ECW3121 International Trade and Finance Lecture 4

1
ECW3121International Trade and FinanceLecture 4
2
Heckscher-Ohlin
Stolper-Samuelson
Factor Price Equalisation
Comparative Advantage
Trade Theory Study Guide 1
Rybzcynski
Absolute Advantage
Immiserising Growth
Mercantilism
International Trade and Finance
Balance Of Payments
Foreign Exchange Markets
Non Tariff Barriers
Interest Arbitrage
TradeBlocs
Tariffs
Finance Study Guide 3
Trade Policy Study Guide 2
International Resource Movements
Tools of the Trade Policy Analysis
Exchange rate theorems
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
• 2x2x2

4
Assumptions
Trade Theory
Comparative Advantage
Increasing cost PPF (Standard Theory of
International Trade)

• Free trade
• Only two nations and two commodities
• Perfect mobility of factors within each nation
  but immobility between the nations
• Increasing opportunity cost of production
• Constant returns to scale
• No transportation costs and
• No technical change

5
Key points
Trade Theory
Comparative Advantage
Increasing cost PPF (Standard Theory of
International Trade)

• A nation should specialise in the good in which
  it enjoys a comparative advantage.
• Incomplete specialisation required for maximum
  world welfare.
• Optimal specialisation occurs at the amount of
  production of two commodities, by both nations,
  corresponding to equal price ratios

6
Key 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.

7
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.

8
Trade Theory
Derivation of the Edgeworth Box Diagram
Heckscher-Ohlin theorem
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
Factor diagram for the product X.
- isoquants for the product X
9
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
10
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
11
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
12
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
13
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

14
Key points
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.

15
Key points
Trade Theory
Stolper- Samuelson theorem

• An Increase in the price of a commodity will
  cause an increase in the price of the factor used
  intensively in the production of that commodity.
• The opening of trade will cause an increase in
  the price of the exported good.
• Therefore, the opening of trade will cause the
  price of the abundant factor to increase and the
  price of the scarce factor to decrease.

16
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
17
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
18
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
19
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

20
Trade Theory
Factor-Price Equalisation

• The end result of free trade
• The wage- rental ratio will be the same in
  each nation corresponding to an equal commodity
  price ratio.
• This result shows that even with the assumption
  of factor immobility between nations, factor
  prices will still adjust as though the factors
  were mobile.
• The factor prices (wages, rental) are embedded in
  the commodity price.
• Free trade is a substitute for factor mobility.

21
Trade Theory
Factor-Price Equalisation
O
Y
Nation 2
A
L
O
Y
B
Nation 1
K
F
F
K
A
B
Ox
Ox
L
22
Trade Theory
Factor-Price Equalisation
O
Y
Nation 2
A
O
Y
B
Nation 1
F
F
A
B
Ox
Nation 2
Nation 1
23
Trade Theory
Factor-Price Equalisation
O
Y
Nation 2
A
O
Y
B
Nation 1
F
F
A
B
Ox
F
Nation 2
F
Nation 1
24
Trade Theory
Factor-Price Equalisation
O
Y
Nation 2
A
O
Y
B
Nation 1
F
F
A
B
Ox
B
Nation 2
B
Nation 1
25
Trade Theory
Factor-Price Equalisation
O
Y
Nation 2
A
O
Y
B
Nation 1
F
F
A
B
Ox
Points B and B are points of stable Equilibrium,
free trade will tend towards these points.
B
Nation 2
B
Nation 1
26
Reading
Trade Theory
Economic growth

• Salvatore, Chapters 7
• The Reader - the articles by T.M.
  Rybchinski and J. Bhagwati.

27
Trade Theory
Economic growth

• Economic Growth - Increase in National Output
  over time.
• Change in GDP from one year to the next.
• Real GDP can only increase
• if a nation acquires more factors of production
  (extensive growth) or
• as a result of technical progress - the existing
  factors of production may be used to produce a
  higher level of output (intensive growth) .

28
In international trade theory
Trade Theory
Economic growth

• Small economy/country - does not affect world
  prices (the price for a particular commodity)
• Large economy/country - affects world prices (the
  price for a particular commodity).

29
Trade Theory
Economic growth
Extensive growth, no technical progress
Rybczynski theorem Small Country

• At constant commodity prices, an increase in the
  endowment of one factor will cause, by a greater
  proportion, an increase in the commodity
  intensive in that factor and will reduce the
  output of the other commodity.

