Chapter 4: Trade: Factor Availability and Factor Proportions Are Key.

Chapter 4:Trade: Factor Availability and Factor Proportions

Are Key

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Four Fundamental Questions About Trade

• What is the basis for trade?• What are the gains from trade?• What are the effects of trade on production

and consumption in each country?• What are the distributional effects of trade in

each nation?


Production with Increasing Marginal Costs

• Increasing marginal costs: As one industry expands at the expense of others, increasing amounts of the other products must be given up to get each extra unit of the expanding industry’s product.

• A country’s production-possibilities curve (ppc) shows the combinations of amounts of different products that a country can produce, given the country’s available factor resources and maximum feasible productivities.


Production Possibilities under Increasing Costs


What’s Behind the Bowed-Out Production Possibilities Curve?

• Why are increasing-cost curves (bowed-out in shape) more realistic than constant-cost (straight-line) production possibility curves?

• A country’s ppc is derived from information on both total factor (resource) supplies and the production functions that indicate how factor inputs can be used to produce outputs in various industries.


What’s Behind the Bowed-Out Production Possibilities Curve?

• The explanation for the realism of increasing costs (and the bowed-out shape)– There are several kinds of factor inputs (land,

skilled labor, unskilled labor, capital, etc.)– Different products use factor inputs in different

proportions


What Production Combination Is Actually Chosen?

• It depends on the price ratio that competitive firms face.

• Suppose that the market price of cloth in terms of wheat is 2 W / C . If you are a competitive firm vying with other firms around you, you will see one of these three conditions at any production point:


What Production Combination Is Actually Chosen?

If the opportunity cost of producing another unit of cloth is….• less than the 2 W / C that you can sell it for, then try to

make more cloth (and take resources away from wheat). The opportunity cost is less (the slope of the ppc is flatter) than 2 W / C .

• more than the 2 W / C that you can sell it for, then try to make less cloth (and shift resources into growing wheat). The opportunity cost is greater (the slope of the ppc is steeper) than 2 W / C .

• equal to the 2 W / C that you can sell it for, then you are producing the right amount. There is no reason to shift any production between cloth and wheat.


Community Indifference Curves

Indifference curves show the various combinations of consumption quantities that lead to the same level of well-being or happiness (utility).

Community indifference curves purport to show how the economic well-being of a whole group depends on the whole group’s consumption of products.


Indifference Curves Relating an Individual’s Levels of Well-Being to Consumption of Two Goods


Indifference Curves

Indifference curves are:• individual specific• downward sloping • concave to the origin• There are infinite indifference curves

(indifference map)• Indifference curves cannot intersect


Community Indifference Curves

Community indifference curves are useful. Still, economic theory raises difficult questions about community indifference curves:• The shapes of individual indifference curves

differ from person to person. There is no clear way to “add up” individuals’ indifference curves to obtain community indifference curves.

• The concept of national well-being or welfare is not clearly defined.


Production and Consumption Together

• Without trade the US must be self-sufficient and find the combination of domestically produced wheat and cloth that will maximize community well-being.

• With trade the US imports cloth from the rest of the world and exports wheat to the rest of the world.


Indifference Curves and Production Possibilities without Trade


Two Views of Free Trade and Its Effects


Gains from Trade

• Trade allows both countries to reach a higher level of economic well-being than before trade.

• A country’s gain depends on the price ratios before trade (autarky price) and after trade

• Trade affects both production and consumption patterns in both countries


Trade Affects Production

The opening up of trade has two types of implications for production

1. Within each country output expands for the product in which the country has a comparative advantage. The expanding industry (export sector) acquires factor resources from other industries in the economy. The import-competing sector reduces its domestic production (the shrinking sector)


Trade Affects Production and Consumption

2. The shift from autarky to free trade results in more efficient world production as each country expands output of the product in which it is initially the lower cost producer.


• Substitution effect: In each country the relative price of the importable product declines, so consumers tend to buy more of the importable product and less of the exportable product.

• Real income effect: In each country real incomes rise, so consumers have more buying power and tend to buy more of both products.

Trade Affects Consumption


Opening up of trade alters the quantities consumed of each product. • In each country the quantity consumed of the

importable product will increase.• In each country the quantity consumed of the

exportable product can decrease, stay the same, or increase. (It depends on the sizes of the negative substitution effect and the positive income effect.)

Trade Affects Consumption


What Determines the Trade Pattern?The immediate basis for the pattern of international trade is that the relative product prices differ between the two countries if there were no trade. But why do product prices differ?Possible causes for relative price differences are:• Production conditions differ (supply-side factors)• Demand conditions differ (demand-side factors)• Some combination of these factors may cause price

differences(supply and demand side factors)


Heckscher-Ohlin (H-O) Theory of Trade • Predicts that a country exports product (or products)

that uses its relatively abundant factor(s) intensively and imports the product (or products) that uses its relatively scarce factor(s) intensively.

• A country is relatively labor-abundant if it has a higher ratio of labor to other factors than does the rest of the world.

• A product is relatively labor-intensive if labor costs are a greater share of its value than they are of the value of other products.


Heckscher-Ohlin (H-O) Theory of Trade

• H-O comparative advantage is actually a triple comparison:across countries across products across factors of production


The Heckscher-Ohlin Model: The Setting for the H-O Theory of Trade

• There are two factors of production, labor and land.

• Factors of production can freely move between industries in a country (perfect factor mobility within each country).

• The owners of land are paid rent (r), and the reward to workers is wage rate (w).


Heckscher-Ohlin (H-O) Model

• Countries differ in their relative endowment of factors of production. In our example, U.S. is assumed to be relatively land abundant, while ROW is assumed to be relatively labor abundant. This implies that: ( ) US > ( )ROW Alternatively, ( ) US < ( )ROW


Heckscher-Ohlin (H-O) Model• Production technologies used to produce goods are

identical across countries. In this example we assume that in both countries, the production of wheat is more land intensive than the production of cloth so that: ( ) Wheat > ( )Cloth

• Identical demand conditions: Consumer tastes are the same across countries

Chapter 4: Trade: Factor Availability and Factor Proportions Are Key.

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Transcript of Chapter 4: Trade: Factor Availability and Factor Proportions Are Key.