Trade Midterm, Chap 5-10

Heckscher-Ohlin (H-O) model

A trade model that says comparative advantage comes from differences in FACTOR ENDOWMENTS (how much capital K and labor L each country has). Technology and tastes are the same everywhere, so the only difference between countries is their endowments. Also called the factor proportions theory. Developed by Heckscher and Ohlin, refined by Samuelson.

Heckscher-Ohlin THEOREM

A country EXPORTS the good that uses its relatively ABUNDANT factor intensively, and IMPORTS the good that uses its relatively SCARCE factor intensively. Example: the capital-abundant U.S. exports capital-intensive cars; labor-abundant Mexico exports labor-intensive textiles.

H-O assumptions (the full list)

1) 2 countries, 2 goods, 2 factors (K and L) ("2x2x2"). 2) Perfect competition in all markets. 3) Each country's factor endowment is fixed. 4) Factors move freely INSIDE a country but not BETWEEN countries. 5) No transportation costs. 6) The two goods have different factor intensities, and this is true at ALL factor prices (no factor-intensity reversal). 7) Identical technology in both countries. 8) Identical tastes and preferences. 9) Constant returns to scale. 10) No trade policies (free trade).

H-O assumptions: memory trick

"2x2x2, SAME tech, SAME tastes, FREE trade, NO shipping costs, PERFECT competition, CRS, factors stuck at home but mobile at home, intensities never flip." Every violation = breaking one of these.

Factor abundance: PHYSICAL definition

Country A is capital abundant if (K/L)A > (K/L)B. Count machines per worker. Example: U.S. K/L about $35,500 vs Mexico about $8,596, so the U.S. is K-abundant and Mexico is L-abundant.

Factor abundance: PRICE definition

Country A is capital abundant (labor scarce) if (w/r)A > (w/r)B. If labor is scarce, it is expensive, so w/r is high. The physical and price definitions agree when technology and tastes are identical (an H-O assumption).

Factor INTENSITY

Good X is capital-intensive if (K/L)X > (K/L)Y at the SAME w/r. On the graph: X's K/L ray from the origin is steeper. H-O assumes this ranking holds at every w/r. Example: steel is K-intensive, clothing is L-intensive.

ABUNDANT vs INTENSIVE (never mix them up)

ABUNDANT describes COUNTRIES (their endowment: the U.S. is capital abundant). INTENSIVE describes GOODS (how they are made: cars are capital-intensive). Never write "capital-abundant good."

Factor-intensity graph: what moves when w/r rises?

The isocost line gets STEEPER. Isoquants do NOT move (technology is unchanged). Each firm slides along its own isoquant (steel A to F, clothing B to G). Both K/L rays get steeper (more machines per worker), but steel's ray stays steeper than clothing's.

Factor price equalization (FPE) theorem

With free trade, both countries face the same relative goods prices. That forces relative costs to be equal, which can only happen if relative factor prices (w/r) become EQUAL in both countries. Goods move, workers do not, but trading goods is like indirectly trading the factors inside them.

Stolper-Samuelson theorem

When trade opens, owners of the relatively ABUNDANT factor gain real income, and owners of the relatively SCARCE factor lose real income. U.S. (K-abundant): capital owners gain, workers lose. Mexico (L-abundant): workers gain, capital owners lose. Explains the politics of free trade (who supports it, who wants protection).

Relative cost curve

Graph with w/r on the horizontal axis and PT/PC (relative price of textiles) on the vertical. Slopes UP because textiles are labor-intensive: higher w/r makes textiles relatively costlier. With trade: U.S. moves DOWN (PT/PC falls, w/r falls), Mexico moves UP (both rise). They meet at Int, so goods prices AND w/r equalize (FPE).

Why does U.S. w/r FALL with trade?

The U.S. makes more cars (K-intensive) and fewer textiles (L-intensive). Demand for capital rises, so r rises. Demand for labor falls, so w falls. So w/r falls. Mexico is the mirror: w rises, r falls.

"Int" / (PT/PC)INT

The international (world) price: the ONE price both countries share once they trade with each other. It always lies BETWEEN the two autarky prices: (PT/PC)US > (PT/PC)INT > (PT/PC)MEX. Not a third country.

Rybczynski theorem

At CONSTANT goods prices, an increase in one factor raises output of the good that uses that factor intensively (by MORE than proportionally) and LOWERS output of the other good. Example: more capital means more cars (K-intensive) and FEWER textiles. The PPF shifts out on both axes but much more toward the K-intensive good (biased growth).

Rybczynski: can the country make more of BOTH goods?

YES, it is POSSIBLE, because the whole PPF shifts out. But AT CONSTANT PRICES it makes more of the K-intensive good and LESS of the other good. Write both sentences on the exam.

Rybczynski: Edgeworth box

More capital (K on the vertical side) makes the box TALLER, width (labor) stays the same, so O_Y moves up from O_Y0 to O_Y1. Draw TWO boxes: old and taller.

Magnification effect

A change in goods prices has a BIGGER percentage effect on factor prices. Example: if P of the K-intensive good rises 10%, r rises MORE than 10% and w falls. (Same idea for Rybczynski: outputs change by more than the factor change.)

