Trade Theories:
#4 – appendix
(Heckscher-Olin)
Trade Equilibrium in H-O Model
45⁰ line
Machines
..
Qeu
EXeu A
eu
Ceu
IMeu
Cind
p
Aind
IMind
EXind
Qind
p
..
Cloth
Notation from preceding graph
45O Line - assumption that countries are identical and trade is
balanced.
Ceu , cind = new (higher!) consumption levels of EU and India … (at
intersection of price lines and 45o line)
Blue “dash” – Trade triangle EU
• EXeu – EU exports of machinery
• Imeu – EU imports of cloth
Red “dash” – Trade triangle IND
• EXind – IND exports of cloth
• Imind – IND imports of machinery
Trade Equilibrium in HO Model
• Terms of trade (p) are determined by
reciprocal demand and lie between the two
countries’ pre-trade price ratios
• Equilibrium production with trade exhibits
incomplete specialization (due to increasing
opportunity cost)
• Equilibrium consumption with trade implies a
rise in standard of living (consumption at “c”)
• Trade triangles are congruent
Trade Equilibrium in HO Model
• Terms of trade (p) are determined by
reciprocal demand and lie between the two
countries’ pre-trade price ratios
• Equilibrium production with trade exhibits
incomplete specialization (due to increasing
opportunity cost)
• Equilibrium consumption with trade implies a
rise in standard of living (consumption at “c”)
• Trade triangles are congruent
Big … Assumptions
•
•
•
•
Perfect competition
Constant returns to scale
No factor mobility
Two countries must be identical and trade
must be balanced
Test of the Heckscher-Ohlin Model
The Test:
• W. Leontief (1951)
• Could “H-O … Factor Proportions Theory”
be used to explain the types of goods the
United States imported and exported?
The Method:
Built input-output model for 200 U.S.
industries for 1947
EMPIRICAL EVIDENCE ON THE H-O
FACTOR-PROPORTIONS THEORY
The Findings:
• The Leontief Paradox
– Leontief found that U.S. exports were less
capital-intensive than U.S. imports, even
though U.S. is the most capital-abundant
country in the world
The Leontief Paradox
The Controversy:
Findings were the opposite of what was
generally believed to be true!
Reconciliations of the Leontief
Paradox
• U.S. workers are more productive than foreign
workers (Leontief) and Human Skills Theory (1966)
• A third factor, natural resources, is not considered
(Vanek)
• U.S. tariffs on labor-intensive goods are high (Travis)
• The identical tastes assumption is violated; Table
(next page) shows that consumption patterns differ
across countries
Consumption Shares by Product Type for OECD Countries
Average Values 1985–1999*
Human Skills Theory
• Donald Keesing (1966)
• Emphasizes differences in endowments and
intensities of skilled and unskilled workers.
• Explains the Leontief paradox:
Since the U.S. has highly trained, educated
workers relative to other countries, U.S.
exports tend to be skilled-labor intensive.
Trade Theories:
#5 - FACTOR-PRICE
EQUALIZATION
FACTOR-PRICE EQUALIZATION AND THE
DISTRIBUTION OF INCOME
• Moving from autarky to free trade
– What happens to the relative size of
industries?
– What happens to the payments or returns
to factors of production?
– What happens to the distribution of income
within the country?
FACTOR-PRICE EQUALIZATION AND THE
DISTRIBUTION OF INCOME
• Factor-Price Equalization
– When trade occurs between countries with
different factor proportions, free trade will
equalize the relative price of the goods (we
saw this in H-O)
– … and cause the relative factor prices to
converge
– Convergence of factor prices happens in the
long run
FACTOR-PRICE EQUALIZATION AND THE
DISTRIBUTION OF INCOME
• Factor-Price Equalization
– Whichever factor receives the lowest price
before two countries begin to trade will
therefore tend to become more expensive
relative to other factors in the economy, …
while those with the highest price will tend
to become cheaper.
