Trade Theories:

1. Trade Theories: #4 – appendix (Heckscher-Olin)

2. Trade Equilibrium in H-O Model 45⁰ line Machines .. Qeu EXeu Aeu Ceu IMeu p Cind Aind IMind Qind EXind p .. Cloth

3. Notation from preceding graph 45O Line - assumption that countries are identical and trade is balanced. Ceu , cind = new (higher!) consumption levels of EU and India … (at intersection of price lines and 45o line) Blue “dash” – Trade triangle EU • EXeu – EU exports of machinery • Imeu – EU imports of cloth Red “dash” – Trade triangle IND • EXind – IND exports of cloth • Imind – IND imports of machinery

4. Trade Equilibrium in HO Model Terms of trade (p) are determined by reciprocal demand and lie between the two countries’ pre-trade price ratios Equilibrium production with trade exhibits incomplete specialization (due to increasing opportunity cost) Equilibrium consumption with trade implies a rise in standard of living (consumption at “c”) Trade triangles are congruent

5. Trade Equilibrium in HO Model Terms of trade (p) are determined by reciprocal demand and lie between the two countries’ pre-trade price ratios Equilibrium production with trade exhibits incomplete specialization (due to increasing opportunity cost) Equilibrium consumption with trade implies a rise in standard of living (consumption at “c”) Trade triangles are congruent

6. Big … Assumptions Perfect competition Constant returns to scale No factor mobility Two countries must be identical and trade must be balanced

7. Test of the Heckscher-Ohlin Model The Test: • W. Leontief (1951) • Could “H-O … Factor Proportions Theory” be used to explain the types of goods the United States imported and exported? The Method: Built input-output model for 200 U.S. industries for 1947

8. EMPIRICAL EVIDENCE ON THE H-O FACTOR-PROPORTIONS THEORY The Findings: • The Leontief Paradox • Leontief found that U.S. exports were less capital-intensive than U.S. imports, even though U.S. is the most capital-abundant country in the world

9. The Leontief Paradox The Controversy: Findings were the opposite of what was generally believed to be true!

10. Reconciliations of the Leontief Paradox U.S. workers are more productive than foreign workers (Leontief) andHuman Skills Theory (1966) A third factor, natural resources, is not considered (Vanek) U.S. tariffs on labor-intensive goods are high (Travis) The identical tastes assumption is violated; Table (next page) shows that consumption patterns differ across countries

11. Consumption Shares by Product Type for OECD Countries Average Values 1985–1999*

12. Human Skills Theory Donald Keesing (1966) Emphasizes differences in endowments and intensities of skilled and unskilled workers. Explains the Leontief paradox: Since the U.S. has highly trained, educated workers relative to other countries, U.S. exports tend to be skilled-labor intensive.

13. Trade Theories: #5 - FACTOR-PRICE EQUALIZATION

14. FACTOR-PRICE EQUALIZATION AND THE DISTRIBUTION OF INCOME • Moving from autarky to free trade • What happens to the relative size of industries? • What happens to the payments or returns to factors of production? • What happens to the distribution of income within the country?

15. FACTOR-PRICE EQUALIZATION AND THE DISTRIBUTION OF INCOME • Factor-Price Equalization • When trade occurs between countries with different factor proportions, free trade will equalize the relative price of the goods (we saw this in H-O) • … and cause the relative factor prices to converge • Convergence of factor prices happens in the long run

16. FACTOR-PRICE EQUALIZATION AND THE DISTRIBUTION OF INCOME • Factor-Price Equalization • Whichever factor receives the lowest price before two countries begin to trade will therefore tend to become more expensive relative to other factors in the economy, … while those with the highest price will tend to become cheaper.

