H-O Model Part 2 PDF

Factor Prices and Goods Prices 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...

Factor Prices and Goods Prices 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/r are tied to changes in PC /PW. Copyright ©2015 Pearson Education, Inc. All rights reserved. 5-1  Fig. 5-6: Factor Prices and Goods Prices Copyright ©2015 Pearson Education, Inc. All rights reserved. 5-2  Four Theorem of the H-O model Stolper-Samuelson Theorem Rybczynski Theorem H-O trade Theorem Factor price equalization theorem Copyright ©2015 Pearson Education, Inc. All rights reserved. 5-3  The Stolper-Samuelson Theorem The Stolper-Samuelson Theorem is an economic concept that helps us understand how changes in international trade can affect the wages and incomes of workers and owners of resources, like land and capital, in a country. Copyright ©2015 Pearson Education, Inc. All rights reserved. 5-4  Factor Prices and Goods Prices (cont.) 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 ©2015 Pearson Education, Inc. All rights reserved. 5-5  Fig. 5-7: From Goods Prices to Input Choices Copyright ©2015 Pearson Education, Inc. All rights reserved. 5-6  Factor Prices and Goods Prices (cont.) An increase in the relative price of cloth, PC /PF, is predicted to – raise income of workers relative to that of capital owners, w/r. – raise the ratio of capital to labor services, K/L, used in both industries. – raise the real income (purchasing power) of workers and lower the real income of capital owners. Copyright ©2015 Pearson Education, Inc. All rights reserved. 5-7  Resources and Output 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 ©2015 Pearson Education, Inc. All rights reserved. 5-8  Resources and Output (cont.) Assume an economy’s labor force grows, which implies that its ratio of labor to capital L/K increases. 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 ©2015 Pearson Education, Inc. All rights reserved. 5-9  Fig. 5-8: Resources and Production Possibilities Copyright ©2015 Pearson Education, Inc. All rights reserved. 5-10  Resources and Output (cont.) 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/K > L*/ 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 ©2015 Pearson Education, Inc. All rights reserved. 5-11  Trade in the Heckscher-Ohlin Model 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 ©2015 Pearson Education, Inc. All rights reserved. 5-12  Trade in the Heckscher-Ohlin Model (cont.) 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 ©2015 Pearson Education, Inc. All rights reserved. 5-13  Fig. 5-9: Trade Leads to a Convergence of Relative Prices Copyright ©2015 Pearson Education, Inc. All rights reserved. 5-14  Trade in the Heckscher-Ohlin Model (cont.) 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 ©2015 Pearson Education, Inc. All rights reserved. 5-15  Trade in the Heckscher-Ohlin Model (cont.) 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 ©2015 Pearson Education, Inc. All rights reserved. 5-16  Trade in the Heckscher-Ohlin Model (cont.) 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 ©2015 Pearson Education, Inc. All rights reserved. 5-17  The Heckscher-Ohlin Theorem Countries have comparative advantage in, and therefore export, goods that use relatively intensively their relatively abundant factors. Copyright ©2015 Pearson Education, Inc. All rights reserved. 5-18  Gains from trade Copyright ©2015 Pearson Education, Inc. All rights reserved. 5-19  Trade and the Distribution of Income 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 ©2015 Pearson Education, Inc. All rights reserved. 5-20  Workers vs. landowners Copyright ©2015 Pearson Education, Inc. All rights reserved. 5-21  Trade and the Distribution of Income (cont.) 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 ©2015 Pearson Education, Inc. All rights reserved. 5-22  Who win and who lose? Copyright ©2015 Pearson Education, Inc. All rights reserved. 5-23  Trade and the Distribution of Income (cont.) Compared with the rest of the world, the United States is abundantly endowed with highly skilled labor while low-skilled labor is correspondingly scarce. – International trade has the potential to make low-skilled workers in the United States worse off - not just temporarily, but on a sustained basis. Copyright ©2015 Pearson Education, Inc. All rights reserved. 5-24  Trade and the Distribution of Income (cont.) Changes in income distribution occur with every economic change, not only international trade. – Changes in technology, changes in consumer preferences, exhaustion of resources and discovery of new ones all affect income distribution. – Economists put most of the blame on technological change and the resulting premium paid on education as the major cause of increasing income inequality in the US. It would be better to compensate the losers from trade (or any economic change) than prohibit trade. – The economy as a whole does benefit from trade. Copyright ©2015 Pearson Education, Inc. All rights reserved. 5-25  Trade and the Distribution of Income (cont.) There is a political bias in trade politics: potential losers from trade are better politically organized than the winners from trade. – Losses are usually concentrated among a few, but gains are usually dispersed among many. – Each of you pays about $8/year to restrict imports of sugar, and the total cost of this policy is about $2 billion/year. – The benefits of this program total about $1 billion, but this amount goes to relatively few sugar producers. Copyright ©2015 Pearson Education, Inc. All rights reserved. 5-26  Factor Price Equalization 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 ©2015 Pearson Education, Inc. All rights reserved. 5-27  Factor Price Equalization (cont.) 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 ©2015 Pearson Education, Inc. All rights reserved. 5-28  Table 5-1: Comparative International Wage Rates (United States = 100) Copyright ©2015 Pearson Education, Inc. All rights reserved. 5-29  Factor Price Equalization (cont.) 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 ©2015 Pearson Education, Inc. All rights reserved. 5-30  Empirical Evidence on the Heckscher-Ohlin Model Tests on US data – Leontief found that U.S. exports were less capital-intensive than U.S. imports, even though the U.S. is the most capital-abundant country in the world: Leontief paradox. Tests on global data – Bowen, Leamer, and Sveikauskas tested the Heckscher-Ohlin model on data from 27 countries and confirmed the Leontief paradox on an international level. Copyright ©2015 Pearson Education, Inc. All rights reserved. 5-31  Table 5-2: Factor Content of U.S. Exports and Imports for 1962 Copyright ©2015 Pearson Education, Inc. All rights reserved. 5-32  Table 5-3: Estimated Technological Efficiency, 1983 (United States = 1) Copyright ©2015 Pearson Education, Inc. All rights reserved. 5-33  Summary 1. Substitution of factors used in the production process generates a curved PPF. – When an economy produces a low quantity of a good, the opportunity cost of producing that good is low. – When an economy produces a high quantity of a good, the opportunity cost of producing that good is high. 2. When an economy produces the most value it can from its resources, the opportunity cost of producing a good equals the relative price of that good in markets. Copyright ©2015 Pearson Education, Inc. All rights reserved. 5-34  Summary (cont.) 3. An increase in the relative price of a good causes the real wage or real rental rate of the factor used intensively in the production of that good to increase, – while the real wage and real rental rates of other factors of production decrease. 4. If output prices remain 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 ©2015 Pearson Education, Inc. All rights reserved. 5-35  Summary (cont.) 5. An economy exports goods that are relatively intensive in its relatively abundant factors of production and imports goods that are relatively intensive in its relatively scarce factors of production. 6. Owners of abundant factors gain, while owners of scarce factors lose with trade. 7. A country as a whole is predicted to be better off with trade, so winners could in theory compensate the losers within each country. Copyright ©2015 Pearson Education, Inc. All rights reserved. 5-36  Summary (cont.) 8. The Heckscher-Ohlin model predicts that relative output prices and factor prices will equalize, neither of which occurs in the real world. 9. Empirical support of the Heckscher-Ohlin model is weak except for cases involving trade between high-income countries and low/middle- income countries or when technology differences are included. Copyright ©2015 Pearson Education, Inc. All rights reserved. 5-37