ECO2008 International Economics Week 7 PDF

ECO2008 International Economics Resources and Trade: The Heckscher-Ohlin Model Week 7 Brian Varian Introduction In addition to differences in labor productivity, trade occurs due to differences in resources across countries. The Heckscher-Ohlin theory ar...

ECO2008 International Economics Resources and Trade: The Heckscher-Ohlin Model Week 7 Brian Varian Introduction In addition to differences in labor productivity, trade occurs due to differences in resources across countries. The Heckscher-Ohlin theory argues that trade occurs due to differences in labor, labor skills, physical capital, capital, or other factors of production across countries. – Countries have different relative abundance of factors of production. – Production processes use factors of production with different relative intensity. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Two-Factor Heckscher-Ohlin Model 1. Two countries: home and foreign. 2. Two goods: cloth and food. 3. Two factors of production: labor and capital. 4. The mix of labor and capital used varies across goods. 5. The supply of labor and capital in each country is constant and varies across countries. 6. In the long run, both labor and capital can move across sectors, equalizing their returns (wage and rental rate) across sectors. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Production Possibilities (1 of 9) With more than one factor of production, the opportunity cost in production is no longer constant and the PPF is no longer a straight line. Why? Numerical example: K = 3000, total amount of capital available for production L = 2000, total amount of labor available for production Copyright © 2018 Pearson Education, Ltd. All rights reserved. Production Possibilities (2 of 9) Suppose use a fixed mix of capital and labor in each sector. aKC = 2, capital used to produce one yard of cloth aLC = 2, labor used to produce one yard of cloth aKF = 3, capital used to produce one calorie of food aLF = 1, labor used to produce one calorie of food Copyright © 2018 Pearson Education, Ltd. All rights reserved. Production Possibilities (3 of 9) Production possibilities describe different amounts of cloth and food that can be produced, given factor endowments and technology. – QC is total yards of cloth production – QF is total calories of food production Copyright © 2018 Pearson Education, Ltd. All rights reserved. Production Possibilities (4 of 9) Production possibilities are influenced by both capital and labor: – Capital used to produce cloth and food cannot exceed the supply of capital available. aKCQC  aKFQF K – Likewise, the labor used to produce cloth and food cannot exceed the supply of labor available. aLCQC  aLFQF L Copyright © 2018 Pearson Education, Ltd. All rights reserved. Production Possibilities (5 of 9) Constraint on capital that capital used cannot exceed supply for the numerical example: 2QC  3QF 3000 Constraint on labor that labor used cannot exceed labor supply: 2QC  QF 2000 Copyright © 2018 Pearson Education, Ltd. All rights reserved. Production Possibilities (6 of 9) Max food production 1000 (point 1) fully uses capital, with excess labor. Max cloth 1000 (point 2) fully uses labor, with excess capital. Intersection of labor and capital constraints occurs at 500 calories of food and 750 yards of cloth (point 3). Copyright © 2018 Pearson Education, Ltd. All rights reserved. Figure 5.1 The Production Possibility Frontier without Factor Substitution If capital cannot be substituted for labor or vice versa, the production possibility frontier in the factor-proportions model would be defined by two resource constraints: The economy can’t use more than the available supply of labor (2,000 work-hours) or capital (3,000 machine-hours). So the production possibility frontier is defined by the red line in this figure. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Production Possibilities (7 of 9) The opportunity cost of producing one more yard of cloth, in terms of food, is not constant: 2  – low  in example  when the economy produces a low 3  amount of cloth and a high amount of food – high (2 in example) when the economy produces a high amount of cloth and a low amount of food Why? Because when the economy devotes more resources towards production of one good, the marginal productivity of those resources tends to be low so that the opportunity cost is high. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Production Possibilities (8 of 9) The above PPF equations do not allow substitution of capital for labor in production. – Unit factor requirements are constant along each line segment of the PPF. If producers can substitute one input for another in the production process, then the PPF is curved (bowed). – Opportunity cost of cloth increases as producers make more cloth. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Figure 5.2 The Production Possibility Frontier with Factor Substitution If capital can be substituted for labor and vice versa, the production possibility frontier no longer has a kink. But it remains true that the opportunity cost of cloth in terms of food rises as the economy’s production mix shifts toward cloth and away from food. