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Week 4: Part 2 Resources and Trade: The Heckscher-Ohlin Model Copyright © 2012 Pearson Education. All rights reserved. Factor Prices and Goods Prices • In competitive markets, the price of a good should equal its cost of production. • The cost of production, in turn, depends on the factor prices (wage w and rental r). • How changes in the wage and rent affect the cost of production depends on the mix of factors used. • For instance, we have earlier assumed that (see Week 3 Slide 23): Cloth is labor-intensive Food is capital-intensive Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 4-26 • Hence, an increase in the wages of labor (w) should affect the price of cloth (PC) more than the price of food (PF). w w/r PC > PF , PC/PF • Similarly, an increase in the rental rate of capital (r) should affect the price of food (PF) more than the price of cloth (PC). r w/r PF > PC , PC/PF Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 4-27 • With competition, changes in w/r are therefore directly related to changes in PC /PW . • In fact, there is a positive relationship between w/r and PC /PF w/r PC/PF w/r PC/PF Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 4-28 Fig. 4-6: Factor Prices and Goods Prices The classic paper by Stolper and Samuelson (1941) demonstrates how changes in output prices affect the prices of the factors. Stolper-Samuelson theorem: if the relative price of a good increases (say PC), then the price of the factor used intensively in the production of that good increases (in this case, wage w as cloth is laborintensive), while the price of the other factor decreases (in this case, renting rate r). For details, click this website. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 4-29 Goods Prices and Input Choices • It is possible to put our earlier figures together, i.e., factor prices-input choices (Slide 23) and goods prices-factor prices (Slide 29). Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 4-30 Fig. 4-7: From Goods Prices to Input Choices Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 4-31 • By putting these 2 diagrams together, Figure 4-7 shows the links between goods prices and input choices. • When good prices = (PC /PF)1, it implies that factor prices = (w/r)1, and input choices for food and cloth will be (LF / KF)1 and (LC / KC)1 respectively. • If the relative price of cloth to (PC /PF)2, the factor prices must to (w/r)2. This will cause the input choices for both food and cloth to (LF / KF)2 and (LC / KC)2 , respectively. • In sum, given output prices, we can determine not only factor prices, but also input choices in the Heckscher-Ohlin model. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 4-32 Goods Prices and Income Distribution • We can also see from Figure 4-7 that when the relative price of goods changes, it will affect the distribution of income. • For instance, an increase in the relative price of cloth, PC /PF, is predicted to: w/r (because cloth is labor-intensive), hence raising the income of workers (wages w) relative to that of capital owners (rental r). L/K (because producers are willing to use less labor and more capital). As a result, the marginal productivity of labor in both industries , the marginal productivity of capital in both industries . Note: The marginal productivity of a factor typically decreases when the level of that factor used in production increases. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 4-33 In a competitive economy, factors of production (labor and capital) are paid their marginal product. Real wage = marginal productivity of labor Real rental = marginal productivity of capital When the marginal productivity of labor in both industries , it implies that the real income of workers (hence higher purchasing power of worker). When the marginal productivity of capital in both industries , it implies that the real income of capital owners (hence lower purchasing power of capital owners). Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 4-34 Resources and Output • Rybczynski theorem: If you hold output prices constant as the amount of a factor of production , then the supply of the good that uses this factor intensively , and the supply of the other good . For instance, holding PC /PF constant, when the supply of capital , the output of food that uses capital intensively (and the output of cloth ). The supply of food rises more than proportionately to the increase in capital. For example, if capital by 10%, food output might by 15 or 20%. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 4-35 Fig. 4-8: Resources and Production Possibilities To see how an increase in capital affects the economy’s output, we will use the PPF. When supply of capital = TT1, the economy produces at point 1, where the PPF touches the highest possible isovalue line with slope –PC/PF. At point 1, Cloth Production = Q Food Production = Q Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 1 C 1 F 4-36 When supply of capital , the PPF will shift out to TT2, indicating that the economy could produce more food and more cloth. Since food is capital-intensive, the outward shift of PPF is much larger in the direction of food. Holding output prices constant (the slope –PC/PF remains unchanged), the new production point is at 2. At point 2, Food Production to Q 2 Cloth Production to Q F 2 C Check this conclusion with Rybczynski theorem. