Lecture 3: Comparative Advantage and Factor Endowments .Describe the major assum
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Lecture 3: Comparative Advantage and Factor Endowments .Describe the major assumptions of the Heckscher-Ohlin model of trade. What determines comparative advantage in this model? What are the predictecd outcomes of this model? What does the model imply with regards to the distribution of income within countries? How does the production possibility frontier differ from the one factor model and why? What are the implications of this difference? Describe the Stolper-Samuelson Theorem. What are the assumptions of the specific factors model of trade? How do the predicted outcomes differ from the factor-proportions theorem and why? What is the Leontief Paradox? Does it support or contradict the factor- proportions theorem? What are some possible explanations for this paradox?Explanation / Answer
The following assumptions pertain to the 2*2 model of Heckscher-Ohlin.
It is assumed that there are only two nations (1 and 2) with two goods for trade (X and Y) and two factors of production (capital and labour).
For producing the goods, both nations use the same technology and they use uniform factors of production.
In both countries, good X is labour intensive and Y is capital intensive.
The tastes and preferences of both nations are the same (both countries can be represented in the same indifference curve).
In both nations, the assumption of constant returns to scale is applicable for the production of goods X and Y.
In both nations, specialization in production is not complete.
Goods and factor markets in both nations are perfectly competitive.
There exists perfect mobility of factors of production within each country though international mobility is not possible.
There are no restrictions or limitations to the free flow of international trade. That is, there exist no transportation costs, tariffs, or like other obstructions either to control or to restrict the exports or imports.
It is assumed that there exists full employment of all resources in both nations. That is, there will not be any under employed resource in either nation.
The exports and imports between the nations are balanced. It means that the total value of the exports will be equal to the total value of imports in both nations.
Comparative Advantage
However, most trade in the world is North-North trade ñ trade between northern hemisphere countries. There is not much of a technology difference between these countries
These theories also fail to examine why productivity differences between countries exists ñ it just assumes that these differences do exist.
Finally, only one factor of production is assumed ñ labor. We know that both labor and capital are used in production.
Model Imply with regards to the distribution of income within countries:-
The U.S. autarky production and consumption points are determined where the aggregate indifference curve is tangent to the U.S. PPF. This occurs at point A. The United States realizes a level of aggregate utility that corresponds to the indifference curve.
The U.S. production and consumption points in free trade are P and C, respectively. In free trade, the United States realizes a level of aggregate utility that corresponds to the indifference curve IFT. Since the free trade indifference curve IFT lies to the northeast of the autarky indifference curve IAut, national welfare rises as the United States moves to free trade.
France’s autarky production and consumption points are determined by finding the aggregate indifference curve that is tangent to the French PPF. This occurs at point A. France realizes a level of aggregate utility that corresponds to the indifference curve IAut.
French production and consumption points in free trade are P and C, respectively. In free trade, France realizes a level of aggregate utility that corresponds to the indifference curve IFT. Since the free trade indifference curve IFT lies to the northeast of the autarky indifference curve IAut, national welfare rises as France moves to free trade.
This means that free trade will raise aggregate welfare for both countries relative to autarky. Both countries are better off with free trade.
However, the use of aggregate indifference curves (or preferences) ignores the issue of income distribution. Although it is correct to conclude from this analysis that both countries benefit from free trade, it is not correct to conclude that all individuals in both countries also benefit from free trade. By calculating changes in real income in the Heckscher-Ohlin (H-O) model, it can be shown that some individuals will likely benefit from free trade, while others will suffer losses. An increase in aggregate welfare means only that the sum of the gains exceeds the sum of the losses.
Another important issue is also typically ignored when using aggregate or national indifference curves to represent a country’s preferences. For these curves to make sense, we must assume that income distribution remains the same when moving from one equilibrium to another.
A production–possibility frontier (PPF) or production possibility curve (PPC) is the possible tradeoff of producing combinations of goods with constant technology and resources per unit time. One good can only be produced by diverting resources from other goods, and so by producing less of them. This tradeoff is usually considered for an economy, but also applies to each individual, household, and economic organization.
Graphically bounding the production set for fixed input quantities, the PPF curve shows the maximum possible production level of one commodity for any given production level of the other, given the existing state of technology. By doing so, it defines productive efficiency in the context of that production set: a point on the frontier indicates efficient use of the available inputs (such as points B, D and C in the graph), a point beneath the curve (such as A) indicates inefficiency, and a point beyond the curve (such as X) indicates impossibility.
PPFs are normally drawn as bulging upwards or outwards from the origin ("concave" when viewed from the origin), but they can be represented as bulging downward (inwards) or linear (straight), depending on a number of assumptions. A PPF illustrates several economic concepts, such as scarcity of resources (the fundamental economic problem that all societies face), opportunity cost (or marginal rate of transformation), productive efficiency, allocative efficiency, and economies of scale.