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Production Possibilities (9 of 9) What does the country produce? The economy produces at the point that maximizes the value of production, V. An isovalue line is a line representing a constant value of production, V: V PCQC  PFQF – where PC and PF are the prices of cloth and food. PC – slope of isovalue line is  PF Copyright © 2018 Pearson Education, Ltd. All rights reserved. Figure 5.3 Prices and Production The economy produces at the point that maximizes the value of production given the prices it faces; this is the point on the highest possible isovalue line. At that point, the opportunity cost of cloth in terms of food is equal to the relative price of cloth, PC /PF. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Choosing the Mix of Inputs (1 of 2) Producers may choose different amounts of factors of production used to make cloth or food. Their choice depends on the wage, w, paid to labor and the rental rate, r, paid when renting capital. As the wage w increases relative to the rental rate r, producers use less labor and more capital in the production of both food and cloth. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Figure 5.4 Input Possibilities in Food Production A farmer can produce a calorie of food with less capital if he or she uses more labor, and vice versa. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Choosing the Mix of Inputs (2 of 2) Assume that at any given factor prices, cloth production uses more labor relative to capital than food production uses: aLC aLF LC LF  or  aKC aKF KC K F Production of cloth is relatively labor intensive, while production of food is relatively capital intensive. Relative factor demand curve for cloth CC lies outside that for food FF. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Figure 5.5 Factor Prices and Input Choices At any given wage-rental ratio, cloth production uses a higher labor- capital ratio; when this is the case, we say that cloth production is labor-intensive and that food production is capital-intensive. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Factor Prices and Goods Prices (1 of 3) In competitive markets, the price of a good should equal its cost of production, which depends on the factor prices. How changes in the wage and rent affect the cost of producing a good depends on the mix of factors used. – An increase in the rental rate of capital should affect the price of food more than the price of cloth since food is the capital-intensive industry. Changes in w are tied to changes in PC. r PW F Copyright © 2018 Pearson Education, Ltd. All rights reserved. Figure 5.6 Factor Prices and Goods Prices Because cloth production is labor-intensive while food production is capital-intensive, the higher the relative cost of labor, the higher must be the relative price of the labor-intensive good. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Factor Prices and Goods Prices (2 of 3) Stolper-Samuelson theorem: If the relative price of a good increases, then the real wage or rental rate of the factor used intensively in the production of that good increases, while the real wage or rental rate of the other factor decreases. Any change in the relative price of goods alters the distribution of income. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Figure 5.7 From Goods Prices to Input Choices If the relative price of cloth rises, the wage-rental ratio must rise. This will cause the labor-capital ratio used in the production of both goods to drop. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Factor Prices and Goods Prices (3 of 3) PC An increase in the relative price of cloth, , is PF predicted to w – raise income of workers relative to that of capital owners,. K r – raise the ratio of capital to labor services, , used in L both industries. – raise the real income (purchasing power) of workers and lower the real income of capital owners. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Resources and Output (1 of 3) How do levels of output change when the economy’s resources change? Rybczynski theorem: If you hold output prices constant as the amount of a factor of production increases, then the supply of the good that uses this factor intensively increases and the supply of the other good decreases. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Resources and Output (2 of 3) Assume an economy’s labor force grows, which implies L that its ratio of labor to capital increases. K Expansion of production possibilities is biased toward cloth. At a given relative price of cloth, the ratio of labor to capital used in both sectors remains constant. To employ the additional workers, the economy expands production of the relatively labor-intensive good cloth and contracts production of the relatively capital-intensive good food. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Figure 5.8 Resources and Production Possibilities An increase in the supply of labor shifts the economy’s production possibility frontier outward disproportionately in the direction of cloth production. At an unchanged relative price of cloth, food production declines. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Resources and Output (3 of 3) An economy with a high ratio of labor to capital produces a high output of cloth relative to food. Suppose that Home is relatively abundant in labor and Foreign in capital: L L*  K K* – Likewise, Home is relatively scarce in capital and Foreign in labor. Home will be relatively efficient at producing cloth because cloth is relatively labor intensive. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Trade in the Heckscher-Ohlin Model (1 of 5) The countries are assumed to have the same technology and the same tastes. – With the same technology, each economy has a comparative advantage in producing the good that relatively intensively uses the factors of production in which the country is relatively well endowed. – With the same tastes, the two countries will consume cloth to food in the same ratio when faced with the same relative price of cloth under free trade. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Trade in the Heckscher-Ohlin Model (2 of 5) Since cloth is relatively labor intensive, at each relative price of cloth to food, Home will produce a higher ratio of cloth to food than Foreign. – Home will have a larger relative supply of cloth to food than Foreign. – Home’s relative supply curve lies to the right of Foreign’s. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Figure 5.9 Trade Leads to a Convergence of Relative Prices In the absence of trade, Home’s equilibrium would be at point 1, where domestic relative supply RS intersects the relative demand curve RD. Similarly, Foreign’s equilibrium would be at point 3. Trade leads to a world relative price that lies between the pretrade prices, such as at point 2. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Trade in the Heckscher-Ohlin Model (3 of 5) Like the Ricardian model, the Heckscher-Ohlin model predicts a convergence of relative prices with trade. With trade, the relative price of cloth rises in the relatively labor abundant (home) country and falls in the relatively labor scarce (foreign) country. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Trade in the Heckscher-Ohlin Model (4 of 5) Relative prices and the pattern of trade: In Home, the rise in the relative price of cloth leads to a rise in the relative production of cloth and a fall in relative consumption of cloth. – Home becomes an exporter of cloth and an importer of food. The decline in the relative price of cloth in Foreign leads it to become an importer of cloth and an exporter of food. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Trade in the Heckscher-Ohlin Model (5 of 5) Heckscher-Ohlin theorem: The country that is abundant in a factor exports the good whose production is intensive in that factor. This result generalizes to a correlation: – Countries tend to export goods whose production is intensive in factors with which the countries are abundantly endowed. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Trade and the Distribution of Income (1 of 2) Changes in relative prices can affect the earnings of labor and capital. – A rise in the price of cloth raises the purchasing power of labor in terms of both goods while lowering the purchasing power of capital in terms of both goods. – A rise in the price of food has the reverse effect. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Trade and the Distribution of Income (2 of 2) Thus, international trade can affect the distribution of income, even in the long run: – Owners of a country’s abundant factors gain from trade, but owners of a country’s scarce factors lose. – Factors of production that are used intensively by the import-competing industry are hurt by the opening of trade – regardless of the industry in which they are employed. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Factor Price Equalization (1 of 3) Unlike the Ricardian model, the Heckscher-Ohlin model predicts that factor prices will be equalized among countries that trade. Free trade equalizes relative output prices. Due to the connection between output prices and factor prices, factor prices are also equalized. Trade increases the demand of goods produced by relatively abundant factors, indirectly increasing the demand of these factors, raising the prices of the relatively abundant factors. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Factor Price Equalization (2 of 3) In the real world, factor prices are not equal across countries. The model assumes that trading countries produce the same goods, but countries may produce different goods if their factor ratios radically differ. The model also assumes that trading countries have the same technology, but different technologies could affect the productivities of factors and therefore the wages/rates paid to these factors. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Factor Price Equalization (3 of 3) The model also ignores trade barriers and transportation costs, which may prevent output prices and thus factor prices from equalizing. 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 rate may vary across countries. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Table 5.1 Comparative International Wage Rates Hourly Compensation of Manufacturing Workers 2015 Country (United States = 100) United States 100 Germany 112 Japan 63 Spain 63 South Korea 60 Brazil 31 Mexico 16 China (2013) 11.3 India (2012) 4.5 Source: The Conference Board, International Labor Comparisons. Copyright © 2018 Pearson Education, Ltd. All rights reserved.