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NEOCLASSICAL TRADE THEORY
CHAPTER 3
Chapter 3
Review
One input Two or more inputs
H-O Model Specific Factor Model
Beneficial to everybody
affect the distribution of
income
Chapter 3
Neoclassical Compare with Classical
Neoclassical Classical
Factor Two or more than two
One factor
Study technique
General equilibrium
Partial equilibrium
Emphases Income distribution
Gain from trade
Chapter 3
The Heckscher-Ohlin Model( Factor Endowment Theory)
Founder The basic H-O model Testing the H-O model Summary
Chapter 3
H-O Model’s Founder: OhlinBertil Ohlin1899-19791977 Nobel Prize
Winner Wrote between 192
1 and 1949.
Chapter 3
H-O Model’s Founder: Heckscher
ELI FILIP HECKSCHERFamous Swedish
EconomistWrote on Mercantilism,
Swedish History, and International Economics
Chapter 3
The basic H-O Model Relations with Ricardian Model Basic Assumptions Basis for trade Pattern of production and trade Numerical example Effects of Trade Rybczyski Theorem
Chapter 3
Relations with Ricardian Model
• What are the ultimate determinants of comparative advantage?
• Ricardo did not bother to answer this question
• He just assumed that the differences in comparative advantage depended on comparative difference in labor productivity (that is, differences in technology), but he did not explain the basis for these differences. Implicit reason in his example was climate...
Chapter 3
Relations with Ricardian Model
• It remained to HeckscherHeckscher and OhlinOhlin to offer an explanation for this. And this theory has become, since 1930s, the orthodox explanation of the ultimate cause of international trade
• Their basic idea is:1. Commodities differ in their factor require
ments2. Countries differ in their factor endowment
s
Chapter 3
Relations with Ricardian ModelA country has comparative advantage in those commodities that use its abundant factors intensively.
This is why labor-abundantlabor-abundant countries, such as India, China and Korea export footwear, rugs, textiles, and other labor intensive commodities; and land-abundantland-abundant countries, such as Argentina, Australia, and Canada, export meat, wheat, wool, and other land-intensive commodities
Chapter 3
Basic Assumptions
1. Number of countries, factors, and commodities are all two 2 x 2 x 2 model
A. Two inputs (factors): Labor (L) & Capital (K)
B. Two outputs: Cloth (Qc) & Steel (QS)
C. Two Countries, e.g. US & China
Different proportion of factor endowment:
US is a capital-abundant country and China is a labor-abundant country (K/L)US > (K/L)China
Chapter 3
Basic Assumptions
2. Technology is the same in both countries same production functionsQc = Qc (Kc, Lc), QS = QS (KS, LS)( cloth is labor-intensive good both in US & China )
3. Strong factor intensity Cloth is labor-intensive good , Steel is capital-intensive good At any given factor price ratio w/r,
KS /LS > Kc /Lc
Chapter 3
Basic Assumptions4. Constant returns to scale
5. Incomplete specializationincreasing opportunity costs
6. Perfect competition
7. Factors are perfectly mobile within each country but not so between countries
8. Tastes are largely similar between countries
9. Free trade, transportation costs are zero
Chapter 3
Factor Abundance (1) “physical” Definitions
Cloth
Steel
PPFChina
PPFUSA
A
B
B
•Physical definition is based on the total amounts of factors:
US is relatively capital abundant compared to China
ChinaUS LKLK )()( **
Chapter 3
Factor Abundance (2) “price” Definitions
Price definition uses wage/rental ratios:
US is relatively capital abundant compared to China. (Why?)
ChinaUS rwrw )()( **
L
K Iso-cost line for US
Iso-cost line for China
Isoquant line
A
B
C D
Chapter 3
Factor IntensiveK
Lr
wSlope
KS /LS
Kc /Lc
Isoquant lineIso-cost line
Chapter 3
Basis for Trade• The structure of trade, in general, can b
e traced back to differences infactor endowments, technology and tastes
• Since Heckscher-Ohlin theory assumes that technology and tastes are similar between countries, it attributes the comparative advantage to differences in factor endowments
Chapter 3
Basis for TradeDifferent relative factor endowmentsdifferent relative factor prices different relative production costdifferent relative prices of products Comparative advantage in producing and exporting the product that uses its abundant recourse intensively (lower relative cost)
Chapter 3
Pattern of production and trade
The capital-abundant country exports the capital-intensive commodity, and the labor-abundant country exports the labor-intensive commodity.
In this case, US should export steel and China should export cloth.
Chapter 3
Numerical example
One country Required inputs per unit of output
Labor Capital
Cloth, Y 4 1
Steel, X 2 3
Endowments 900 600
Chapter 3
Derivation of PPF Derivation of PPF (one country)(one country)
Steel
Cloth
200150 450
600
150
225
Labor constraint
Capital Constraint
E
G
M
H
0
J
•
•
•
•
•
Labor Capital
Cloth, Y 4 1
Steel, X 2 3
Endowments 900 600
If the economy had an unlimited supply of capital (labor), it would be able to produce along the labor constraint JG (capital constraint MH). When the supplies of both factors are limited, both constraints become binding and the production frontier coincides with the heavy kinked line JEH. Because steel is capital intensive relative to cloth, the capital constraint is steeper than the labor frontier.
Chapter 3
Derivation of PPF Derivation of PPF (two countries)(two countries)
Chapter 3
Graphical Presentation
Chapter 3
Effects of Trade To relative price of goods
Trade increase the relative price of goods for export, while decrease that for import.
To Factor Prices To production
More resources are used in the productions for export.
To consumption Comparing with close economy state, the
consumptions possibility rise, but the consumptions for both goods need not rise. It depend on the relative price change and community preferences
Chapter 3
Effects of Trade on Factor Prices Short-Run (no factors are mobile amo
ng sectors) Long-Run (all factors are able to move
among sectors ) The Factor Price Equalization Theore
m & Stopler - Samuelson theorem
Chapter 3
Short-Run EffectReturn to factors
w = P x MPL r = P x MPK ( No changes in marginal productivity of fact
or , so w&r are determined by changes in Product Price )
Price of export product , both factors in the export sector gain
Price of import-competing product , both factors in the import-competing sector loss
Chapter 3
Long-run Effect
1. The Stolper-Samuelson (S-S) TheoremFree trade raises the return to the factor used intensively in the rising-price sector (export sector) and lowers the return to factor used intensively in the falling-price (import competing sector)2. Effect on distribution of income Owners of a country’s abundant factors gain from trade,but owners of scarce factors lose.