Resources, Comparative

Advantage and Income

Distribution
 Introduction
• If labour were the only factor of production, as the Ricardian model assumes,
comparative advantage could arise only because of international differences
in labour productivity. In the real world, however, while trade is partly
explained by differences in labour productivity, it also reflects differences in
countries’ resources.
• Thus a realistic view of trade must allow for the importance not just of
labour, but also of other factors of production such as land, capital, and
mineral resources.
• To explain the role of resource differences in trade, we examine a model in
which resource differences are the only source of trade. This model shows
that comparative advantage is influenced by the interaction between
nations’ resources (the relative abundance of factors of production) and the
technology of production (which influences the relative intensity with which
different factors of production are used in the production of different goods).
• That international trade is largely driven by differences in countries’
resources is one of the most influential theories in international
economics. Developed by two Swedish economists, Eli Heckscher and
Bertil Ohlin (Ohlin received the Nobel Prize in economics in 1977), the
theory is often referred to as the Heckscher-Ohlin theory.
• Because the theory emphasizes the interplay between the
proportions in which different factors of production are available in
different countries and the proportions in which they are used in
producing different goods, it is also referred to as the factor-
proportions theory.
 Model of a two factor economy
• The simplest version of the factor-proportions model, sometimes referred
to as “2 by 2 by 2”: two countries, two goods, two factors of production.
The two countries Home and Foreign, produce the same two goods, cloth
(measured in metres) and food (measured in calories).
• Both cloth and food are produced using capital and labour. The amount of
each good produced, given how much capital and labour are employed in
each sector, is determined by a production function for each good. Overall,
the economy has a fixed supply of capital K and labour L that is divided
between employment in the two sectors
QC= QC(KC,LC)
QF=QF(KF,LF)
• The following expressions that are related to the two production
technologies
aKC = capital (machine hours) used to produce one metre of cloth
aLC = hours of labour used to produce one metre of cloth
aKF = capital (machine hours) used to produce one calorie of food
aLF = hours of labour used to produce one calorie of food
• These unit input requirements are very similar to the ones defined in
the Ricardian model (for labour only). However, there is one crucial
difference: In these definitions, we speak of the quantity of capital or
labor used to produce a given amount of cloth or food, rather than the
quantity required to produce that amount.
• Production possibilities are influenced by both land and capital
(requirements):
aKFQF + aKCQC ≤ K
aLFQF + aLCQC ≤ L
• Let’s assume that each unit of food production uses capital intensively and
each unit of cloth production uses labour intensively
aKF /aLF > aKC /aLC or aKC /aKF < aLC /aLF
• Or, we consider the total resources used in each industry and say that cloth
production is labour intensive and food production is capital intensive if
KF /LF > KC /LC
• This assumption influences the slope of the production possibility frontier.
• Consider the following numerical example: Production of one metre of
cloth requires a combination of two work-hours and two machine-
hours. The production of food is more automated; as a result,
production of one calorie of food requires only one work-hour along
with three machine-hours. Thus all input requirements are fixed and
factor substitution is not possible aKC = 2; aLC = 2; aKF = 3; aLF = 1;
• The respective resource constraints are given by:
2QC + 3QF < 3,000 (total K)
2QC + QF < 2,000 (total L)
PPF without factor substitution
• Each resource constraint is drawn in the same way that we drew the
production possibility line for the Ricardian case. In this case, however, the
economy must produce subject to both constraints. So the production
possibility frontier is the kinked line shown in red.
• The important feature of this production possibility frontier is that the
opportunity cost of producing an extra metre of cloth in terms of food is
not constant. When the economy is producing mostly food (to the left of
point 3), then there is spare labour capacity. Producing two fewer units of
food releases six machine-hours that can be used to produce three metres
of cloth: The opportunity cost of cloth is 2/3.
• When the economy is producing mostly cloth (to the right of point 3), then
there is spare capital capacity. Producing two fewer units of food releases
two work-hours that can be used to produce one metre of cloth: The
opportunity cost of cloth is 2. Thus, the opportunity cost of cloth is higher
when more units of cloth are being produced.
• Now let’s make the model more realistic and allow the possibility of
substituting capital for labour and vice versa in production. This
substitution removes the kink in the production possibility frontier;
instead, the frontier PP has the bowed shape.
 Production and Prices
• The production possibility frontier describes what an economy can
produce, but to determine what the economy does produce, we must
determine the prices of goods.
• In general, the economy should produce at the point that maximizes
the value of production, V:
V = PCQC + PFQF
where PC is the price of cloth and PF is the price of food.
• Define an isovalue line as a line representing a constant value of
production. 𝑉 = PCQC + PFQF
PF QF = 𝑉 − PC QC
• After rearranging we get that the slope of an isovalue line is –PC/PF
• Given prices of output, one isovalue line represents the maximum
value of production, say at a point Q.
