ECW3121 International Trade and Finance Lecture 3

1
ECW3121International Trade and FinanceLecture 3
2
Heckscher-Ohlin
Stolper-Samuelson
This week
Comparative Advantage
Factor Price Equalisation
Trade Theory Study Guide 1 Weeks 1-5
Trade Theory Study Guide 1
Rybzcynski
Absolute Advantage
Immiserising Growth
Mercantilism
3
Assumptions
Trade Theory
Why do Nations Trade?

• Perfect Competition in Product and Factor Markets
  (PMC)
• Each Country has a fixed endowment of resources
  that are fully used and are homogeneous
• Technology is Unchanging
• No Transportation Costs or barriers to trade
• Factors of Production are perfectly mobile
  between industries but are immobile between
  countries
• 2x2x1 or 2x2x2

4
Trade Theory
Comparative Advantage
Specialisation
Increasing cost PPF
Televisions
Pw Pt
(Singapore)
Singapore
Pw Pt
(Australia)
Australia
0
Wine
5
Trade Theory
Comparative Advantage
Free trade
Increasing cost PPF
Televisions
Singapore
C
Pw/Pt (Singapore)
Pw/Pt (Australia)

C
Australia
0
Wine
6
Trade Theory
Comparative Advantage
Free trade
Increasing cost PPF
Televisions
Pw/Pt (Singapore) Pw/Pt (Australia)
Australia - Free Trade
Produces Te of televisions We of
wine. Exchanges We - Wec of wine for Tec -
Te of televisions Increase in production We -
Wa of wine Decrease in production Te - Ta of
televisions Increase in consumption Tec - Ta
of televisions Wec - Wa of wine
Australia - Autarky
Produces and consumes Ta of televisions Wa
of wine
Eec
Tec
A
Ta
E
Te
Wa
Wec
0
Wine
We
7
Trade Theory
Comparative Advantage
Free trade
Increasing cost PPF
Televisions
Pw/Pt (Singapore) Pw/Pt (Australia)
Singapore - Free Trade
Produces Te of televisions We of
wine. Exchanges Te - Tec of televisions for Wec
- We of wine Increase in production Te - Ta of
televisions Decrease in production We - Wa of
wine Increase in consumption Tec - Ta of
televisions Wec - Wa of wine
E
Te
Singapore - Autarky
Produces and consumes Ta of televisions Wa
of wine
Tec
Eec
A
Ta
Wa
We
Wec
0
Wine
8
Trade Theory
Heckscher-Ohlin theorem
Reminder Isoquants, Isocosts, Equilibrium
Slope of Isocost w/r Slope of Isoquant
MRTS Therefore w/r MRTS in equilibrium
K
Isocost
Isoquant
0
L
9
Trade Theory
Heckscher-Ohlin theorem
Reminder Isoquants, Isocosts, Equilibrium
K
K/L Ratios
w/r ratios
Q4
Q3
Q2
Q1
0
L
10
Main points
Trade Theory
Heckscher-Ohlin theorem

• Explains why nations have a comparative
  advantage.
• Examines what lies behind a production
  possibilities frontier.
• A nation will have a comparative advantage in the
  good that uses its abundant factor intensively.

11
Main points
Trade Theory
Heckscher-Ohlin theorem

• Each nation will export the good which uses its
  abundant factor intensively and will import the
  good which uses its scarce factor intensively.
• Factor abundance refers to a comparison of the
  two nations.
• Factor intensity compares the two goods.

12
Assumptions
Trade Theory
Heckscher-Ohlin theorem

• As for the standard theory of trade, and
• Two factors - labour and capital
• Isoquants are homothetic.
• Homothetic isoquants have the same slope along
  any given capital / labour ratio.
• If the proportion of capital and labour remains
  the same, so will the MRTS.

13
Trade Theory
Derivation of the Edgeworth Box Diagram
Heckscher-Ohlin theorem
L
O
O
O
O
Y

• The length of the horizontal sides L of the
  rectangular corresponds to the total amount of
  factor L available in the economy
• The length of the vertical sides K of the
  rectangular corresponds to the total amount of
  factor K available in the economy
• Each tangent point of two isoquants reflects
  factor utilisation for a feasible combination of
  products X and Y
• Kx and Lx - the amount of factors used for the
  production of X
• (K- Kx) and (L-Lx ) - the amount of factors
  used for the production of Y..

