INTERNATIONAL ECONOMICS

1. INTERNATIONAL ECONOMICS Lectures 7 & 8| Lucía Rodríguez| Heckscher-Ohlin and the Role of Factor Endowments

2. TESTING NEOCLASSICAL THEORY • Suppose Spain can produce 90 million tons of oranges if it uses all of its productive resource in the orange industry, or 60 million car units if it uses all of its resources in the car industry. Answer to the following questions: • Assuming constant opportunity costs, draw the Spanish production-possibility curve. • What is Spanish barter exchange ratio in autarky? • Domestic preferences lead to a consumption of 30 million tons of oranges in autarky. How many cars will Spain produce? And consume?

3. TESTING NEOCLASSICAL THEORY • If Spain engages in international trade, and the world exchange ratio is 1O:1C, how will the Spanish allocation of resources be affected? • Determine the final equilibrium consumption and production of both goods after trade, if Spain consumes 40 million tons of oranges ex-post trade. • What are the gains from trade? Graphically and numerically.

4. TESTING NEOCLASSICAL THEORY • In isolation, Country A produces 10 million tons of coffee and 16 million liters of milk. One ton of coffee exchanges for 2 liters of milk and there are constant costs. • Construct Country A's PPC and label its endpoints • Suppose Country A now has the opportunity to trade with Country E at the exchange ratio 1C:1M. In equilibrium country A consumes 10 million liters of milk. • What will country A produce after trade? • What will country A consume after trade? Show its consumption points and its trade triangle • What is the gain from trade to Country A?

5. HECKSCHER-OHLIN: MOTIVATION • Extension of the Standard Trade Model: • New Source of Comparative Advantage: Alternative explanation of Trade Patterns: Factor Endowments versus labor productivity. • Implications for the internal distribution of Income Analyze the effects of international trade on the earnings of labour and capital. • Main references: • Eli Heckscher (1919): The effect of Foreign Trade on the Distribution of Income. • Bertil Ohlin (1933): Interregional and International Trade.

6. HECKSCHER-OHLIN: ASSUMPTIONS • 2 Countries x 2 Goods x 2 Inputs Model: • Standard Neoclassical Assumptions: • No Transportation Costs • Perfect Competition • Inputs Internationally immobile and perfectly mobile across domestic industries • Concave production function. • Techonologies and Tastes are identical across countries (No Demand Bias). • Production Function Irreversibility (Production processes unchanged).

7. HECKSCHER-OHLIN: SOME CONCEPTS • Relative Endowment: • In physical terms: • In price terms: • Relative Intensity of Production: look for optimality • Isocosts: Various combinations of L, K that keep production costs constant, given their relative price w/r. • Isoquants : Various combinations of L,K that can produce a constant output. Equivalent under identical D structures K w/r Good Y Good X Rule out Factor Intensity Reversals L

8. HECKSCHER-OHLIN: COROLLARIES • H-O Theorem: A country has a production bias, and hence tends to export, the good which uses intensively the factor with which it is relatively well endowed. • Rybczynski Theorem: If goods prices are kept constant, an increase in the endowment of one factor causes a more than proportionate increase in the output of the commodity which uses that factor intensively and an absolute decline in the output of the other good. • Stolper-Samuelson Theorem: An increase in the relative prices of one of the two goods, raises the real return of the factor used intensively in its production and lowers the real return of the other factor. • Factor Price Equalization Theorem: Under certain conditions, free trade in final goods is sufficient to bring about complete international equalization of factor prices.

9. HECKSCHER-OHLIN: H-O THEOREM • Production Possibility Curve: Origins • Total resource endowments: Edgeworth Box • Efficiency Locus: Tangency between isoquants, factor prices are equal in both industries. • Translate efficient points into the Production Possibility Curve. Slope depends upon differences in factor intensities: Opportunity cost at work Y Oy K X’ Y R ● z Y’ X Q ● Z ● Y’’ q r X L Ox

10. HECKSCHER-OHLIN: H-O THEOREM • International Trade • Common Indifference curves • Relative Prices: P<P' • Trade through CA H-O Theorem: A country has a production bias, and hence tends to export, the good which uses intensively the factor with which it is relatively well endowed. Pre-Trade Post-Trade P’’ P’ Y Y U’ U B’ ● Nation B A’ ● E=E’ ● Nation A A ● B ● X O X O P

11. HECKSCHER-OHLIN: TRADE BENEFITS • Separate Production from Consumption decisions: Greater Welfare for both countries, smoothing consumption. • Equilibrium Relative Prices: Markets clear. • Specialization will depend (+) on: Sustituibility among inputs. Factor endowments gap. • Production will become more intensive in the non-abundant factor: • Country A (L-abundant) opens to free-trade and receives grater demand for good X (L-intensive) • Needs inputs to produce more X (gets them from Y, K-intensive) • There is an excess Demand of L and Supply of K, therefore we witness higher w/r.

