Welcome to Econ 414
International Economics
Study Guide
Week Three
You must complete all tasks outlined here by Friday,
September 14. Our first exam is scheduled for Wednesday,
September 19 at 2 PM. This is a 50 minutes exam. You will
need to go to Thomas 223 at that time to take your exams.
Under WebCT’s Discussion, I have listed the topic
“Questions on Exam 1”. Post all of your questions on the
material covered on exam 1 there.
1
Assignment 1
• Is graded and mailed to you via WebCT mail.
• Answer key is posted is on the homepage of
WebCT
– Review it carefully as it contains some lessons on
• how to determine the comparative advantage
• How to determine the mutually beneficial range of terms
of trade
• how to show that a nation is better off as a result of
trade.
• How to show that the world is better off as a result of a
trade.
2
Here is the animated version of Asst 1 Graph
•
The slope of US PPF (blue line) = 0.5 = opportunity cost of 1 computer = MRT of beer for computer
• The slope of German PPF (blue line) = 1 = opportunity cost of 1 computer = MRT of beer to computer
• The red lines are the trading possibility curves
• The slope of the trading possibility curves = the terms of trade = 3/4.5 or 1/1.5
beer
beer
Germany
U.S.
5
P
5
C
3
Exports
B
2.5
B
2
Imports
C
Imports
Exports
0
5
P
computers
4.5
10
0
3
4.5 5
computers
3
The Terms of Trade
• The terms of trade is the relative price of
the exportable good expressed in units of
the importable good.
4
The theory of reciprocal demand
•
In Assignment 1, remember that the range of mutually
beneficial terms of trade was
–
–
–
2 computers >1beer>1 computer
But what affects the actual exact exchange rate within this
limit?
The theory of reciprocal demand suggests that:
1. The stronger the German demand for US computer, the higher the
price German’s will pay for US computer, the closer the actual
exchange rate will be to 1 beer for 1 computer
2. The stronger the US demand for German beer, the higher the
price US will pay for German beer, the closer the actual exchange
rate will be to 1 beer for 2 computer
–
So the actual exchange rate will depends on how strong the
demand of one nation is for the other nation’s product.
5
Note: Under constant cost assumption (linear
PPFs), the supply curve of a good in each
country is horizontal.
The Price of computer in terms of the
number of forgone beer is always constant
beer
Price of
Computer in
terms of
forgone
beer
US
0.5
US
Supply
5
computers
10
computers
6
Trade Under Increasing
Opportunity Costs
• Increasing Costs and the Production Possibilities
– The increasing amount of a good that a country must
forego to release enough resources to produce each
additional unit of another good.
– A country may have increasing opportunity costs
because:
• Factors of production are specialized in the production of a
particular product.
– For example, highly skilled labor is used in the computer
production while low skilled labor is used in the beer production.
• Production of different goods use resources in different relative
proportions.
– For example, the computer industry may require large amounts of
capital and the beer industry may require large amounts of labor.
7
Supply Curves of a Good and the Production
Possibilities Frontier Under Increasing Cost
Conditions
•The opportunity coat of first computer is 0.5 beer.
• The opportunity cost of 10th computer is 2 beers.
beer
Price of
computers
5
A
4.5
Supply
B
2
C
D
2
E
0.5
F
1
9
10
computers
computers
1
10
8
Trade Under Increasing
Opportunity Costs
• Study Figure 2.8 carefully
– Notice that the only difference between this and
constant cost case is
• At any given point on PPF the slope of the tangency line =
opportunity cost of the good measured on horizontal axis.
• The blue line (the line representing the exchange rate) is
tangent to PPF at the production level after trade.
• Complete specialization is not possible under increasing cost
assumption because if a nation wants to completely
specialize in production of a good, its cost of producing that
good will be extremely high.
9
Static/ Dynamic Gains From Trade
• Static Gains from trade
– Gains in word output that result from
specialization and trade are the static gains
from trade.
• Dynamic gains from trade
– Gains from trade over time that occur
because trade causes an increase in a
country’s economic growth or induces greater
efficiency in the use of existing resources.