17. FACTOR-PRICE EQUALIZATION AND THE DISTRIBUTION OF INCOME • For example – U.S. and India • Trade opening up causes prices of machines and the prices of cloth to equalize between countries (H-O) • Size of machine and cloth industries will change for each country changing their industrial structure

18. FACTOR-PRICE EQUALIZATION AND THE DISTRIBUTION OF INCOME • (Assume) U.S. has a comparative advantage in machines … (machines are K intensive) • This causes an increased demand for machines • The price of machines rises relative to price of cloth • Machine production expands • Cloth production contracts • Increased demand for inputs to make machines

19. FACTOR-PRICE EQUALIZATION AND THE DISTRIBUTION OF INCOME … (continued) • Increase in capital greater than increase in labor as machines are capital intensive • Resources shift from cloth to machines • Cloth industry declines • Imports replace much domestic production • More labor than capital released on market • Shortage of capital increase “profit” (return to K) • Surplus of labor decreases wages • Ratio of wages to “profit” (return to K) declines

20. FACTOR-PRICE EQUALIZATION AND THE DISTRIBUTION OF INCOME • India has a comparative advantage in cloth • Increased demand for cloth • Price of cloth rises relative to price of machines • Machine production contracts • Cloth production expands • Increased demand for inputs to make cloth

21. FACTOR-PRICE EQUALIZATION AND THE DISTRIBUTION OF INCOME • Increase in labor greater than increase in capital as cloth is labor intensive • Resources shift from machines to cloth • Machine industry declines • Imports replace much domestic production • More capital than labor released on market • Shortage of labor increase wages • Surplus of capital decreases “profit” • Ratio of wages to “profit” increases

22. FACTOR-PRICE EQUALIZATION AND THE DISTRIBUTION OF INCOME • Wages • Decline in U.S. • Increase in India • “Profits” (return to capital) • Increase in U.S. • Decrease in India Overall – Factor Prices get closer to equalization (just as we saw with “Goods Prices” in H-O

23. FACTOR-PRICE EQUALIZATION AND THE DISTRIBUTION OF INCOME • Trade and the Distribution of Income • Trade produces a convergence of relative prices • Changes in relative prices have strong effects on the relative earnings of labor and capital in both countries • In U.S., where the relative price of machines rises • Capitalists are made better off and workers are made worse off • In India, where the relative price of machines falls, the opposite happens • Capitalists are made worse off and workers are made better off • Owners of a country’s abundant factors gain from trade, but owners of a country’s scarce factors lose

24. FACTOR-PRICE EQUALIZATION AND THE DISTRIBUTION OF INCOME Table 4.4Economic Data for South Korea and India

25. Trade Theories: #6 - The Stolper-Samuelson Theorem

26. The Stolper-Samuelson Theorem • Derived from the HO model • Assumptions: • Labor earns wages proportionate to its skill level • Owners of capital earn profits • Landowners earn rents • The amount of income earned per unit of input depends on both the demand for inputs and the supply of inputs (demand for an input = derived demand)

27. The Stolper-Samuelson Theorem • An increase in the demand for a good (opening International Trade?) … increases the price of a good…. and raises the income earned by factors that are used intensively in its production • Conversely, decrease in the demand for a good … decreases the price of a good…. and reduces the income earned by factors that are used intensively in its production

28. The Stolper-Samuelson Theorem Example … increase production of steel … increase need for K ...

29. The Stolper-Samuelson Theorem • Note: • Not all factors used in the export industries will be better off, and not all factors used in import competing industries get hurt: Abundant factors will benefit, while scarce ones will be hurt

30. The Stolper-Samuelson Theorem • Ultimately, the effects on income of an opening of trade depends on the flexibility of the affected factors • If labor is stuck in bread production and unable to move to making steel, it will be hurt much worse than when it is flexible and free to move • U.S. avocado producers might not oppose Mexican avocado imports as fiercely as they do, if they could easily move to producing other goods

31. Implications of Stolper-Samuelson Theorem Some groups in society will oppose international trade. Scarce factors will lobby government for trade protection. Even though some in society lose, the country overall benefits from international trade relative to autarky. A system of taxation and transfers could be developed to compensate the losers while leaving the gainers better off relative to autarky.