12. HECKSCHER-OHLIN: Δ ENDOWMENTS • One-time increase in the labor force, keeping world commodity prices constant. • Initial production point A. • World prices remain constant • The ex-post wage-rental ratio is the same. • Corresponding capital-labor ratios also. • Intuition: To keep K/L constant in good X, you need K, detracting it from the production of Y. Rybczynski Theorem: If goods prices are kept constant, an increase in the endowment of one factor causes a more than proportionate increase in the output of the commodity which uses that factor intensively and an absolute decline in the output of the other good. Oy Y K X’ X Y’ Y R Line B A X Ox L

13. HECKSCHER-OHLIN: Δ FACTOR PRICES • How are the gains from trade distributed across factors? • The opportunity to trade improves the ToT: R to Q. • X production rises (at the expense of Y) • K/L rises in both sectors. • Labor is more productive and its wages rise. • Trade creates more demand for each countries scarce factor, making the pre-trade gap in factor returns decline. Stolper-Samuelson Theorem: An increase in the relative prices of one of the two goods, raises the real return of the factor used intensively in its production and lowers the real return of the other factor. Y Oy K X’ R ● Y X Q ● Y’ Q R X L Ox

14. HECKSCHER-OHLIN: Δ FACTOR PRICES • Important Implication: Widening Income gap Owners of the scarce factor will oppose free trade and support protectionism. • Changes in the distribution of Income in the US and Europe have favored skilled labor and hurt unskilled labor. Is trade to blame? Think of two alternative questions: • Have the prices of goods that require unskilled labor intensively actually fallen? • Has the expansion of output in skilled labor industries increased the unskilled/skilled labor ratio? NO There is no evidence of S-S being the major determinant of Δw

15. HECKSCHER-OHLIN: Δ FACTOR PRICES • So what are the alternative explanations? • Changes in technology and catch-up (less demand for unskilled labor). • Outsourcing the most unskilled labor-intensive steps (no Δ in relative prices) • DC and LDC produce different bundles of goods (workers in DC insulated)

16. HECKSCHER-OHLIN: EQUALIZATION • Will we reach a point where factor prices equalize across countries? • How are factor prices and intensity in use related? Irreversibility in production. X producers (as well as Y producers) in each country, will use the same L/K proportion in production, as they face the same prices and have the same technology. • How are factor prices and goods prices related? 1 to 1. • International Trade, assuming the same technology and initial conditions. Factor Price Equalization Theorem: Under certain conditions, free trade in final goods is sufficient to bring about complete international equalization of factor prices. w/r w/r w/r A B A’ X X B’ Y Pa Y Pa’ Px/Py Px/Py Pb Pb’ L/K L/K

17. HECKSCHER-OHLIN: EQUALIZATION • Intuition: free trade becomes a perfect substitute for factor trade. Goods price equalization implies factors price equalization. • Also in absolute terms thanks to perfect competition (constant MP across industries): • Real world: we don’t observe factor price equalization, where is the catch? Assumptions needed: • How to set international factor movements? Different Options: in exchange for free trade, relaxing assumptions,… • No transportation costs. • No full specialization. • Same technology across countries

18. HECKSCHER-OHLIN: EQUALIZATION • If we relax the Production Function Irreversibility • There is not a one to one relationship between both relative prices. Factor Price Equalization Theorem: Will not hold w/r X Y Px/Py L/K

19. HECKSCHER-OHLIN: EXTENSIONS • Consider Specific Factors to some industry: • Labor is still mobile between two sectors. (same initial wage) • Capital takes longer to adjust and remains industry-specific. • Law of diminishing returns makes the curves downward sloping. • Due to profit maximization, wages will equate the value of marginal product. • Trade implies higher Px/Py and therefore an increase in VMPLx. • W increases by less than the increase in Px, so W falls in terms of X but rises in terms of Y. • The effect on r is unambiguous, since the proportion L/K changes in both industries, this moves the VMPk (and so r) in the opposite direction. w w VMPLx VMPLy W’ Wo VMPLx Ox Lo L’ Oy

20. HECKSCHER-OHLIN: EMPIRICALLY • The Leontief Paradox: • Input-Output table: intermediate inputs, primary factors use. • How much L and K is necessary to produce domestically $1m worth of US exports and imports? • Different explanations: • Human Capital is indeed behind labor intensity. • Demand Bias towards K-intensive goods. • Tariffs on L-intensive industries. • Methodological flaws: Appropriate test would be US production (K-intensive) against US consumption. Expected result: US exports are more K-intensive than its import-competing goods [K/L] export good > [K/L] import good Final result: US exports were more L-intensive than its import-competing goods!!!

21. HECKSCHER-OHLIN: EMPIRICALLY • Trefler’s Missing Trade: • Looking at factor endowments: • Poor countries: appear to be abundant in most factors but export too little. • Rich countries: appear to be scarce in most factors but import too little. • We should observe more trade flows! • To account for missing trade: allow differences in technology Measure Labor in units of comparable productivity so that less trade is predicted If US labor is more productive due to its technological advantage, then the US will appear labor-abundant.

22. HECKSCHER-OHLIN: BOTTOM LINE • Comparative Advantage Theory was a great contribution to International Trade Theory • Dornbusch: Under the skin of every expert in International Trade, lies a defender of CA theory. • However it underwent some difficulties: • Empirical Paradoxes. • Unable to explain New Phenomena, such as IntraIndustry Trade • Since the 80s, some New Trade Theories were developed in order to complement Neoclassical ideas. Scale, Competition and Trade