10
Chapter 3:
The Factor-Proportions Theory (the theory attempts to
explain what determines comparative advantage.)
•
Assumptions of the Factor Proportions Theory
1.
2.
Two countries – U.S. and India producing two goods
– machines and cloth
Production and consumption conducted under
perfect competition
A.
B.
C.
Firms are price takers.
Prices of factors are determined by supply and demand in
each market.
In long run, prices of goods are equal to their respective
costs of production.
11
The Factor-Proportions Theory
3.
4.
5.
6.
No constraints to trade
International trade will not lead to complete
specialization.
Consumers in both countries have equal
tastes and preferences.
Both countries are endowed with
homogeneous factors of production and both
are used in production: Capital (K) and Labor
(L).
12
The Factor-Proportions Theory
7.
8.
9.
Technology for production same in both
countries and produced under constant
returns to scale.
Capital and Labor can flow freely from one
industry to the other domestically
Labor and Capital cannot move freely
between countries.
13
The Factor-Proportions Theory
10.
Production techniques available lead to
cloth being a labor-intensive good and
machines being a capital-intensive good
in both countries.
a)
b)
Machines use a lot of capital relative to labor
– high K/L ratio.
Cloth uses a lot of labor relative to capital –
low K/L ratio.
14
The Factor-Proportions Theory
11.
The U.S. is relatively capital abundant
and India is relatively labor abundant
a)
b)
The K/L ratio is higher in U.S. than in India.
Important: It is the relative quantity of
capital to labor that is key.
15
The Factor-Proportions Theory
Table 3.1: Production conditions in the U.S. and India
Input Requirements to Produce
Country
1 Machine
10 Yards of Cloth
U.S.
10 units of capital
+4 days of labor
4 units of capital
+8 days of labor
India
10 units of capital
+4 days of labor
4 units of capital
+8 days of labor
16
The Factor-Proportions Theory
•
Factor Intensity: In a world of two
commodities (cloth and machine) and
two factors (labor and capital), we say
that machine is capital-intensive if the
capital-labor ratio (K/L) used in the
production of machine is greater than
K/L used in the production of cloth.
17
The Factor-Proportions Theory
•
Factor Abundance: In a world of two
countries (U.S. and India) and two factors
(labor and capital), U.S. is capital-abundant
compared to India (and India is landabundant compared to U.S.) if and only if the
ratio of the total amount of capital to the total
amount of labor (K/L) available in U.S. is
greater than that in India.
18
The Factor-Proportions Theory
•
The Factor-Proportions Theorem
–
–
–
Assume that U.S. and India have the same tastes:
When faced with the same relative price of the two
goods, U.S. and India have identical relative
demands for machines and cloth.
Assume that both countries have the same
technology: A given amount of capital and labor
yields the same output of either cloth or machines in
the two countries.
The only difference between the countries is in their
resources: U.S. has a higher ratio of capital to labor
than India does.
19
The Factor-Proportions Theory
– Before trade
•
•
Capital less expensive in capital-abundant
country – U.S.
Labor less expensive in labor-abundant country India
20
The Factor-Proportions Theory
•
Ratio of payment made to labor, wages
and payment made to capital, rent is
higher in the U.S. than in India
Wages in U.S. Wages in India
>
Rent in U.S.
Rent in India
21
The Factor-Proportions Theory
• Lower opportunity cost to produce goods
in the country abundant in the main factor
of production
– U.S. has lower opportunity cost in production
of goods using more capital and less labor.
– India has lower opportunity cost in production
of goods using more labor and less capital.
22
The Factor-Proportions Theory
• U.S. (capital abundant) has comparative
advantage in the production of machines
(capital intensive).
• India (labor abundant) has comparative
advantage in production of cloth (labor
intensive).
23
The Factor-Proportions Theory
•
Factor-proportions theorem
– A country will have a comparative
advantage (disadvantage) and export
(import) goods whose production
intensively uses its relatively abundant
(scarce) factor of production.
24
The Factor-Proportions Theory
– The U.S. imports goods from countries where
labor in the abundant factor.
– The U.S. exports goods that are capital
intensive.
