UMD ECON 340 - Chapter 3 SOURCES OF COMPARATIVE ADVANTAGE

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Chapter 3SOURCESOFCOMPARATIVEADVANTAGEpp.66-74Heckscher-Ohlin Theory• Ricardian model: comparative advantage could only arise because of international differences in labor productivity• What are the determinants of comparative advantage?• What are the effects of international trade on the earnings of different factors of production?Factor Endowments• Factor-Endowment (Heckscher-Ohlin) Theory – Explains comparative advantage by differences in relative national supply conditions– Key determinant: Relative resource endowments – Assumptions: • Perfect competition• Same demand conditions• Uniform quality factor inputs • Same technology used across countries but different across sectorsFactor-Endowment Theory• Relative price levels differ among nations because:– Nations have different relative endowments of factor inputs– Different commodities require factor inputs with differing intensities for production• Example: Hypothetical resource endowments in the U.S. and China that are used in the production of aircraft and textiles (Table 3.1)• Capital/labor ratios for selected countries (Table 3.2)BackBackFactor-Endowment Theory• Since the US has relatively more capital than China, capital would be relatively cheaper in the US before trade.The US will have a lower opportunity cost in the production of aircrafts, which are more capital intensive• Similarly, labor would be relatively cheaper in China before trade. China will have a lower opportunity cost in the production of textiles.Factor-Endowment Theory• We say that:– US: capital-abundant country– China: labor-abundant country• Heckscher-Ohlin theory: the US has the comparative advantage in the production of the commodity that is capital intensive (aircraft) and China has the comparative advantage in the production of the labor intensive commodity (textiles), and hence, US will export the capital intensive commodity, and China, on the other hand, will export the labor intensive commodity.Factor-Price Equalization• Suppose that there are no import restrictions (tariffs, quotas, etc) and that transportation costs are negligible. International trade will equalize commodity prices.• What will happen to factor prices? – Trade will expand output in its comparative-advantage industry (that is intensive in the abundant factor). Thus, trade will redirect demand away from the scarce factor toward the abundant factor. As the demand for the abundant factor increases, its price will rise.– Scarce factor: release from the comparative-disadvantage industry, and its price falls.– Cheap factor becomes more expensive; expensive factor becomes cheaper– This process occurs in both countries, and therefore trade in goods leads to an equalization of the relative factor prices across countriesFactor-Price EqualizationWhy don’t we observe that, say, wages in Mexico are not the same as the wages in the US?Answer:Not fully possible in the real world:• Income inequality across countries might reflect differences of human capital• Technology usage not identical • Transportation costs and trade barriers– Indexes of hourly compensation (Table 3.3)BackA formal treatment of the H-O Model• H-O model: relative resource differences explain why do countries trade• Consider a two-factor (labor and capital), two-country (Home and Foreign), two-good economy (food and cloth)• Ricardian model:– Countries have different opportunity costs due to differences in technology, and thus, differences in relative productivities will give a reason to trade– Why are we a little dissatisfied with this explanation?• Theory predicts complete specialization (can be fixed though, with increasing –and not constant-opportunity cost• If relative productivity in Home and Foreign the same: countries do not gain from tradeA formal treatment of the H-O Model• Assumptions:1. Two goods: food (F) and clothing (C)2. Two factors of production: Labor (L) and Capital (C)– Substitutes in production– Mobile between sectors3. Fixed endowments of labor and capital, these endowments differ between countries4. Perfect competition: firms’ profits will be zero, and price equals marginal cost5. Technology is the same for both countries, but differs across sectorsA formal treatment of the H-O Model• Notation for country A:– F, C: denotes food and clothing, respectively– , :endowments of capital and labor in country A– :rental price of capital in country A– : wage rate in country A– : autarky prices of food and clothing in A– : total labor used in each sector– : total amount of capital used in each sectorNote: change A for B for country BA formal treatment of the H-O ModelAKALArAw,AAFCPP,AAFCLL,AAFCKK• Abundance of a factor:– We say that country A is labor abundant relative to country B if:– We say that country A is capital abundant relative to country B if:A formal treatment of the H-O ModelABABLLKK>,AB BAAB BALLKKorKKLL<<• Sector/Industry factor usage intensity:– The clothing sector is labor intensive relative to the food sector if:– The clothing sector is capital intensive relative to the food sector if:A formal treatment of the H-O ModelAACFAACFLLKK>AACFAACFLLKK<• For this particular example, assume that:– A is labor abundant (and thus, B is capital abundant);– C is labor intensive (and thus, F is capital intensive)A formal treatment of the H-O ModelA formal treatment of the H-O Model• Since we have two factors of production, we have two resource constraints (one in land and the other in labor). For country A, we have (change superscripts for B):AAAFCAAAFCLLLKKK=+=+A formal treatment of the H-O Model• Review of ECON 200:– Production function: maximum output you can produce given a certain amount of inputs– From the production function, it is possible to derive the isoquants (alternative combinations of inputs that will give you the same amount of output)– 2 units of capital and 2 units of labor will give you 10 units of clothing. 1 unit of capital and 3 units of labor will also give you 10 units of clothingSlope = ∆ KAF/∆ LAF=MRTSAFKAFLAFA formal treatment of the H-O ModelFA=15FA=101223A formal treatment of the H-O Model• Review of ECON 200:– Isocost line: represents all possible combinations of capital and labor that a firm can use for a total cost of C, taking factor prices as given.• For a firm in the food sector, we have that:AAAAFFCwL rK=+KAFLAFA formal treatment


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UMD ECON 340 - Chapter 3 SOURCES OF COMPARATIVE ADVANTAGE

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