Chapter 5 Resources and Trade The Heckscher Ohlin Model Copyright 2012 Pearson Addison Wesley All rights reserved Preview Factor constraints and production possibilities How factor endowments affect output Comparative advantage and trade Changing the mix of inputs How prices of goods affect the incomes of factors Factor price equalization Trade and income distribution Empirical evidence Copyright 2012 Pearson Addison Wesley All rights reserved 5 2 Introduction In addition to differences in labor productivity trade occurs due to differences in resources across countries The Heckscher Ohlin theory argues that trade occurs due to differences in labor labor skills physical capital capital or other factors of production across countries Countries have different relative abundance of factors of production Production processes use factors of production with different relative intensity Copyright 2012 Pearson Addison Wesley All rights reserved 5 3 Two Factor Heckscher Ohlin Model 1 2 3 4 5 Two countries home and foreign Two goods cloth and food Two factors of production labor and capital Mix of labor and capital used varies across goods The supply of labor and capital in each country is constant and varies across countries 6 Both labor and capital can move across sectors equalizing their returns wage and rental rate across sectors 7 Countries have the same technology and the same consumer tastes Copyright 2012 Pearson Addison Wesley All rights reserved 5 4 Production Possibilities Fixed mix of capital and labor in each sector To produce one yard of cloth need aKC 2 capital AND aLC 2 labor To produce one pound of food need aKF 3 capital AND aLF 1 labor Fixed amount of capital and labor available for production in each country K 3 000 units of capital and L 2 000 hours of labor available for production in home country K 4 000 and L 2 000 available for production in foreign country Copyright 2012 Pearson Addison Wesley All rights reserved 5 5 Production Possibilities Relative Factor Intensity Cloth production is labor intensive relative to food production if cloth production uses more labor for each unit of capital than food production 1 2 aLC aLF 1 2 aKC aKF 3 In the example cloth uses one hour of labor for every unit of capital while food uses 1 3 hour of labor for every unit of capital in production Copyright 2012 Pearson Addison Wesley All rights reserved 5 6 Production Possibilities Implies that food production uses capital relatively intensively 3 3 aKF aKC 2 1 1 aLF aLC 2 So each factor is used relatively intensively in the production of a good and each good uses a factor relatively intensively no ties 5 7 Copyright 2012 Pearson Addison Wesley All rights reserved Production Possibilities Production possibilities are influenced by both capital and labor aKCQC aKFQF K Capital used for each yard of cloth production Total yards of cloth production Capital used for each pound of food production aLCQC aLFQF L Labor used for each yard of cloth production Copyright 2012 Pearson Addison Wesley All rights reserved Total amount of capital Total pounds of food production Total amount of labor Labor required for each pound of food production 5 8 Production Possibilities Slope intercept formats Capital QF K a KC QC aKF aKF QF L a LC QC aLF aLF Labor Labor constraint steeper than capital constraint because cloth is relatively labor intensive Copyright 2012 Pearson Addison Wesley All rights reserved 5 9 Production Possibilities Endpoints of capital and labor constraints Cloth endpoints have enough capital to produce 1 500 yards of cloth but only enough labor to produce 1 000 yards K L 3 000 2 000 1 500 1 000 aKC aLC 2 2 Food endpoints have enough labor to produce 2 000 pounds of food but only enough capital to produce 1 000 pounds K L 3 000 2 000 1 000 2 000 aKF aLF 3 1 Copyright 2012 Pearson Addison Wesley All rights reserved 5 10 Production Possibilities Max food production 1000 point 1 fully uses capital with excess labor Max cloth 1000 point 2 fully uses labor with excess capital Intersection of labor and capital constraints occurs at 500 pounds of food and 750 yards of cloth point 3 Copyright 2012 Pearson Addison Wesley All rights reserved 5 11 Production Possibilities Economy produces subject to both constraints must have enough capital and labor Production possibilities frontier Production possibilities are the interior of the factor constraints Equilibrium production A country produces at the intersection of the capital and labor constraints if its factors are fully employed Copyright 2012 Pearson Addison Wesley All rights reserved 5 12 Fig 5 1 The Production Possibility Frontier Without Factor Substitution Copyright 2012 Pearson Addison Wesley All rights reserved 5 13 Production Possibilities With more than one factor of production the opportunity cost is no longer constant and the PPF is no longer a straight line The opportunity cost of producing one more yard of cloth is low 2 3 in example when the economy produces a low amount of cloth and a high amount of food high 2 in example when the economy produces a high amount of cloth and a low amount of food When the economy devotes more resources towards production of one good the marginal productivity of those resources tends to be low so that the opportunity cost is high Copyright 2012 Pearson Addison Wesley All rights reserved 5 14 Example 5 1 Factors and Output Suppose 2 hours labor and 2 units capital required to produce 1 yard of cloth while 1 hour labor and 3 units capital required to produce 1 pound of food The United States has 2 000 labor and 3 000 capital Copyright 2012 Pearson Addison Wesley All rights reserved 5 15 Example 5 1 Factors and Output What is the U S labor constraint aLCQC aLFQF L 2QC QF 2000 QF 2000 2QC Copyright 2012 Pearson Addison Wesley All rights reserved 5 16 Example 5 1 Factors and Output What is the U S capital constraint aKCQC aKFQF K 2QC 3QF 3000 2 QF 1000 QC 3 5 17 Copyright 2012 Pearson Addison Wesley All rights reserved Example 5 1 Factors and Output What production bundle fully employs both factors 2 2000 2QC 1000 QC 3 2 2 QC 2000 1000 3 4 QC 1000 3 QC 750 Copyright 2012 Pearson Addison Wesley All rights reserved Q F 2000 2QC Q F 2000 2 750 Q F 2000 1500 Q F 500 5 18 Example 5 1 Factors and Output 2000 Pounds of food Labor 1000 500 Capital 0 0 750 1000 1500 2000 Yards of cloth Copyright 2012 Pearson Addison Wesley All rights reserved 5 19 Exercise 5 1 US Output In either country producing one yard of