FACTOR-PRICE EQUALIZATION AND THE
DISTRIBUTION OF INCOME
• For example – U.S. and India
– Trade opening up causes prices of machines
and the prices of cloth to equalize between
countries (H-O)
– Size of machine and cloth industries will
change for each country changing their
industrial structure
FACTOR-PRICE EQUALIZATION AND THE
DISTRIBUTION OF INCOME
• (Assume) U.S. has a comparative advantage
in machines … (machines are K intensive)
– This causes an increased demand for machines
– The price of machines rises relative to price of
cloth
– Machine production expands
– Cloth production contracts
– Increased demand for inputs to make machines
FACTOR-PRICE EQUALIZATION AND THE
DISTRIBUTION OF INCOME … (continued)
– Increase in capital greater than increase in labor
as machines are capital intensive
– Resources shift from cloth to machines
– Cloth industry declines
•
•
•
•
Imports replace much domestic production
More labor than capital released on market
Shortage of capital increase “profit” (return to K)
Surplus of labor decreases wages
• Ratio of wages to “profit” (return to K) declines
FACTOR-PRICE EQUALIZATION AND THE
DISTRIBUTION OF INCOME
• India has a comparative advantage in cloth
– Increased demand for cloth
– Price of cloth rises relative to price of
machines
– Machine production contracts
– Cloth production expands
– Increased demand for inputs to make cloth
FACTOR-PRICE EQUALIZATION AND THE
DISTRIBUTION OF INCOME
• Increase in labor greater than increase in capital
as cloth is labor intensive
• Resources shift from machines to cloth
• Machine industry declines
–
–
–
–
Imports replace much domestic production
More capital than labor released on market
Shortage of labor increase wages
Surplus of capital decreases “profit”
• Ratio of wages to “profit” increases
FACTOR-PRICE EQUALIZATION AND THE
DISTRIBUTION OF INCOME
• Wages
– Decline in U.S.
– Increase in India
• “Profits” (return to capital)
– Increase in U.S.
– Decrease in India
Overall – Factor Prices get closer to
equalization (just as we saw with “Goods
Prices” in H-O
FACTOR-PRICE EQUALIZATION AND THE
DISTRIBUTION OF INCOME
• Trade and the Distribution of Income
– Trade produces a convergence of relative prices
– Changes in relative prices have strong effects on the
relative earnings of labor and capital in both countries
• In U.S., where the relative price of machines rises
• Capitalists are made better off and workers are made worse
off
• In India, where the relative price of machines falls, the
opposite happens
• Capitalists are made worse off and workers are made better
off
– Owners of a country’s abundant factors gain from
trade, but owners of a country’s scarce factors lose
FACTOR-PRICE EQUALIZATION AND THE
DISTRIBUTION OF INCOME
Table 4.4
Economic Data for South Korea and India
Economic Variable
GDP per Capita
Capital/Worker
Degree of Openness
[(Exports + Imports)/GDP]
South Korea
India
Year
Value
Year
Value
1953
$796
1953
$641
1962
$928
1962
$760
1972
$1,450
1972
$786
1982
$3,395
1982
$936
1991
$7,251
1991
$1,251
1965
$2,093
1965
$786
1975
$6,533
1975
$1,259
1085
$12,036
1085
$1,712
1992
$17,995
1992
$1,997
1953
11.8%
1953
10.4%
1962
22.1%
1962
11.2%
1972
44.5%
1972
8.8%
1982
71.5%
1982
14.5%
1990
62.5%
1990
21.2%
Trade Theories:
#6 - The Stolper-Samuelson
Theorem
The Stolper-Samuelson Theorem
• Derived from the HO model
• Assumptions:
– Labor earns wages proportionate to its skill level
– Owners of capital earn profits
– Landowners earn rents
– The amount of income earned per unit of input depends on
both the demand for inputs and the supply of inputs
(demand for an input = derived demand)
The Stolper-Samuelson Theorem
• An increase in the demand for a good (opening International
Trade?) … increases the price of a good…. and raises the
income earned by factors that are used intensively in its
production
• Conversely, decrease in the demand for a good …
decreases the price of a good…. and reduces the income
earned by factors that are used intensively in its production
The Stolper-Samuelson Theorem
Example … increase production of steel … increase need for K ...
