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Classical Trade Theory
Globalization: It’s the Factor
2 x 2 x 2 Model
• Two goods, two countries, two factors of
production: neat analytical framework
• General competititve equilibrium: markets clear,
resource constraints and optimization of
production (marginal productivity conditions)
• Relative prices are given
• Country is better off when it moves to a higher
indifference curve. This is the economic
meaning of “welfare”.
Hecksher – Ohlin Theorem
• Specialization and comparative advantage:
works out the Ricardian theory of comparative
advantage in a full general equilibrium
framework with capital and labor, abandons
fixed coefficient production function
• Result: countries that are relatively labor
abundant should specialize in relative labor
intensive goods; countries that are capital
abundant should specialize in capital abundant
Factor Price Equalization Theorem
• Trade is a substitute for movement of factors of
production: this is a fundamental reason for
trade agreements such as NAFTA.
• If two countries move from autarky to free trade,
wages will fall in the capital abundant country
and rise in the labor abundant country, while
rental rates will rise in capital abundant country
and fall in labor abundant country
Stolper-Samuelson Theorem
• Tariffs and relative returns to factors of
• A tariff on a labor intensive good (or a rise
in its price) will lead to an increase in
wages relative to rental rates on capital
• A tariff on a capital intensive good will lead
to a fall in wages relative to capital
Rybczynski Theorem
• Effect of changes in supply of labor or
• An increase in capital in a country will lead
to an expansion in the production of the
capital intensive good and a contraction in
the production of the labor-intensive good
• An increase in labor will lead to expansion
of labor-abundant good and a contraction
of the capital-abundant good.
General Equilibrium Issues
What about a third factor of production, land, and
production of agricultural goods as well as capital and
labor intensive manufactured goods?
• Example: cut in tariffs on agriculural goods. Labor is
freed from farms and there is migration to cities, so
wages should fall. But with cheaper food, wages may
actually increase.
• Skilled labor and increasing returns: skilled labor
actually goes to places where there are already pools of
skilled labor. Not just for social reasons! Productivity of
good surgeons higher with good nurses, internists.
Skilled labor ofen compliments, rather than substitutes,
other skilled labor.
Measurement of Capital
Mobility: What is Capital?
• Interest Parity Theorem (relating to issue of
independent monetary policy).
• Feldstein-Horioka Paradox: savings and
investment correlations
• Arbitrage and claims on capital (k and k*)
R = R* = f’(k) + ln[Q(t+1)]-ln[Q(t)]=
f’(k*) + ln[Q*(t+1)]-ln[Q(t)]
Q and Q*: real share prices of claims on capital,
f’(k) and f’(k*) marginal productivity of capital
Issue of Growth and Productivity:
Growth Is All That Matters
• Solow model and sources of growth
log(Y) = ln(A) + alpha *ln(K) + (1alpha)ln(L), this is Cobb-Douglas function
in logarithmic form
If A is constant, we can describe growth,
Diff(y) = alpha Diff(k) + (1-alpha) Diff(l),
Where y is the log of Y, k log of K, l log of L,
And Diff is the difference operator.
Solow Residuals
• Is A really constant? We call Diff(a), the
total factor productivity, or TFP effect.
• We can rewrite the growth equation
Diff(y) = Diff(a) + alpha Diff(k) + (1-alpha)
According to many studies, the TFP effect
explains more than half of growth of
industrial countries
Krugman Controversy
• Asian miracle: fast growth in the NIC’s or
Gang of Four, for over 10 years.
• Krugman said it was due to forced saving
and investment, long hours of work, little of
the growth can be explained by the TFP
• So if we are forced to saving 40% of our
income, and get only two weeks off a year,
of course a country will grow.
Real Business Cycle Theory
• Kydland-Prescott and macroeconomic
fluctuations in US GDP for over a century.
• Measured shocks to GDP productivity as
the Solow residual.
• They concluded that over 80 percent of
the variance of real GDP is due to real
productivity shocks, not due to demand
factors such as fiscal policy or monetary
policy. Hard anti-Keynesian theory.
Emerging Markets and RBC
• Terms of trade shocks drive GDP cycles,
not productivity shocks
• Real exchange rate and the terms of
• Harberge-Laursen-Metzler Effect vs
classical effect of a devaluation (change in
terms of trade
Devaluation Effects
• Elasticity pessimism vs. optimism
• Income distribution effects
• Effects on imported inputs: the
contractionary effects of a devaluation
• J-curve effects