Implication of production possibilities
The Stolper–Samuelson theorem is a basic theorem in Heckscher–Ohlin trade theory. It describes the relationship between relative prices of output and relative factor rewards—specifically, real wages and real returns to capital.
The theorem states that—under specific economic assumptions (constant returns to scale, perfect competition, equality of the number of factors to the number of products)—a rise in the relative price of a good will lead to a rise in the return to that factor which is used most intensively in the production of the good, and conversely, to a fall in the return to the other factor.
The specific factor model assumes that an economy produces two goods using two factors of production, capital and labor, in a perfectly competitive market. One of the two factors of production, typically capital, is assumed to be specific to a particular industry. That is, it is completely immobile. The second factor, labor, is assumed to be freely and costlessly mobile between the two industries. Because capital is immobile, one could assume that the capital in the two industries are different, or differentiated, and thus are not substitutable in production. Under this interpretation, it makes sense to imagine that there are really three factors of production: labor, specific capital in industry one, and specific capital in industry two.
These assumptions place the specific factor model squarely between an immobile factor model and the Heckscher-Ohlin model. In an immobile factor model, all of the factors of production are specific to an industry and cannot be moved. In a Heckscher-Ohlin model, both factors are assumed to be freely mobile; that is, neither factor is specific to an industry. Since the mobility of factors in response to any economic change is likely to rise over time, we can interpret the immobile factor model results as short-run effects, the specific factor model results as medium-run effects and the Heckscher-Ohlin model results as long-run effects.
Production of good one requires the input of labor and industry-one specific capital. Production of good two requires labor and industry-two specific capital. There is a fixed endowment of sector-specific capital in each industry as well as a fixed endowment of labor. Full employment of labor is assumed, which implies that the sum of the labor used in each industry equals the labor endowment. Full employment of sector-specific capital is also assumed, however, in this case the sum of the capital used in all of the firms within the industry must equal the endowment of sector-specific capital.
The model assumes that firms choose an output level to maximize profit, taking prices and wages as given. The equilibrium condition will have firms choosing an output level, and hence labor usage level, such that the market determined wage is equal to the value of the marginal product of the last unit of labor. The value of the marginal product is the increment to revenue that a firm will obtain by adding another unit of labor to its production process. It is found as the product of the price of the good in the market and the marginal product of labor. Production is assumed to display diminishing returns because the fixed stock of capital means that each additional worker has less capital to work with in production. This means that each additional unit of labor will add a smaller increment to output, and since the output price is fixed, the value of the marginal product declines as labor usage rises. When all firms behave in this way, the allocation of labor between the two industries is uniquely determined.
The production possibilities frontier will exhibit increasing opportunity costs. This is because expansion of one industry is possible by transferring labor out of the other industry, which must therefore contract. Due to the diminishing returns to labor, each additional unit of labor switched will have a smaller effect on the expanding industry and a larger effect on the contracting industry. This means that the graph of the PPF in the specific factor model will look similar to the PPF in the variable proportion Heckscher-Ohlin model. However, in relation to a model in which both factors were freely mobile, the specific factor model PPF will lie on the interior. This is because the lack of mobility by one factor, inhibits firms from taking full advantage of efficiency improvements that can arise when both factors can be freely reallocated.
Leontief's paradox in economics is that a country with a higher capital per worker has a lower capital/labor ratio in exports than in imports.
This econometric find was the result of Wassily W. Leontief's attempt to test the Heckscher–Ohlin theory ("H–O theory") empirically. In 1953, Leontief found that the United States—the most capital-abundant country in the world—exported commodities that were more labor-intensive than capital-intensive, contrary to H-O theory. Leontief inferred from this result that the U.S. should adapt its competitive policy to match its economic realities.
Responses to the paradox
For many economists, Leontief's paradox undermined the validity of the Heckscher–Ohlin theorem (H–O) theory, which predicted that trade patterns would be based on countries' comparative advantage in certain factors of production (such as capital and labor). Many economists have dismissed the H-O theory in favor of a more Ricardian model where technological differences determine comparative advantage. These economists argue that the United States has an advantage in highly skilled labor more so than capital. This can be seen as viewing "capital" more broadly, to include human capital. Using this definition, the exports of the United States are very (human) capital-intensive, and not particularly intensive in (unskilled) labor.
Some explanations for the paradox dismiss the importance of comparative advantage as a determinant of trade. For instance, the Linder hypothesis states that demand plays a more important role than comparative advantage as a determinant of trade—with the hypothesis that countries which share similar demands will be more likely to trade. For instance, both the United States and Germany are developed countries with a significant demand for cars, so both have large automotive industries. Rather than one country dominating the industry with a comparative advantage, both countries trade different brands of cars between them. Similarly, New Trade Theory argues that comparative advantages can develop separately from factor endowment variation (e.g., in industrial increasing returns to scale).
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