ECW3121 International Trade and Finance Lecture 3

1
ECW3121International Trade and FinanceLecture 3
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
Heckscher-Ohlin
Stolper-Samuelson
Factor Price Equalisation
Comparative Advantage
Trade Theory Study Guide 1 Weeks 1-5
Last Lecture
Trade Theory Study Guide 1
Rybzcynski
Absolute Advantage
Immiserising Growth
Mercantilism
4
Heckscher-Ohlin
Stolper-Samuelson
This week
Comparative Advantage
Factor Price Equalisation
Trade Theory Study Guide 1 Weeks 1-5
Trade Theory Study Guide 1
Rybzcynski
Absolute Advantage
Immiserising Growth
Mercantilism
5
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
• 2x2x1 or 2x2x2

6
Trade Theory
Why do Nations Trade?

• Mercantilism - zero sum game - one nation gains
  at the expense of the other.
• Absolute Advantage - each nation should
  specialise in production of the good which it is
  most efficient at producing.
• Comparative advantage - A nation should
  specialise in the good in which it enjoys a
  comparative advantage.
• Fixed costs - complete specialisation
• Variable costs - incomplete specialisation

7
Trade Theory
Comparative Advantage
Why do Nations Trade?
To increase in welfare of nations
What are the gains from trade?
Increase in consumption of both (all) tradables
Who gains from trade?
Both (all) nations participating in trade
8
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

9
Reminder Production Possibility Frontier
Trade Theory
Comparative Advantage
Increasing cost PPF
x
x
Y
Y
Variable (increasing) opportunity cost
Constant opportunity cost
10
Trade Theory
Comparative Advantage
Specialisation
Increasing cost PPF
Televisions
Pw Pt
(Singapore)
Singapore
Pw Pt
(Australia)
Australia
0
Wine
11
Trade Theory
Comparative Advantage
Free trade
Increasing cost PPF
Televisions
Singapore
C
Pw/Pt (Singapore)
Pw/Pt (Australia)

C
Australia
0
Wine
12
Trade Theory
Comparative Advantage
Free trade
Increasing cost PPF
Televisions
Pw/Pt (Singapore) Pw/Pt (Australia)
Australia - Free Trade
Produces Te of televisions We of
wine. Exchanges We - Wec of wine for Tec -
Te of televisions Increase in production We -
Wa of wine Decrease in production Te - Ta of
televisions Increase in consumption Tec - Ta
of televisions Wec - Wa of wine
Australia - Autarky
Produces and consumes Ta of televisions Wa
of wine
Eec
Tec
A
Ta
E
Te
Wa
Wec
0
Wine
We
13
Trade Theory
Comparative Advantage
Free trade
Increasing cost PPF
Televisions
Pw/Pt (Singapore) Pw/Pt (Australia)
Singapore - Free Trade
Produces Te of televisions We of
wine. Exchanges Te - Tec of televisions for Wec
- We of wine Increase in production Te - Ta of
televisions Decrease in production We - Wa of
wine Increase in consumption Tec - Ta of
televisions Wec - Wa of wine
E
Te
Singapore - Autarky
Produces and consumes Ta of televisions Wa
of wine
Tec
Eec
A
Ta
Wa
We
Wec
0
Wine
14
Trade Theory
Heckscher-Ohlin theorem
Reminder Isoquants, Isocosts, Equilibrium
K
Isoquant - Various combinations
of factors K and L that a firm can use to
produce a specific level of
output
Isocost
- Various amounts of K and L that a firm
can hire with a given total outlay
Isocost
Isoquant
0
L
15
Trade Theory
Heckscher-Ohlin theorem
Reminder Isoquants, Isocosts, Equilibrium
K
Producers equilibrium points when
she maxi- mises output for a given
cost outlay.
Isocost
Equilibrium
Isoquant
0
L
16
Trade Theory
Heckscher-Ohlin theorem
Reminder Isoquants, Isocosts, Equilibrium
Slope of Isocost Rise / Run Amount of Capital
/ Amount of Labour
K
Amount of Capital Budget / r Amount of Labour
Budget / w
Budget / r
Budget w r
Slope of Isocost


