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

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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

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The Heckscher-Ohlin Model（ Factor Endowment Theory)

Founder The basic H-O model Testing the H-O model Summary

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H-O Model’s Founder: OhlinBertil Ohlin1899-19791977 Nobel Prize

Winner Wrote between 192

1 and 1949.

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H-O Model’s Founder: Heckscher

ELI FILIP HECKSCHERFamous Swedish

EconomistWrote on Mercantilism,

Swedish History, and International Economics

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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

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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...

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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

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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

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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

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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

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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

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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 )()( **

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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

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Factor IntensiveK

Lr

wSlope

KS /LS

Kc /Lc

Isoquant lineIso-cost line

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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

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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)

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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.

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Numerical example

One country Required inputs per unit of output

Labor Capital

Cloth, Y 4 1

Steel, X 2 3

Endowments 900 600

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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.

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Derivation of PPF Derivation of PPF (two countries)(two countries)

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Graphical Presentation

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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

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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

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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

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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.