The Stolper-Samuelson Theorem
• Note:
• Not all factors used in the export industries will be better off,
and not all factors used in import competing industries get
hurt: Abundant factors will benefit, while scarce ones will be
hurt
The Stolper-Samuelson Theorem
• Ultimately, the effects on income of an opening of
trade depends on the flexibility of the affected
factors
– If labor is stuck in bread production and unable to move to
making steel, it will be hurt much worse than when it is
flexible and free to move
– U.S. avocado producers might not oppose Mexican
avocado imports as fiercely as they do, if they could easily
move to producing other goods
Implications of Stolper-Samuelson
Theorem
• Some groups in society will oppose international
trade.
• Scarce factors will lobby government for trade
protection.
• Even though some in society lose, the country
overall benefits from international trade relative
to autarky.
• A system of taxation and transfers could be
developed to compensate the losers while leaving
the gainers better off relative to autarky.
Trade Theories:
#7 – Specific Factors and
Income Distribution
Introduction
• If trade is so good for the economy, why is there
such opposition?
• There are two main reasons why international
trade has strong effects on the distribution of
income within a country:
– Resources cannot move immediately or “costlessly”
from one industry to another.
– Industries differ in the factors of production they
demand.
Specific Factors Model
• The HO model assumes that factors are mobile, meaning that
they can migrate easily from one sector to another
The Specific Factors model assumes that:
1. land and capital are immobile and cannot migrate
.... (specific factors)
2. labor is fully mobile and can migrate from one sector
to another ... (variable factor)
Specific Factors Model
• A country’s endowment of a specific factor plays a
more critical role than a factor in the HO model in
determining comparative advantage
– When trade opens, incomes rise for the owners of
the abundant specific factor
– The income distribution effect on labor is
indeterminate, as workers can easily move to the
expanding sector
A Specific Factors Model
Outputs
Inputs
Bread
Steel
Specific Factors
Land
Capital
Variable
(Mobile) Factors
Labor
Labor
The Specific Factors of land and capital can be used to produce only one good., each.
The variable factor of labor is used in both bread and steel production.
The Specific Factors Model
• The specific factors model allows trade to
affect income distribution.
• Assumptions of the model:
– Two goods … bread and steel.
– Three factors of production: labor (L), capital
(K) and land (T for land/terrain).
– Perfect competition prevails in all markets.
The Specific Factors Model (cont.)
– Land and capital are both specific factors used
only in the production of one good.
• steel produced using capital and labor (but not land).
• bread produced using land and labor (but not capital).
– Labor is a mobile factor that can move
between sectors.
The Specific Factors Model (cont.)
• How much of each good does the economy
produce?
• The production function for steel gives the
quantity of steel that can be produced, given any
input of capital and labor:
Qs = Qs (K, Ls)
– Qs is the output of steel
– K is the capital stock
– Ls is the labor force employed in steel
The Specific Factors Model (cont.)
• The production function for bread gives the quantity
of bread that can be produced given any input of land
and labor:
Qb = Qb (T, Lb)
– Qb is the output of bread
– T is the supply of land
– Lb is the labor force employed in bread
Production Possibilities
• How does the economy’s mix of output
change as labor is shifted from one sector
to the other?
• When labor moves from bread to steel …
bread production falls while output of
steel rises.
The Production Function for steel (“c”)
Production Possibilities (cont.)
• The shape of the production function reflects… the law of
diminishing marginal returns.
– Adding one worker to the production process
(without increasing the amount of capital) means
that each worker has less capital to work with.
– Therefore, each additional unit of labor adds less
output than the previous one...
Production Possibilities (cont.)
• Use a four-quadrant diagram to construct production
possibilities frontier
– Lower left quadrant indicates the allocation of labor.
– Lower right quadrant shows the production function for
steel
– Upper left quadrant shows the corresponding production
function for bread.
– Upper right quadrant indicates the combinations
of steel and bread that can be produced.
The Production Possibility Frontier in the Specific
Factors Model
Output of bread
output of steel
Production Possibilities (cont.)
• Why is the production possibilities frontier
curved?
– Diminishing returns to labor in each sector cause the
opportunity cost to rise when an economy produces
more of a good.