Specific factors model

A SHORT-RUN trade model. Labor is MOBILE between industries, but each industry also uses a factor STUCK in that industry (example: capital only in manufacturing, land only in food). Contrast with H-O, the long run, where all factors are mobile.

Specific factors: who gains and loses from trade?

The specific factor in the EXPORT sector GAINS. The specific factor in the IMPORT-COMPETING sector LOSES. Mobile labor is AMBIGUOUS: its wage rises, but by less than the export price, so it depends on what workers buy.

Specific factors wage diagram

Horizontal axis = total labor. L_X measured from the left, L_Y from the right. Downward curves P_X x MPL_X (from left) and P_Y x MPL_Y (from right). They cross at the wage W and the labor split. If only P_X rises by 10%, P_X x MPL_X shifts UP 10%, the wage rises by LESS than 10%, and labor moves into X.

CLASSICAL trade theory

Adam Smith and David Ricardo (Exam 1). ONE factor (labor). CONSTANT opportunity cost, so a STRAIGHT-LINE PPF. Comparative advantage comes from differences in labor productivity (technology). Usually leads to complete specialization.

NEOCLASSICAL trade theory

TWO factors (K and L). INCREASING opportunity cost, so a BOWED-OUT PPF. Adds demand (community indifference curves). Equilibrium where MRT = price ratio = MRS. Usually incomplete specialization. H-O is a neoclassical model.

Classical vs neoclassical: the difference

Classical: 1 factor, constant cost, straight PPF, trade based on technology differences, supply side only. Neoclassical: 2 factors, increasing cost, bowed-out PPF, adds demand (indifference curves), trade can be based on endowments (H-O) or tastes.

Why is the neoclassical PPF bowed out?

Because of INCREASING OPPORTUNITY COST. The two goods use K and L in different amounts, so as you make more X you have to move resources that are worse at X and better at Y. Each extra X costs more and more Y.

Violations of H-O: the list (slides call them "Qualifications")

1) Demand reversal. 2) Factor-intensity reversal (FIR). 3) Transportation costs. 4) Imperfect competition. 5) Factor immobility. Also: relaxing constant returns, identical technology, and no policy obstacles.

Violation 1: DEMAND REVERSAL

Tastes differ: each country STRONGLY prefers the good that uses its own abundant factor (U.S. loves cars, Mexico loves textiles). That pushes up each country's autarky price of that good. In the extreme, prices flip: (PC/PT)US > (PC/PT)MEX. Then the K-abundant U.S. exports the L-intensive good. H-O FAILS.

Violation 2: FACTOR-INTENSITY REVERSAL (FIR)

A good is K-intensive at one w/r but L-intensive at another. Happens when K and L substitute more easily in one industry. Example: France (K-abundant) makes apples K-intensively; Germany (L-abundant) makes apples L-intensively, so H-O says BOTH export apples. H-O FAILS. Most economists doubt FIR alone explains real trade patterns.

Violation 3: TRANSPORTATION COSTS

Shipping costs money, so prices can't fully equalize. The U.S. price rises above PIntl and Mexico's falls below it until the price GAP = the transport cost. Both countries pay part (depends on elasticities). H-O STILL HOLDS, but FPE FAILS: factor prices only move TOWARD each other.

Violation 4: IMPERFECT COMPETITION

H-O needs perfect competition for product and factor prices to equalize. With monopoly power, product and factor prices keep differing between countries, so FPE fails.

Violation 5: FACTOR IMMOBILITY

If factors can't move between industries (the specific factors idea), income effects differ from Stolper-Samuelson. The scarce factor is NO LONGER unanimously against trade: it depends on which industry it is stuck in.

Leontief paradox (Ch 9)

Leontief tested H-O on U.S. data (1953). He found U.S. IMPORTS were MORE capital-intensive than U.S. exports: the OPPOSITE of H-O for a capital-abundant country. Explanations: demand reversal, factor-intensity reversal, U.S. tariffs protecting labor-intensive industries, skilled labor (human capital), and natural resources.

Krugman model (monopolistic competition)

Firms have ECONOMIES OF SCALE and sell DIFFERENTIATED products (different varieties). Trade makes the market bigger (S rises). In a bigger market more firms survive (n rises), each produces more at lower average cost, so PRICE FALLS and consumers get MORE VARIETY. Explains trade between SIMILAR countries, which H-O can't.

Krugman graph (Macronations notation)

Number of firms n on the horizontal axis, P and AC on the vertical. CC = c + nF/S slopes UP (more firms, each sells less, higher average cost). PP = c + 1/(bn) slopes DOWN (more rivals, lower markup). Trade raises market size S, so CC shifts DOWN: n rises, P falls. Example: S=300 gives n=6, P=10; S=600 gives n about 8.5, P about 9.4.

Intra-industry trade

When countries export AND import the same kind of good (the U.S. and Germany both sell cars to each other). Explained by the Krugman model (economies of scale + product variety), not by H-O.

Economies of scale (internal)

Average cost FALLS as a firm produces more. Key ingredient in the Krugman model: a bigger market lets each firm produce more and cheaper.