30
Trade Theory
Economic growth
Extensive growth, no technical progress
Rybczynski theorem Small Country
At an equilibrium point A, X1 and y1 are
produced at a relative price PA for commodity X.
Y
A
y1
PA
0
X1
31
Trade Theory
Economic growth
Extensive growth, no technical progress
Rybczynski theorem Small Country
At an equilibrium point A, X1 and y1 are
produced at a relative price PA for commodity X.
This corresponds to a particular allocation of
labour and capital between commodities X and Y at
an equilibrium price ratio (w/r)A.
0y
K
(w/r)A
y
x
0x
L
Y
A
y1
PA
0
X1
32
Trade Theory
Economic growth
Extensive growth, no technical progress
Rybczynski theorem Small Country
Increase in the endowment of one factor (labour)
expands the Edgeworth box along the L-side and
PPF - along the axis X.
0y
0y
y
K
(w/r)A
y
x
0x
L
Y
A
y1
A
PA
0
x1
X
33
Trade Theory
Economic growth
Extensive growth, no technical progress
Rybczynski theorem Small Country
Increase in the endowment of one factor (labour)
expands the Edgeworth box along the L-side and
PPF - along the axis X. Relative prices for the
commodities remain unchanged. Therefore,
relative capital/labour ratio remains unchanged
(w/r)A
0y
0y
y
K
(w/r)A
y
x
x
0x
L
Y
A
y1
A
PA
PA
0
x1
X
34
Trade Theory
Economic growth
Extensive growth, no technical progress
Rybczynski theorem Small Country
The output of the product X increases. The output
of the product Y decreases.
(w/r)A
0y
0y
y
K
(w/r)A
y
x
x
0x
L
Y
A
y1
A
y2
PA
PA
0
x2
x1
X
35
Trade Theory
Economic growth
Extensive growth, no technical progress
Immiserising Growth Large Country

• Increase in the output of exported commodity by a
  large nation can deteriorate nations welfare.

36
Trade Theory
Economic growth
Immiserising Growth Large Country

• A Large country, at a given production
  possibility and relative price for commodity X
• Produces Xbp of the product X and Ybp of the
  product Y

Y

• Exchanges Xbp-Xec of the product X for Yec-Ybp of
  the product Y
• Consumes Xec of the product X
• and Yec of the product Y.

E
Yec
Ybp
B
Pb
0
Xec
X
Xbp
37
Trade Theory
Economic growth
Immiserising Growth Large Country

• If the production possibility of the commodity X
  increases (corresponding factor endowment
  increases)
• PPF expands along the axis X and becomes flatter
  at the same level of output
• or
• the same level of output of the product X
  becomes relatively cheaper.

Y
E
Yec
Ybp
B
Pb
0
Xec
X
Xbp
38
Trade Theory
Economic growth
Immiserising Growth Large Country
If the production possibility of the commodity X
increases (corresponding factor endowment
increases), at a new equilibrium point the
country Produces Xcpgt Xbp of the product X and
Ycplt Ybp of the product Y (why the output of Y
decreases?)
Y
E
Yec
C
B
Pc
Ybp
Pb
0
Xec
X
Xbp
Xcp
39
Trade Theory
Economic growth
Immiserising Growth Large Country
If the production possibility of the commodity X
increases (corresponding factor endowment
increases), at a new equilibrium consumption
point F, the country consumes XFClt XEC of the
product X and YFClt YEC.
Y
E
Yec
YFC
F
C
Ybp
B
Pc
Pb
0
XFC
Xec
X
Xbp
40
Trade Theory
Economic growth
Technical progress

• Neutral technical progress
• Labour-saving technical progress
• Capital-saving technical progress.

41
Trade Theory
Economic growth
Technical progress
Neutral technical progress

• Increases productivity of labour and capital in
  the same proportion.
• No change in relative prices for factors.
• Equivalent to proportional increase in the
  endowment both factors
• No factor substitution

42
Trade Theory
Economic growth
Technical progress
Labour-saving technical progress

• Increases productivity of capital proportionately
  more than labour.
• Equivalent to increase in capital endowment.
• Capital is substituted for labour.

43
Trade Theory
Economic growth
Technical progress
Capital-saving technical progress

• Increases productivity of labour proportionately
  more than capital.
• Equivalent to increase in capital endowment.
• Labour is substituted for capital.

44
Trade Theory
Economic growth
Neutral technical progress. Small country
Y
E
Yec
B
Ybp
Pb
0
Xec
X
Xbp
45
Trade Theory
Economic growth
Neutral technical progress. Small country
Y
E
Yec
E
Yec
Ybp
B
B
Ybp
Pb
0
Xec
Xec
X
Xbp
Xbp
46
Trade Theory
Economic growth
Neutral technical progress. Small country
Y
E
Yec
E
Yec
Ybp
B
B
Ybp
Pb
0
Xec
Xec
X
Xbp
Xbp
47
Trade Theory
Economic growth
Labour saving technical progress. Small labour
abundant country
Y
E
Yec
B
Ybp
Pb
0
Xec
X
Xbp
48
Trade Theory
Economic growth
Labour saving technical progress. Small labour
abundant country
Y
E
Yec
B
Ybp
Pb
0
Xec
X
Xbp
49
Trade Theory
Economic growth
Capital saving technical progress. Small labour
abundant country
Y
E
Yec
B
Ybp
Pb
0
Xec
X
Xbp
50
Trade Theory
Economic growth
Capital saving technical progress. Small labour
abundant country
Y
E
Yec
B
Ybp
Pb
0
Xec
X
Xbp
51
Heckscher-Ohlin
Stolper-Samuelson
Factor Price Equalisation
Comparative Advantage
Trade Theory Study Guide 1
Rybzcynski
Absolute Advantage
Immiserising Growth
Mercantilism
International Trade and Finance
Balance Of Payments
Foreign Exchange Markets
Non Tariff Barriers
Interest Arbitrage
TradeBlocs
Tariffs
Finance Study Guide 3
Trade Policy Study Guide 2
International Resource Movements
Tools of the Trade Policy Analysis
Exchange rate theorems
52
Reading
Trade Theory
Tools of the Trade Policy Analysis

• Salvatore, Chapter 4,8