– Gains from trade are realized when a country
exports goods based on its comparative
advantage and imports goods based on
comparative disadvantage.
25
Factor-Price Equalization and the
Distribution of Income
•
Moving from autarky to free trade
– What happens to an economy’s industrial
structure?
– What happens to payments/returns to
factors of production?
– What happens to the distribution of income
within the country?
26
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 price of the goods and cause
the relative factor prices to converge.
– Convergence of factor prices happens in the
long run.
27
Factor-Price Equalization and the
Distribution of Income
•
Example: U.S. and India
– Trade opening up causes prices of
machines and cloth to equalize between
countries.
– Size of machine and cloth industries will
change for each country changing their
industrial structure.
– Industrial Structure – percentage of output
accounted for by each industry within a
country
28
Factor-Price Equalization and the
Distribution of Income
•
U.S. has comparative advantage in machines
–
–
–
–
So it will produce more machines and less cloth
Price of machines relative to cloth will increase in
the US.
US will demand more capital to produce more
machines and demands less labor to produce cloth
Price of capital (rent) relative to the price of labor
(wage) will increase in the US
29
Factor-Price Equalization and the
Distribution of Income
•
India has comparative advantage in cloth
–
–
–
–
So it will produce more cloth and less machines
Price of cloth relative to machine will increase in
India.
India will demand more labor to produce more cloth
and demands less capital to produce machines
Price of labor (wage) relative to the price of capital
(wage) will increase in India.
30
Factor-Price Equalization and the
Distribution of Income
•
Wages
– Decline in U.S.
– Increase in India
– Overall – Prices get closer to equalization
•
Rents
– Increase in U.S.
– Decrease in India
– Overall - Prices get closer to equalization
31
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 land 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.
32
Factor-Price Equalization and the
Distribution of Income
– Stolper-Samuelson Theorem
•
International trade will reduce the income of the
scarce factor of production and increase the
income of the abundant factor of production
within a country.
33
The Specific-Factors Model
•
Factor proportions theory assumed factors
moved quickly between industries.
However, adjustments in capital and labor
take time.
•
–
–
•
Labor will take time to retrain or gain new skills.
Capital will take time to adapt or may not be
adaptable at all to another industry.
Attempts to explain what determines
comparative advantage.
34
The Specific-Factors Model
•
Specific Factor
– A factor of production that is specific to an
industry or is immobile between industries.
•
Mobile Factor
– A factor of production that can move
between industries or is mobile between
industries.
35
The Specific-Factors Model
• If the U.S. is well endowed with the
specific factor used to produce machines,
it will have comparative advantage in
production of machines.
• Note: I will not ask questions on Figure 3.1
and the related discussion
36
Empirical Evidence on the FactorProportions Theory
•
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.
37
Empirical Evidence on the FactorProportions Theory
•
Explanations of the Leontief Paradox
– Some imports depend on a country’s
resources, not just capital and labor
•
Capital-intensive resource extraction leads to
increase of capital-intensive imports
– US labor intensive industries are heavily
protected.
•
Decrease of labor intensive imports
38
Empirical Evidence on the FactorProportions Theory
– Assumed labor is homogeneous
•
•
Labor differs by levels of human capital
U.S. exports not labor intensive but human
capital intensive
– Technology differs from other factors.
•
U.S. exports are more technology intensive.
39
Empirical Evidence on the FactorProportions Theory
•
•
Factor proportions theory is correct in
general.
Needs to consider what a factor of
production is
•
•
•
•
Skilled labor force
Human Capital
Technology
Resources
40
Empirical Evidence on the FactorProportions Theory
•
International Trade Not Explained by the
Factor-Proportions Theory
– Natural Resources
•
A country either has them or not
– Diamonds, Oil, Gold, Climate
– Intra-Industry Trade (Ch. 4)
•
Importing and Exporting similar but differentiated
goods
– Computers, Automobiles, Steel
41
Summary
• The factor-proportions theory is a way to explain
why countries have different opportunity costs
associated with producing different goods.
• The factor-proportions theory suggests that
differences in relative factor endowments
between countries determine the basis for trade.
42