– Opportunity cost of steel in terms of bread is the slope of
the production possibilities frontier – the slope becomes
steeper as an economy produces more steel.
Prices, Wages, and Labor
Allocation
• At the production point, the production
possibility frontier must be tangent to a line
whose slope is minus the price of steel divided
by that of bread.
slope = MRT =
-PBPB
Production in the Specific Factors
Model
Output of bread
slope = -(Ps/Pb)1
Qb 1
Qs1
Output of Steel
Prices, Wages, and Labor
Allocation
(cont.)
• What happens to the allocation of labor and
the distribution of income when the prices of
bread and steel change?
• Two cases:
1. An equal proportional change in prices
2. A change in relative prices
Prices, Wages, and Labor
Allocation (cont.)
• When both prices change in the same
proportion, no real changes occur.
– The wage rate (w) rises in the same proportion as
the prices, so real wages (i.e., the ratios of the
wage rate to the prices of goods) are unaffected.
– The real incomes of capital owners and
landowners also remain the same.
Prices, Wages, and Labor
Allocation (cont.)
• When only Ps rises, labor shifts from the bread
sector to the steel sector and the output of
steel rises while that of bread falls.
Response of Output to a Change in
the Relative Price of steel
Output of bread
slope = -(Ps/Pb)1
Qb 1
Qb 2
slope = -(Ps/Pb)2
Qs1
Q s2
Relative Price of steel up … output of steel up…
Output of Steel
Prices, Wages, and Labor
Allocation
• What is the economic effect of this price
increase on the incomes of the following three
groups?
– Workers, owners of capital, and owners of land
Prices, Wages, and Labor
Allocation (cont.)
• Owners of capital are definitely better off.
• Landowners are definitely worse off.
• Workers: cannot say whether workers are
better or worse off:
– Depends on the relative importance of steel and
bread in workers’ consumption.
International Trade in the Specific
Factors Model
• Trade and Relative Prices
– Free trade relative price of steel is determined by
the intersection of world relative supply of steel
and world relative demand.
– Opening up to trade increases the relative price
of steel in an economy whose relative supply of
steel is larger than for the world as a whole.
Trade and Relative Prices
Relative price
of steel, Ps/Pb
(Ps/Pb)2
(Ps/Pb)1
Relative quantity
of steel, Qs/Qb
International Trade in the Specific
Factors Model (cont.)
• Gains from Trade
– Without trade, the economy’s output of a good
must equal its consumption.
– International trade allows the mix of steel and
bread consumed to differ from the mix produced.
4-57
International Trade in the Specific
Factors Model (cont.)
• The economy as a whole gains from trade.
– It is able to afford amounts of steel and bread that
the country is not able to produce itself. (Just as
we saw with H-O)
– The budget constraint with trade lies above the
production possibilities frontier
Income Distribution and the
Gains from Trade
• International trade shifts the relative price of
steel to bread, so factor prices change.
• Trade benefits the factor that is specific to the
export sector of each country, but hurts the
factor that is specific to the import-competing
sectors.
• Trade has ambiguous effects on mobile factors.
4-59
THE SPECIFIC-FACTORS MODEL
• The results arising from the existence of
specific factors are short-run effects
• The existence for specific factors helps
explain why some groups resist free trade
– Owners of abundant factors are likely to favor
free trade
– Owners of scarce factors are likely to favor
trade restrictions
Income Distribution and the Gains
from Trade (cont.)
• Trade benefits a country by expanding
choices.
– Possible to redistribute income so that everyone
gains from trade.
– Those who gain from trade could compensate
those who lose and still be better off themselves.
– That everyone could gain from trade does not
mean that they actually do – redistribution usually
hard to implement.
4-61
The Political Economy of Trade:
A Preliminary View
• Income Distribution and Trade Politics
– Typically, those who gain from trade are a much
less concentrated, informed, and organized group
than those who lose.
• Example: Consumers and producers in the U.S. sugar
industry, respectively
– Governments usually provide a “safety net” of
income support to cushion the losses to groups
hurt by trade (or other changes).
– Most economists strongly favor free trade.