x
Budget / w
Budget
Isocost

0
L
17
Trade Theory
Heckscher-Ohlin theorem
Reminder Isoquants, Isocosts, Equilibrium
K
A? B MRTS change K/change L MPL/MPK
A
B
Isoquant
0
L
18
Trade Theory
Heckscher-Ohlin theorem
Reminder Isoquants, Isocosts, Equilibrium
A? B MRTS change K/change L MPL/MPK
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Trade Theory
Heckscher-Ohlin theorem
Reminder Isoquants, Isocosts, Equilibrium
Slope of Isocost w/r Slope of Isoquant
MRTS Therefore w/r MRTS in equilibrium
K
Isocost
Isoquant
0
L
20
Trade Theory
Heckscher-Ohlin theorem
Reminder Isoquants, Isocosts, Equilibrium
K
K/L Ratios
w/r ratios
Q4
Q3
Q2
Q1
0
L
21
Main 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.

22
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.

23
Assumptions
Trade Theory
Heckscher-Ohlin theorem

• As for the standard theory of trade, and
• Two factors - labour and capital
• Isoquants are homothetic.
• Homothetic isoquants have the same slope along
  any given capital / labour ratio.
• If the proportion of capital and labour remains
  the same, so will the MRTS.

24
Trade Theory
Derivation of the Edgeworth Box Diagram
Heckscher-Ohlin theorem
130X
50X
95x
K
O
x
L
Factor diagram for the product X.
- isoquants for the product X
25
Trade Theory
Derivation of the Edgeworth Box Diagram
Heckscher-Ohlin theorem
60Y
K
Factor diagram for the product Y.
45Y
- isoquants for the product Y
20Y
Y
O
O
L
26
Trade Theory
Derivation of the Edgeworth Box Diagram
Heckscher-Ohlin theorem
L
L
O
O
Y
Factor diagram for the product Y.
20Y
45Y
- isoquants for the product Y
K
60Y
27
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
28
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
29
Trade Theory
Derivation of the Edgeworth Box Diagram
Heckscher-Ohlin theorem
L
L
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
The contract curve of Nation 1 - Efficient
combinations of factors and products Eficient
means the factors are fully utilised.
Factor diagram for the product X.
- isoquants for the product X
30
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 -
efficient points
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
X
50X
95x
130X
31
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
32
Trade Theory
Derivation of the Edgeworth Box Diagram
Heckscher-Ohlin theorem
L
L
L
L
L
L
O
Y
Y
Edgeworth Box Diagram for Nation 2 Nation 2 has
a relative abundance of K compare with Nation 1.

K
80X
40Y
40
(A)
65x
A
K
85Y
85
F
40X
(F)
120Y
120
(B)
B
L
O
x
65
80
40
x
(B)
(F)
(A)
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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
34
Factor Abundance
Trade Theory
Heckscher-Ohlin theorem
Need to Compare Two Nations
0Y
L
K
Labour Abundant
K
0X
L
35
Factor Intensity
Trade Theory
Heckscher-Ohlin theorem

• Factor Intensity refers to the proportion of each
  factor used in the production of the goods.
• Good X is labour intensive if it uses more labour
  per unit of capital than Good Y.

36
Trade Theory
Heckscher-Ohlin theorem
Edgeworth Box Diagram for Nation 1
L
O
Y

• Labour Abundant
• Has comparative advantage in producing labour
  intensive good X
• Good X requires more labour per unit of capital
  than Good Y.

130X
20Y
50X
G
95x
B
45Y
K
F
K
60Y
A
O
x
L
Y
A
60Y
F
45Y
B
G
20Y
X
0
130X
50X
95x
37
Trade Theory
Heckscher-Ohlin theorem
Edgeworth Box Diagram for Nation 2
L
L
L
L

• Capital abundant
• Has comparative advantage in producing the
  capital intensive good Y
• Good Y requires more more capital per unit of
  labour than Good X.

