower in Foreign. Home would
export cloth and Foreign would
export food. Free trade would
move Pf/Pc between the two
price levels. Home is relatively
abundant in labor and Foreign is
relatively abundant in land.
25
Price Lines in Both Countries
C
C
Foreign
Home
F
F
The country at left has a lower Pf/Pc than the country at right.
The slope of the tangent line is equal to Pf/Pc.
26
Price Lines with Trade
C
C
Foreign
Home
F
F
The world price changes the production in both countries.
The trade triangle should match both countries if these are
the only countries trading.
27
Trade in the Heckscher-Ohlin Model
28
Price Changes
Free trade will raise the price of the product
produced by the abundant factor and will
lower the price of the product produced by
the scarce factor.
 The country abundant in land sees an
increase in the price of food and a drop in
the price of cloth.
 The country abundant in labor sees an
increase in the price of cloth and a drop in
the price of food.

29
Income Distribution
Owners of land in the land-abundant
country will benefit.
 Labor in the land-abundant country will
lose.
 Owners of land in the cloth specialized
country will lose.
 Labor in the cloth specialized country
will benefit.

30
Factor Price Equalization
There is a one-to-one correspondence
between w/r and Pc/Pf. As Pc/Pf becomes
the same for both countries, so should w/r.
 The country that exports the product with the
abundant factor sees a higher return for that
factor. Before trade, abundant factor got the
lower return.
 Scarce factor got the higher return before
trade and the lower return after trade.

31
Factor Price Equalization
Trade makes two separate markets become
one.
 The country with the relatively abundant labor
exports labor-intensive products. It is similar
to exporting labor itself.
 The country with the relatively abundant land,
exports land-intensive goods.
 The unified market makes the prices of labor
and capital in both countries to converge.

32
Testing Factor Price Equalization
Contrary to the prediction of the model,
factor prices vary across the countries.
 Should we scrap the model? What
characteristics of the model lead to
equalization?

Both countries produce both goods.
 Technologies in both countries are the
same.
 Prices of products become the same in
both countries.

33
Divergent Resource Endowments



Convergence happens when resource endowments
are similar and the relative differences force each
country to move more toward the specializing in
abundant factor using product.
If endowments are very divergent, each country
would already specialize in a different product and
trade would not equalize the factor prices.
Factor prices need not be equalized between
countries with radically different ratios of capital to
labor or of skilled to unskilled labor.
34
Different Technologies of
Production
A country with a far superior technology
in both products will have higher prices
of both factors compared with the
country with low technology.
 Factor price convergence will not take
place if technologies are very different.

35
Convergence of Prices
If prices in both countries do not
become the same, factor prices will not,
either.
 Non-traded goods, transportation costs,
tariffs, quotas all keep prices from
converging.

36
Short vs. Long Run
The model says wages and land rents will
be the same no matter which industry
employs them. This is the long-run
expectation.
 In the short run, both factors in the
expanding industry may benefit and those
in the shrinking industry suffer (Pc/Pf
changes).
 Politics is a short run phenomenon.

37
Factor Price Equalization?
Real wages for unskilled labor (10th percentile
of workers) rose only 0.2% between 1979 and
2001.
 Real wages for highly skilled labor (95th
percentile of workers) rose 29%.
 College premium was 21% in 1979; 44% in
2002.
 If US exports highly skilled labor products and
imports unskilled labor products, then H-O
theory prediction seems to hold.

38
Factor Price Equalization Does
Not Apply to US Experience
H-O theory predicts that prices of goods
will change before prices of factors.
 Goods that are exported will experience
a rise in price.
 Studies fail to show any increase in the
prices of skill-intensive products.

39
Factor Price Equalization Does
Not Apply to US Experience
H-O says the price of the abundant
factor will increase and the price of the
scarce factor will decrease.
 There is no indication that the return to
skilled labor in NIEs has been falling; in
fact, it has been increasing.

40
Factor Price Equalization Does
Not Apply to US Experience
US trade with LDCs is very small
percentage of GDP. In 1990, manufactured
imports of US from LDCs was under 2% of
GDP.
 Labor content of both the exports and
imports constitute a very small percent of
total labor; it is not possible to have such a
large impact on the wages.

41
What Is Responsible for the
GAP?

Technological change.
42
Trade and Benefits
Does trade increase the total consumption
of the people in a country?
 How do you show this in a PPF and price
line?
 Ideally, every one can be better off.

43
Trade and Benefits
Different groups, different industries
benefit and lose from trade.
 But wages and rents will be the same
across the industries in the long run,
helping exporters and hurting importers.
 Is there enough surplus to make both the
exporters and importers better off?

44
Trade and Income Distribution

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.
45
Unemployment?

How much unemployment can be traced
back to trade?
•
•
•
From 1996 to 2008, only about 2.5% of involuntary
displacements stemmed from import competition or
plants moved overseas.
Unemployment is primarily a macroeconomic problem
that rises during recessions.
The best way to reduce unemployment is by adopting
macroeconomic policies to help the economy recover,
not by adopting trade protection.
46
Import Penetration and Unemployment
47
Leontief Paradox
Wassily Leontief (Nobel 1973) tried to
test Hecksher-Ohlin theorem.
 H-O says countries export products
embodying the abundant factor.
 Leontief pioneered in creating inputoutput tables; he had the data on inputs
used for outputs.