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 4-37 • The biased expansion of PPF is the key to understanding how differences in resources give rise to international trade. Labor , PPF expands disproportionately in the direction of cloth production (since cloth is labor-intensive), QC Capital , PPF expands disproportionately in the direction of food production (since food is capital-intensive), QF The changes in resources depend on what the country is relatively well endowed. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 4-38 • An economy is relatively efficient at producing goods that are intensive in the factors of production in which the country is relatively well endowed. Home: Labor-abundant, Cloth: Labor-intensive Home will be relatively efficient at producing cloth. Foreign: Capital-abundant, Food: Capital-intensive Foreign will be relatively efficient at producing food. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 4-39 Can a country be both labor- and capital-abundant? • Note that abundance is defined in terms of ratio and not in absolute quantities. Foreign: Labor (L*) = 80 million Capital (K*) = 200 million Home: Labor (L) = 20 million Capital (K) = 20 million In absolute term, Foreign is abundant in both labor and capital. How about relative term?? Labor abundance (Home) = L / K = 20/20 = 1 Labor abundance (Foreign) = L*/ K* = 80/200 = 0.4 Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 4-40 Capital abundance (Home) = K / L = 20/20 = 1 Capital abundance (Foreign) = K*/ L* = 200/80 = 2.5 So, what is your answer? Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 4-41 International trade in the Heckscher-Ohlin model Further assumptions in H-O model: • Home and Foreign have the same consumer tastes (hence identical relative demands for food and cloth). • They have the same technology, with each factor of production (labor, capital) yielding the same amount of output in both countries. • The only difference between Home and Foreign is in their resources [Recall that in H-O model, differences in resources give rise to international trade]. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 4-42 • Further assume: Foreign has an abundant amount of capital (capitalabundant) Home has an abundant amount of labor services (laborabundant) Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 4-43 What happen to relative prices with international trade? • The RD curve is downward sloping, reflecting substitution effects. • Relative demand of cloth is the quantity of cloth demanded in all countries (QC + Q*C) relative to the quantity of food demanded (QF + Q*F) in all countries. • As the price of cloth relative to the price of food rises (PC /PF ), consumers in all countries will tend to purchase less cloth and more food, so that the relative quantity of cloth demanded falls (negative relationship). • We have assumed earlier that both countries have the same consumer tastes, hence they have similar RD curve. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 4-44 • The RS curve, on the other hand, is upward sloping. Relative supply of cloth is the quantity of cloth supplied in all countries (QC + Q*C) relative to the quantity of food supplied (QF + Q*F) in all countries. Given that cloth is labor-intensive and Home is laborabundant. At each relative price (PC /PF), Home will produce more cloth to food than Foreign. Hence, Home will have a higher relative supply of cloth than Foreign Home RS curve will be to the right of Foreign RS*. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 4-45 Fig. 4-9: Trade Leads to a Convergence of Relative Prices No Trade Home equilibrium will be at point 1. Foreign equilibrium will be at point 3. 3 2 1 In the absence of trade, PC /PF is higher in Foreign. With Trade PC /PF will converge with a new world relative price (similar to Ricardian model). The new relative price is between the two countries’ pretrade prices (say at point 2). Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 4-46 How does the convergence of relative prices translate into a pattern of international trade? • Like the Ricardian model, the Heckscher-Ohlin model predicts a convergence of relative prices when countries engage in international trade (see Figure 49). • With trade, the relative price of cloth (labor-intensive) is predicted to in the labor-abundant Home (from point 1 to 2) When PC /PF , the relative production of cloth , the relative consumption of cloth Hence RS (Cloth) > RD (Cloth), Home becomes an exporter of cloth and an importer of food. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 4-47 • With trade, the relative price of cloth is predicted to in Foreign (from point 3 to 2). This implies that the relative price of food (capital-intensive) in the capital-abundant Foreign. When PF /PC , the relative production of food , the relative consumption of food Hence RS (Food) > RD (Food), Foreign becomes an exporter of food and an importer of cloth Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 4-48 • Heckscher-Ohlin theorem: An economy has a comparative advantage in producing, and thus will export, goods that are relatively intensive in using its relatively abundant factors of production. Home: Labor-abundant EXPORT Labor-intensive Cloth Foreign: Capital-abundant EXPORT Capital-intensive Food Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 4-49 How does the convergence of relative prices affect income distribution? • International trade leads to convergence of relative prices (see Figure 4-9). • Changes in relative prices will affect the relative earnings of labor and capital. • With trade, the relative price of cloth (labor-intensive) is predicted to in the labor-abundant Home (see slide 47) When PC /PF , the real income/purchasing power of workers , but the real income/purchasing power of capital owners (see Slides 33-34) Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 4-50 • With trade, the relative price of food (capital-intensive) is predicted to in the capital-abundant Foreign (see slide 48) When PF /PC , the real income/purchasing power of capital owners , but the purchasing power of workers (see Slides 33-34) 4-51 The Heckscher-Ohlin model predicts that owners of abundant factors gain with trade, but owners of scarce factors lose. Home: Labor-Abundant Workers Gain Capital owners Lose Foreign: Capital-Abundant Capital owners Gain Workers Lose Unlike Ricardian model, not everyone gains from trade in the H-O model. For “Trade and Income Distribution”, Read the Case Study in Textbook, page 122-126. 4-52 How does the convergence of relative prices lead to equalization of input (factor) prices? • Unlike the Ricardian model, the Heckscher-Ohlin model predicts that input (factor) prices will be equalized among countries that trade (wages and rental will be the same in Home and Foreign). • From Figure 4-6 (see Slide 29), given the goods prices (PC /PF), we can determine w/r. • With trade, relative goods prices converged in both countries (see Figure 4-9). • If Home and Foreign face the same relative prices, they will also have the same factor prices (due to the positive relationship). Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 4-53 • In the real world, factor prices are not equal across countries (see Table 4-1 for differences in wages). • Why the H-O model does not give an accurate prediction? Look at the underlying assumptions. 1. The model assumes that trading countries produce the same goods (cloth and food), so that prices for those goods will equalize, but countries may produce different set of goods. 2. The model also assumes that trading countries have the same technology (see Slide 42), but different technologies could affect the productivities of factors and therefore the wages/rental paid to these factors. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 4-54 Table 4-1 Comparative International Wage Rates (United States = 100) Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 4-55 3. The model also ignores trade barriers (e.g., tariffs, import quotas) and transportation costs, which may prevent output prices and factor prices from equalizing. 4. The model predicts outcomes for the long run, but after an economy liberalizes trade, factors of production may not quickly move to the industries that intensively use abundant factors. In the short run, the productivity of factors will be determined by their use in their current industry, so that their wage/rental may vary across industries. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 4-56 Empirical evidence on the Heckscher-Ohlin Model • Tests on the U.S. data U.S. is the most capital-abundant country in the world (higher capital-labor ratios) One would expect U.S. would be an exporter of capitalintensive goods and an importer of labor-intensive goods However, Leontief found that U.S. exports were less capitalintensive than U.S. imports (Leontief paradox) Table 4-2 illustrates the paradox, where U.S. exports were produced with a lower capital-labor ratio than U.S. imports (see line 3). Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 4-57 Table 4-2 Factor Content of U.S. Exports and Imports for 1962 Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 4-58 • Tests on global data Bowen, Leamer, and Sveikauskas tested the HeckscherOhlin model on data from 27 countries and confirmed the Leontief paradox on an international level. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 4-59 • Looking at changes in patterns of exports between developed (high income) and developing (low/middle income) countries supports the theory. • US imports from Bangladesh are highest in low-skill-intensity industries, while US imports from Germany are highest in high- skillintensity industries. 4-60 Fig. 4-10 Skill Intensity and the Pattern of U.S. Imports from Two Countries Source: John Romalis, “Factor Proportions and the Structure of Commodity Trade,” American Economic Review 94 (March 2004), pp. 67–97. 4-61 • As Japan and the four Asian “miracle” countries became more skill-abundant, U.S. imports from these countries shifted from less skill-intensive industries toward more skillintensive industries. 4-62 Fig. 4-11A Changing Patterns of Comparative Advantage (1960) 4-63 Fig. 4-11B Changing Patterns of Comparative Advantage (1998) 4-64