XE
K
YE
E
K
Kx
O
x
Lx
L
14
Trade Theory
Derivation of the Edgeworth Box Diagram
Heckscher-Ohlin theorem
L
L
L
L
L
L
O
O
O
O
Y
130X
Factor diagram for the product Y.
50X
20Y
95x
45Y
- isoquants for the product Y
K
K
60Y
O
x
L
The contract curve of Nation 1 - Efficient
combinations of factors and products Eficient
means the factors are fully utilised.
Factor diagram for the product X.
- isoquants for the product X
15
Trade Theory
Derivation of the Edgeworth Box Diagram
Heckscher-Ohlin theorem
L
L
L
L
L
L
O
O
O
O
130X
Y
The contract curve for Nation 1 - efficient
combinations of factors and products A, F, B -
feasible and efficient points What means
infeasible point? What means feasible but
inefficient point?
20Y
50X
95x
B
45Y
F
K
K
60Y
A
O
x
L
Edgeworth Box Diagram for Nation 1
Y
A
60Y
F
45Y
B
20Y
Production possibility frontier for Nation 1
X
50X
95x
130X
16
Trade Theory
Derivation of the Edgeworth Box Diagram
Heckscher-Ohlin theorem
L
L
L
L
L
L
O
Y
Y
Edgeworth Box Diagram for Nation 2 Nation 2 has
a relative abundance of K compare with Nation 1.

K
80X
40Y
40
(A)
65x
A
K
85Y
85
F
40X
(F)
120Y
120
(B)
B
L
O
x
65
80
40
x
(B)
(F)
(A)
17
Factor Abundance
Trade Theory
Heckscher-Ohlin theorem
L
0Y
Need to Compare Two Nations
Capital Abundant
K
0Y
L
K
Labour Abundant
K
K
0X
L
L
0X
18
Factor Abundance
Trade Theory
Heckscher-Ohlin theorem
Need to Compare Two Nations
0Y
L
K
Labour Abundant
K
0X
L
19
Factor Intensity
Trade Theory
Heckscher-Ohlin theorem

• Factor Intensity refers to the proportion of each
  factor used in the production of the goods.
• Good X is labour intensive if it uses more labour
  per unit of capital than Good Y.

20
Trade Theory
Heckscher-Ohlin theorem
Edgeworth Box Diagram for Nation 1
L
O
Y

• Labour Abundant
• Has comparative advantage in producing labour
  intensive good X
• Good X requires more labour per unit of capital
  than Good Y.

130X
20Y
50X
G
95x
B
45Y
K
F
K
60Y
A
O
x
L
Y
A
60Y
F
45Y
B
G
20Y
X
0
130X
50X
95x
21
Trade Theory
Heckscher-Ohlin theorem
Edgeworth Box Diagram for Nation 2
L
L
L
L

• Capital abundant
• Has comparative advantage in producing the
  capital intensive good Y
• Good Y requires more more capital per unit of
  labour than Good X.

22
Trade Theory
Heckscher-Ohlin theorem
Autarky
O
L
L
L
Y
Nation 2
A and A - Autarky
Nation 2 - steep w/r ratio Nation 1 - flat w/r
ratio
K
A
K
L
O
Y
F
B
Nation 1
B
F
K
A
L
Ox
23
Trade Theory
Heckscher-Ohlin theorem
Free trade/specialisation
O
L
L
L
Y

• Production possibility frontier
• Nation 2 - steep (capital abundant)
• Nation 1 - flat (labour abundant)

Y
Nation 2
B
Nation 2
K
80X
40Y
F
A
K
65x
L
A
O
85Y
F
F
Y
130X
A
B
20Y
40X
95x
B
B
120Y
45Y
Nation 1
K
A
50X
0
60Y
X
L
Nation 1

• The labour abundant nation 1 specialises in
  producing the labour intensive good X
• The capital abundant nation 2 specialises in
  producing the capital intensive good Y

24
Trade Theory
Stolper- Samuelson theorem

• Explains the impact of free trade on the returns
  to factors.
• The increase in the relative price for a
  commodity raises the return or earnings of the
  factor used intensively in the production of the
  commodity.

25
Trade Theory
Stolper- Samuelson theorem
O
L
L
L
Y
Nation 2
K
A
K
L
O
F
Y
B
Nation 1
F
B
K
A
L
Ox
26
Trade Theory
Stolper- Samuelson theorem
O
L
L
L
Y
Labour Abundant Nation 1 has comparative
advantage in producing labour intensive good X
Nation 2

• Capital abundant Nation 2 has comparative
  advantage in producing the capital intensive good
  Y

K
A
K
L
O
Y
F
B
B
F
A
K
L
Nation 1
Ox
27
Trade Theory
Stolper- Samuelson theorem
O
L
L
L
Y
Increase in the price for X causes increase in
the production of X by the labour abundant Nation
1. This will cause increase in w/r ratio (or
increase in wage in the units of capital
rent) Specialisation of nation 2 in good Y
causes increase of r/w ratio.
Nation 2
K
A
K
L
O
F
Y
B
Nation 1
F
B
K
A
L
Ox
28
Trade Theory
Stolper- Samuelson theorem

• In a Labour Abundant Nation, which exports a
  Labour Intensive Commodity,
• wages will increase relative to rental and the
  Labour force will be the winners......
• capital owners the losers when free trade is
  opened.
• In a Capital Abundant Nation, which exports a
  Capital Intensive Commodity,
• rental will increase relative to wages and the
  Capital Owners will be the winners......
• labour owners the losers when free trade is
  opened.
• Because Each Nation gains from free trade, the
  winner will gain enough to fully compensate the
  losers......
• the result being a net gain