• At that point, the slope of the PPF equals – (PC/PF), so the opportunity
cost of cloth equals the relative price of cloth.
 Choosing the mix of inputs
• In a two-factor model producers may have room for choice in the use
of inputs. A farmer, for example, can choose between using relatively
more mechanized equipment (capital) and fewer workers, or vice
versa.
• What input choice will producers actually make? It depends on the
relative costs of capital and labour. If capital rental rates are high and
wages low, farmers will choose to produce using relatively little
capital and a lot of labour; on the other hand, if the rental rates are
low and wages high, they will save on labour and use a lot more
capital.
Isoquants
Factor prices and input choices
In each sector, the ratio of labour to
capital used in production depends
on the cost of labour relative to the
cost of capital, w/r . The curve FF
shows the labour-capital ratio
choices in food production, while the
curve CC shows the corresponding
choices in cloth production.
At any given wage-rental ratio, cloth
production uses a higher labour-
capital ratio; when this is the case,
we say that cloth production is
labour-intensive and that food
production is capital-intensive.
• The CC and FF curves are called relative factor demand curves; they
are very similar to the relative demand curve for goods. Their
downward slope characterizes the substitution effect in the producers’
factor demand. As the wage w rises relative to the rental rate r,
producers substitute capital for labour in their production decisions.
• The previous case we considered with no factor substitution is a
limiting case, where the relative demand curve is a vertical line: The
ratio of labour to capital demanded is fixed and does not vary with
changes in the wage-rental ratio w/r.
 Factor prices and Goods Prices
• The cost of producing a good depends on factor prices: If wages rise, then
other things equal, the price of any good whose production uses labour
will also rise.
• The importance of a particular factor’s price to the cost of producing a
good depends, however, on how much of that factor the good’s production
involves. If food production makes use of very little labour, for example,
then a rise in the wage will not have much effect on the price of food,
whereas if cloth production uses a great deal of labour, a rise in the wage
will have a large effect on the price.
• We can therefore conclude that there is a one-to-one relationship between
the ratio of the wage rate to the rental rate, w/r, and the ratio of the price
of cloth to that of food, PC/PF
Stolper-Samuelson theorem: if
the relative price of a good
increases, then the real wage or
rate of return of the factor used
intensively in the production of
that good increases, while the real
wage or rate of return of the other
factor decreases.
From goods prices to input choices
• The left panel in the previous figure shows the SS curve turned
counterclockwise 90 degrees, while the right panel shows factor
prices and input choices. By putting these two diagrams together, we
see what may seem at first to be a surprising linkage of the prices of
goods to the ratio of labour to capital used in the production of each
good.
• If the relative price of cloth were to rise to the level indicated by
(PC/PF)2 the ratio of the wage rate to the capital rental rate would rise
to (w/r)2 . Because labour is now relatively more expensive, the ratios
of labour to capital employed in the production of cloth and food
would therefore drop to (LC/KC)2 and (LF/KF)2
• An increase in the price of cloth relative to that of food will raise the
income of workers relative to that of capital owners. But it is possible
to make a stronger statement: Such a change in relative prices will
unambiguously raise the purchasing power of workers and lower the
purchasing power of capital owners by raising real wages and
lowering real rents in terms of both goods.
 Resources and Output
• We investigate how changes in resources (the total supply of a factor)
affect the allocation of factors across sectors and the associated changes in
output produced.
• A given relative price of cloth, say (PC/PF)1 , is associated with a fixed wage-
rental ratio (w/r)1 (so long as both cloth and food are produced). That ratio,
in turn, determines the ratios of labour to capital employed, in both the
cloth and the food sectors: (LC/KC)1 and (LF/KF)1, respectively.
• Now we assume that the economy’s labour force grows, which implies that
the economy’s aggregate labour to capital ratio, L/K , increases. How can
the economy accommodate the increase in the aggregate relative supply of
labour if the relative labour demanded in each sector remains constant?
• The labour-capital ratio in the cloth sector is higher than that in the
food sector, so the economy can increase the employment of labour
to capital (holding the labour-capital ratio fixed in each sector) by
allocating more labour and capital to the production of cloth (which
is labour-intensive). As labour and capital move from the food sector
to the cloth sector, the economy produces more cloth and less food.
• The economy can produce more of both cloth and food than before.
The outward shift of the frontier is, however, much larger in the
direction of cloth than of food—that is, there is a biased expansion of
production possibilities, which occurs when the production
possibility frontier shifts out much more in one direction than in the
other.
• The biased effect of increases in resources on production possibilities
is the key to understanding how differences in resources give rise to
international trade. An increase in the supply of labour expands
production possibilities disproportionately in the direction of cloth
production, while an increase in the supply of capital expands them
disproportionately in the direction of food production.