32. Trade Theories: #7 – Specific Factors and Income Distribution

33. Introduction • If trade is so good for the economy, why is there such opposition? • There are two main reasons why international trade has strong effects on the distribution of income within a country: • Resources cannot move immediately or “costlessly” from one industry to another. • Industries differ in the factors of production they demand.

34. Specific Factors Model • The HO model assumes that factors are mobile, meaning that they can migrate easily from one sector to another The Specific Factors model assumes that: • land and capital are immobile and cannot migrate .... (specific factors) • labor is fully mobile and can migrate from one sector to another ... (variable factor)

35. Specific Factors Model • A country’s endowment of a specific factor plays a more critical role than a factor in the HO model in determining comparative advantage • When trade opens, incomes rise for the owners of the abundant specific factor • The income distribution effect on labor is indeterminate, as workers can easily move to the expanding sector

36. A Specific Factors Model Outputs The Specific Factors of land and capital can be used to produce only one good., each. The variable factor of labor is used in both bread and steel production.

37. The Specific Factors Model • The specific factors model allows trade to affect income distribution. • Assumptions of the model: • Two goods … bread and steel. • Three factors of production: labor (L), capital (K) and land (T for land/terrain). • Perfect competition prevails in all markets.

38. The Specific Factors Model (cont.) • Land and capital are both specific factors used only in the production of one good. • steel produced using capital and labor (but not land). • bread produced using land and labor (but not capital). • Labor is a mobile factor that can move between sectors.

39. The Specific Factors Model (cont.) • How much of each good does the economy produce? • The production function for steel gives the quantity of steel that can be produced, given any input of capital and labor: Qs = Qs (K, Ls) • Qs is the output of steel • K is the capital stock • Ls is the labor force employed in steel

40. The Specific Factors Model (cont.) • The production function for bread gives the quantity of bread that can be produced given any input of land and labor: Qb = Qb (T, Lb) • Qb is the output of bread • T is the supply of land • Lb is the labor force employed in bread

41. Production Possibilities • How does the economy’s mix of output change as labor is shifted from one sector to the other? • When labor moves from bread to steel … bread production falls while output of steel rises.

42. The Production Function for steel (“c”)

43. Production Possibilities (cont.) • The shape of the production function reflects… the law of diminishing marginal returns. • Adding one worker to the production process (without increasing the amount of capital) means that each worker has less capital to work with. • Therefore, each additional unit of labor adds less output than the previous one...

44. Production Possibilities (cont.) • Use a four-quadrant diagram to construct production possibilities frontier • Lower left quadrant indicates the allocation of labor. • Lower right quadrant shows the production function for steel • Upper left quadrant shows the corresponding production function for bread. • Upper right quadrant indicates the combinations of steel and bread that can be produced.

45. The Production Possibility Frontier in the Specific Factors Model Output of bread output of steel

46. Production Possibilities (cont.) • Why is the production possibilities frontier curved? • Diminishing returns to labor in each sector cause the opportunity cost to rise when an economy produces more of a good. • Opportunity cost of steel in terms of bread is the slope of the production possibilities frontier – the slope becomes steeper as an economy produces more steel.

47. Prices, Wages, and Labor Allocation • At the production point, the production possibility frontier must be tangent to a line whose slope is minus the price of steel divided by that of bread. slope = MRT = -PBPB

48. Production in the Specific Factors Model Output of bread slope = -(Ps/Pb)1 Qb1 Qs1 Output of Steel

49. Prices, Wages, and Labor Allocation(cont.) • What happens to the allocation of labor and the distribution of income when the prices of bread and steel change? • Two cases: • An equal proportional change in prices • A change in relative prices

50. Prices, Wages, and Labor Allocation (cont.) • When both prices change in the same proportion, no real changes occur. • The wage rate (w) rises in the same proportion as the prices, so real wages (i.e., the ratios of the wage rate to the prices of goods) are unaffected. • The real incomes of capital owners and landowners also remain the same.