48
K and L Required to Produce $1 million
Proceedings of American Philosophical Society , 1953 (Leontief's first article)
All industries; 1947 input-output table; 1947 composition of trade
Exports
Import Repl A=(K/L)m/(K/L)x
K (1947 $)
$2,550,780
$3,091,339
L (Man-years)
182
170
K/L
$14,015
$18,184
1.297
Review of Economics and Statistics , 1956 (Leontief's second article)
All industries; 1947 input-output table; 1951 composition of trade
Exports
Import Repl A=(K/L)m/(K/L)x
K (1947 $)
$2,256,780
$2,303,400
L (Man-years)
174
168
K/L
$12,977
$13,726
1.058
Without 19 nat. res. ind.; 1947 input-output table; 1947 composition of trade
Exports
Import Repl A=(K/L)m/(K/L)x
K (1947 $)
$2,274,700
$1,853,900
L (Man-years)
225
200
K/L
$10,129
$9,287
0.917
Without 19 nat. res. ind.; 1947 input-output table; 1951 composition of trade
Exports
Import Repl A=(K/L)m/(K/L)x
K (1947 $)
$2,577,100
$2,092,700
L (Man-years)
224
207
K/L
$11,493
$10,127
0.881
Excluding agriculture; 1947 input-output table; 1947 composition of trade
Exports
Import Repl A=(K/L)m/(K/L)x
K (1947 $)
$1,501,500
$1,780,000
L (Man-years)
166
157
K/L
$9,048
$11,306
1.250
Excluding agriculture; 1947 input-output table; 1951 composition of trade
Exports
Import Repl A=(K/L)m/(K/L)x
K (1947 $)
1562200
1868200
L (Man-years)
169
151
K/L
9256
12412
1.341
49
K and L Required to Produce $1 million of US Exports and
Import Replacements
Baldwin, R., American Economic Review (March 1971)
All industries; 1958 input-output table; 1962 composition of trade
Ex ports
Import Re pl A=(K/L)m/(K/L)x
K (1947 $)
$1,876,000
$2,132,000
L (Man-years)
131
119
K/L
$14,321
$17,916
1.251
Excluding nat. res.; 1958 input-output table; 1962 composition of trade
Ex ports
Import Re pl A=(K/L)m/(K/L)x
K (1947 $)
$1,223,000
$1,259,000
L (Man-years)
107
106
K/L
$11,430
$11,877
1.039
Excluding agriculture; 1958 input-output table; 1962 composition of trade
Ex ports
Import Re pl A=(K/L)m/(K/L)x
K (1947 $)
$1,403,000
$1,806,000
L (Man-years)
109
100
K/L
$12,872
$18,060
1.403
Stern and Maskus, Journal of International Economics, (May 1981)
All industries; 1972 input-output table; 1972 composition of trade
Ex ports
Import Re pl A=(K/L)m/(K/L)x
K (1947 $)
$1,478,000
$1,368,200
L (Man-years)
99
96
K/L
$14,929
$14,250
0.955
Excluding nat. res.; 1972 input-output table; 1972 composition of trade
Ex ports
Import Re pl A=(K/L)m/(K/L)x
K (1947 $)
$455,000
$497,000
L (Man-years)
24
29
K/L
$18,958
$17,138
0.904
50
Explaining Leontief Paradox?
When exports and imports are tested
according to labor skills, the US is seen to
export more skilled labor intensive products.
 New products usually are more high-skill
labor-intensive than mature manufacturing,
which are capital-intensive.
 Baldwin’s numbers:

Education per worker 9.9 years for imports,
10.1 for exports.
 Engineers and scientists 1.89% for imports,
2.55% for exports.

51
Further Tests
H-O predicts that a country will export
its abundant factor.
 In general, exports of countries should
include products embodied with their
abundant factor.
 If a country’s endowment as a share of
world endowment is compared to its
income as a share of world income,
then it will export the factor if the ratio is
greater than one.

52
H-O Test Using Global Data
Factor of Production
Capital
Labor
Professionals
Managers
Clerical workers
Salespeople
Service workers
Agricultural workers
Production workers
Arable land
Pasture land
Forest
Predictive Success
52%
67%
78%
22%
59%
67%
67%
63%
70%
70%
52%
70%
Source: H.P. Bowen, E.L. Leamer, and L. Sveikauskas, Multicountry, Multifactor
Tests of the Factor Abundance Theory,” American EconomicReview 77
(December 1987), pp. 791-809.
53
H-O Tests of North-South Trade
When trade between two countries with
very different endowments, like North and
South, is evaluated, it conforms to the
predictions of H-O.
 However, the trade between the developed
countries and the LDCs constitute 10% of
world trade.

54
Technological Differences



The basic H-O relies on differences on factor
endowments and assumes same technology
available to all countries.
For example, that would mean that China would
export its labor to US much more than the numbers
indicate.
If technologies differ, then US might have an
“effective” labor force much larger than the raw data
indicates.