• An economy with a high relative supply of labour to capital will be
relatively better at producing cloth than an economy with a low
relative supply of labour to capital. Generally, an economy will tend to
be relatively effective at producing goods that are intensive in the
factors with which the country is relatively well endowed.
 Relative Prices and Pattern of trade
• Since Home has a higher ratio of labour to capital than Foreign, Home is
labour-abundant and Foreign is capital-abundant. Note that abundance is
defined in terms of a ratio and not in absolute quantities.
• Since cloth is the labour-intensive good, Home’s production possibility
frontier relative to Foreign’s is shifted out more in the direction of cloth
than in the direction of food. Thus, other things equal, Home tends to
produce a higher ratio of cloth to food.
• Because trade leads to a convergence of relative prices, one of the other
things that will be equal is the price of cloth relative to that of food.
Because the countries differ in their factor abundances, however, for any
given ratio of the price of cloth to that of food, Home will produce a higher
ratio of cloth to food than Foreign will: Home will have a larger relative
supply of cloth.
• The relative supply schedules of Home (RS) and Foreign (RS*). The
relative demand curve, which we have assumed to be the same for
both countries, is shown as RD. If there were no international trade,
the equilibrium for Home would be at point 1, while the equilibrium
for Foreign would be at point 3. That is, in the absence of trade, the
relative price of cloth would be lower in Home than in Foreign.
• When Home and Foreign trade with each other, their relative prices
converge. The relative price of cloth rises in Home and declines in
Foreign, and a new world relative price of cloth is established at a
point somewhere between the pre-trade relative prices, say at point
2.
Trade leads to convergence of prices
• Home becomes an exporter of cloth because it is labour-abundant
(relative to Foreign) and because the production of cloth is skill-
intensive (relative to food production). Similarly, Foreign becomes an
exporter of food because it is capital-abundant and because the
production of food is capital-intensive.
• These predictions for the pattern of trade (in the two-good, two-
factor, two-countries version that we have studied) can be generalized
as the following theorem, named after the original developers of this
model of trade:
• Hecksher-Ohlin Theorem: The country that is abundant in a factor
exports the good whose production is intensive in that factor.
• In the more realistic case with multiple countries, factors of
production, and numbers of goods, we can generalize this result as a
correlation between a country’s abundance in a factor and its exports
of goods that use that factor intensively: Countries tend to export
goods whose production is intensive in factors with which the
countries are abundantly endowed.
 Trade and distribution of income
• Changes in relative prices, in turn, have strong effects on the relative
earnings of labour and capital. A rise in the price of cloth raises the
purchasing power of labour in terms of both goods while lowering the
purchasing power of capital in terms of both goods. A rise in the price
of food has the reverse effect.
• Thus international trade can have a powerful effect on the
distribution of income, even in the long run. In Home, where the
relative price of cloth rises, people who get their incomes from labour
gain from trade, but those who derive their incomes from capital are
made worse off. In Foreign, where the relative price of cloth falls, the
opposite happens: Labourers are made worse off and capital owners
are made better off.
• The resource of which a country has a relatively large supply (labour in
Home, capital in Foreign) is the abundant factor in that country, and the
resource of which it has a relatively small supply (capital in Home, labour in
Foreign) is the scarce factor.
• The general conclusion about the income distribution effects of
international trade in the long run is: Owners of a country’s abundant
factors gain from trade, but owners of a country’s scarce factors lose.
• Thus income distribution effects that arise because labour and other
factors of production are immobile represent a temporary, transitional
problem (which is not to say that such effects are not painful to those who
lose). In contrast, effects of trade on the distribution of income among
land, labour, and capital are more or less permanent.
Increased Wage Inequality: Trade or Skill-
Biased Technological Change?
• The LL and HH curves show the skilled-unskilled employment ratio, SL/UL , as
a function of the skilled-unskilled wage ratio, ws/wu, in the low-tech and
high-tech sectors. The high-tech sector is more skill-intensive than the low
tech sector, so the HH curve is shifted out relative to the LL curve. Panel (a)
shows the case where increased trade with developing countries leads to a
higher skilled-unskilled wage ratio. Producers in both sectors respond by
decreasing their relative employment of skilled workers: and both decrease.
• Panel (b) shows the case where skill-biased technological change leads to a
higher skilled-unskilled wage ratio. The LL and HH curves shift out (increased
relative demand for skilled workers in both sectors). However, in this case
producers in both sectors respond by increasing their relative employment
of skilled workers: SL /UL and SH/UH both increase.
• We can examine the relative merits of the trade versus skill-biased
technological change explanations for the increase in wage inequality
by looking at the changes in the skilled-unskilled employment ratio
within sectors in the United States. A widespread increase in these
employment ratios for all different kinds of sectors (both skilled-
labour-intensive and unskilled-labour-intensive sectors) in the U.S.
economy points to the skill-biased technological explanation.