38
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
39
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

40
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.

41
Trade Theory
Stolper- Samuelson theorem
O
L
L
L
Y
Nation 2
K
A
K
L
O
Y
F
B
Nation 1
B
F
A
K
L
Ox
42
Trade Theory
Stolper- Samuelson theorem
O
L
L
L
Y
Nation 2
K
A
K
L
O
F
Y
B
Nation 1
F
B
K
A
L
Ox
43
Trade Theory
Stolper- Samuelson theorem
O
L
L
L
Y
Nation 2
K
A
K
L
O
Y
F
B
Nation 1
B
F
K
A
L
Ox
44
Trade Theory
Stolper- Samuelson theorem
L
O
Y
Nation 1
K
K
A
Ox
L
45
Trade Theory
Stolper- Samuelson theorem
Ly
O
Y
Nation 1
A
Kx
Ky
Ox
Lx
46
Trade Theory
Stolper- Samuelson theorem
Ly
O
Y
Nation 1
A
Kx
Ky
Ox
Lx
47
Trade Theory
Stolper- Samuelson theorem
Ly
O
Y
Nation 1
A
Kx
Ky
Ox
Lx
48
Trade Theory
Stolper- Samuelson theorem
L
O
Y
Nation 1
K
K/L
K
A
Ox
L
49
Trade Theory
Stolper- Samuelson theorem
L
O
Y
Nation 1
K
F
K
A
Ox
L
50
Trade Theory
Stolper- Samuelson theorem
LyA
O
Y
Nation 1
F
K
A
KxA
KyA
Ox
LA1
51
Trade Theory
Stolper- Samuelson theorem
LyF
LyA
O
Y
Nation 1
F
KyF
KxF
A
KxA
KyA
Ox
LA1
LF2
52
Trade Theory
Stolper- Samuelson theorem
L
O
Y
Nation 1
K
F
K
A
Ox
L
53
Trade Theory
Stolper- Samuelson theorem
L
O
Y
Nation 1
K
F
K
A
Ox
L
54
Trade Theory
Stolper- Samuelson theorem
L
O
Y
Nation 1
K
F
K
A
Ox
L
55
Trade Theory
Stolper- Samuelson theorem
L
O
Y
Nation 1
K
F
K
A
Ox
L
56
Trade Theory
Stolper- Samuelson theorem
O
L
Y
Nation 2
K
K
A
F
Ox
L
57
Trade Theory
Stolper- Samuelson theorem
O
LyA
Y
Nation 2
KyA
KxA
A
F
Ox
LxA
58
Trade Theory
Stolper- Samuelson theorem
O
LyA
LyF
Y
Nation 2
KyA
KxA
A
F
KyF
KxF
Ox
LxF
LxA
59
Trade Theory
Stolper- Samuelson theorem
O
Y
Nation 2
A
F
Ox
60
Trade Theory
Stolper- Samuelson theorem
O
Y
Nation 2
A
F
Ox
61
Trade Theory
Stolper- Samuelson theorem
O
Y
Nation 2
A
F
Ox
62
Trade Theory
Stolper- Samuelson theorem
O
Y
Nation 2
A
F
Ox
63
Trade Theory
Stolper- Samuelson theorem
O
Y
Nation 2
L
A
O
Y
Nation 1
K
F
F
K
A
Ox
L
Ox
64
Trade Theory
Stolper- Samuelson theorem
O
Y
Nation 2
L
A
O
Y
Nation 1
K
F
F
K
A
Ox
L
Ox
65
Trade Theory
Stolper- Samuelson theorem
O
Y
Nation 2
L
A
O
Y
B
Nation 1
K
F
F
K
A
B
Ox
L
Ox
66
Trade Theory
Stolper- Samuelson theorem
O
Y
Nation 2
A
L
O
Y
B
Nation 1
K
A
B
Ox
L
67
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
68
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
69
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

70
DONT FORGET

• Reading Salvatore Chapter 7 before next lecture.
• Tutorial Exercise