US has ¼ of world income but 1/20 of world labor.
China has 1/35 of world income but 1/7 of world labor.
55
Success of H-O
Empirical studies have given less than
full support to H-O.
 We need to utilize some other model to
explain trade patterns between similar
countries.
 If H-O can predict trade patterns
relatively well between North and South,
then we can use the income
distributional predictions in that case, as
well.

56
Movements in Factors of
Production


4-57
Movements in factors of production include

labor migration

the transfer of financial assets through international
borrowing and lending

transactions of multinational corporations involving
direct ownership of foreign firms
Like movements of goods and services (trade),
movements of factors of production are
politically sensitive and are often restricted.
International Labor Mobility

Why does labor migrate and what effects does labor
migration cause?

Workers migrate to wherever wages are highest.

Consider movement of labor across countries instead of
across sectors.

Suppose two countries produce one non-traded good
(food) using two factors of production:

4-58
Land cannot move across countries but labor can.
International Labor Mobility
(cont.)

Figure 4-13 finds the equilibrium wage and labor
allocation with migration across countries.


Start with OL1 workers in Home earning a lower real wage
(point C) than the L1O* workers in Foreign (point B).


4-59
Similar to how Figure 4-4 determined the equilibrium allocation of
labor between sectors.
Lower wage due to less land per worker (lower productivity).
Workers in the home country want to migrate to the
foreign country where they can earn more.
International Labor Mobility
(cont.)

If no obstacles to labor migration exist, workers move
from Home to Foreign until the purchasing power of
wages is equal across countries (point A), with OL2
workers in Home and L2O* workers in Foreign.

Emigration from Home decreases the supply of labor and raises
real wage of the workers who remain there.



Workers who start in the Home country earn more due to emigration
regardless if they are among those who leave.
Immigration into Foreign increases the supply of labor and
decreases the real wage there.
Wages do not actually equalize, due to barriers to
migration such as policies restricting immigration and
natural reluctance to move.
4-60
Fig. 4-13: Causes and Effects of
International Labor Mobility
4-61
International Labor Mobility
(cont.)

4-62
Labor migration increases world output.

The value of foreign output rises by the area under its MPL*
curve from L1 to L2

The value of domestic output falls by the area under its MPL
curve from L2 to L1

World output rises because labor moves to where it is more
productive (where wages are higher).

The value of world output is maximized when the marginal
productivity of labor is the same across countries.
International Labor Mobility
(cont.)

4-63
Workers initially in Home benefit while
workers in Foreign are hurt by inflows of
other workers.

Landowners in Foreign gain from the inflow of
workers decreasing real wages and
increasing output.

Landowners in Home are hurt by the outflow
of workers increasing real wages and
decreasing output.
International Labor Mobility
(cont.)




4-64
Does migration lead to the wage changes predicted?
Table 4-1 shows that real wages in 1870 were much
higher in destination countries than in origin countries.
Up until the eve of World War I in 1913, wages rose
faster in origin countries than in destination countries
(except Canada).
Migration moved the world toward more equalized
wages.
Table 4-1
4-65
International Labor Mobility
(cont.)

In the early 20th century, share of immigrants in the
U.S. increased dramatically.


Tight restrictions on immigration imposed in the 1920s.


4-66
Immigrants were a minor force in the U.S. by the 1960s.
New wave of immigration began around 1970.


Vast immigration from Eastern and Southern Europe.
Mostly from Latin America and Asia.
As of 2006, 15.3% of the U.S. labor force foreign-born.
Fig. 4-14: Immigrants as a Percentage of the U.S.
Population
4-67
Immigration and the U.S.
Economy

4-68
The largest increase in recent immigration
occurred among workers with the lowest
education levels, making less educated
workers more abundant.

possibly reduced wages for native-born
workers with low education levels while
raising wages for the more educated

widening wage gap between less educated
workers and highly educated workers.
Summary
International trade often has strong effects on the
distribution of income within countries -- produces
losers as well as winners.
Income distribution effects arise for two reasons:
1.
2.


4-69
Factors of production cannot move costlessly and quickly from
one industry to another.
Changes in an economy’s output mix have differential effects
on the demand for different factors of production.
Summary (cont.)
International trade affects the distribution of income in
the specific factors model.
3.


4-70
Factors specific to export sectors in each country gain from
trade, while factors specific to import-competing sectors lose.
Mobile factors that can work in either sector may either gain or
lose.
Summary (cont.)
4.
5.
6.
4-71
Trade nonetheless produces overall gains in the sense
that those who gain could in principle compensate those
who lose while still remaining better off than before.
Most economists would prefer to address the problem
of income distribution directly, rather than by restricting
trade.
Those hurt by trade are often better organized than
those who gain, causing trade restrictions to be
adopted.
Summary (cont.)
Labor migrates to countries with higher labor
productivity and higher real wages, where labor is
scarce.
7.


8.
4-72
Real wages fall due to immigration and rise due to emigration.
World output increases.
Real wages across countries are far from equal due to
differences in technology and due to immigration
barriers.