 Factor price Equalization
• When Home and Foreign trade, the relative prices of goods converge.
This convergence, in turn, causes convergence of the relative prices of
capital and labor. Thus there is clearly a tendency toward equalization
of factor prices.
• Although Home has a higher ratio of labour to capital than Foreign
does, once they trade with each other, the wage rate and the capital
rent rate are the same in both countries. Given the prices of cloth and
food, we can determine the wage rate and the rental rate without
reference to the supplies of capital and labor.
• If Home and Foreign face the same relative prices of cloth and food,
they will also have the same factor prices.
• To understand how this equalization occurs, we have to realize that
when Home and Foreign trade with each other, more is happening
than a simple exchange of goods. In an indirect way, the two
countries are in effect trading factors of production.
• Home lets Foreign have the use of some of its abundant labour, not by
selling the labor directly but by trading goods produced with a high
ratio of labour to capital for goods produced with a low labour-capital
ratio. The goods that Home sells require more labour to produce than
the goods it receives in return; that is, more labour is embodied in
Home’s exports than in its imports.
• Thus Home exports its labour, embodied in its labour-intensive
exports. Conversely, since Foreign’s exports embody more capital than
its imports, Foreign is indirectly exporting its capital.
• In the real world, factor prices are not equalized. For example, there is
an extremely wide range of wage rates across countries. While some
of these differences may reflect differences in the quality of labor,
they are too wide to be explained away on this basis alone.
• To understand why the model doesn’t give us an accurate prediction,
we need to look at its assumptions. Three assumptions crucial to the
prediction of factor-price equalization are in reality certainly untrue.
These are the assumptions that (1) both countries produce both
goods; (2) technologies are the same; and (3) trade actually equalizes
the prices of goods in the two countries.
 Empirical evidence
• One would expect the United States to be an exporter of capital-
intensive goods and an importer of labor-intensive goods.
Surprisingly, however, this was not the case in the 25 years after
World War II. In a famous study published in 1953, economist Wassily
Leontief (winner of the Nobel Prize in 1973) found that U.S. exports
were less capital-intensive than U.S. imports. This result is known as
the Leontief paradox.
United States may be exporting goods that heavily use skilled labour
and innovative entrepreneurship, while importing heavy
manufactures (such as automobiles) that use large amounts of
capital.
• Bowen et al. calculated the ratio of each country’s endowment of
each factor to the world supply of that factor. They then compared
these ratios with each country’s share of world income. If the factor-
proportions theory was right, a country would always export factors
for which the factor share exceeded the income share, and import
factors for which it was less.
• This result confirms the Leontief paradox on a broader level: Trade
often does not run in the direction that the Heckscher-Ohlin theory
predicts. As with the Leontief paradox for the United States,
explanations for this result have centered on the failure of the
common technology assumption.
• Consider the United States, on one side, and China on the other. In 2008, the
United States had about 23 percent of world income but only about 5
percent of the world’s workers; so a simple factor-proportions theory would
suggest that U.S. imports of labor embodied in trade should have been huge,
something like four times as large as the nation’s own labor force. In fact,
calculations of the factor content of U.S. trade showed only small net
imports of labor.
• Conversely, China had 7 percent of world income but approximately 20
percent of the world’s workers in 2008; it therefore “should” have exported
most of its labour via trade—but it did not.
• Allowing for technology differences also helps to resolve this puzzle of
“missing trade.” The way this resolution works is roughly as follows: If
workers in the United States are much more efficient than those in China,
then the “effective” labour supply in the United States is much larger
compared with that of China than the raw data suggest.
 Patterns of exports between developed and
developing countries
• Although the overall pattern of international trade does not seem to
be very well accounted for by a pure Heckscher-Ohlin model,
comparisons of the exports of labour-abundant, skill scarce nations in
the third world with the exports of skill-abundant, labour-scarce
nations do fit the theory quite well.
• Consider the following figure, which compares the pattern of U.S.
imports from Bangladesh, whose work force has low levels of
education, with the pattern of U.S. imports from Germany, which has
a highly educated labour force.
Skill intensity and pattern of US imports
 Conclusion
• The empirical testing of the Heckscher-Ohlin model has produced mixed
results. The factor content of a country’s exports does not always reflect
that country’s abundant factors; and the volume of trade is substantially
lower than what would be predicted based on the large differences in
factor abundance between countries. However, the pattern of goods trade
between developed and developing countries fits the predictions of the
model quite well.
• The Heckscher-Ohlin also remains vital for understanding the effects of
trade, especially its effects on the distribution of income. Indeed, the
growth of North-South trade in manufactures—a trade in which the factor
intensity of the North’s imports is very different from that of its exports—
has brought the factor-proportions approach into the center of practical
debates over international trade policy.