Classical Model

4Classical Model

• Strengths– Trade is mutually beneficial– High & low wage countries may trade– Explains some of the trade patterns we observe

• Weaknesses– Why does so much trade occur among developed

countries?– Why does technology differ across countries?

5Heckscher-Ohlin (HO) Model

• Built upon observed differences among– Factors that countries possess– Factors required to produce various goods

• Insights– Causes of trade– Effects of trade on factor prices– Effect of economic growth on trade patterns– Political behavior

7Assumptions for HO Model

• Keep assumptions 1 through 10

• Drop assumptions 11 & 12

• Add assumptions 13 through 17

8Assumption #13

• There are two factors of production, labor (L), and capital (K). Owners of capital are paid a rental payment (R) for the services of their assets, and labor receives a wage payment (W).

9Assumption #14

• The technologies available to each country are identical.

– Any technology is available to any country

– Factor prices determine the technology chosen

10

//

Input combinations that produce one bushel of Soybeans

Unit Capital input aTS ,in machines per bushel

Unit Labor input aLF ,in hours per bushel

A Model of a Two-Factor Economy

Compare to Figure 4-1: Input Possibilities in Soybean Production

11Assumption #15

• The production of T is labor intensive relative to the production of S

– That is, T requires more labor per machine

• Implies that production of S is capital intensive (relative to the production of T).

– That is, S requires more machines per worker

12K per Worker for US Industries

Industry 1960 1980

Apparel 1.5 3.2

Leather products 2.3 4.5

Chemicals 30.4 58.9

Petroleum & coal 93.8 161.2

Thousands of 1972 dollars. Item 4.1, page 89, 5th edition, Husted & Melvin

13

12

Wage-rental ratio, w/r

Capital-laborratio, K/L

Compare to Figure 4.2, page 70

Factor Prices and Input ChoicesWhich line represents the Capital-intensive industry, 1 or 2?

14

TTSS

Wage-rental ratio, w/r

Capital-laborratio, K/L

Soybean production is capital-intensive at any given wage/rental ratio

Factor Prices and Input Choices

15

SSTT

PW

Capital-labor Ratio, K/L

Relativeprice ofT, PT/PS

Wage-rentalratio, w/r

(PT/PS)1 (KT/LT)2(KT/LT)1 (KS/LS)2(KS/LS)1

(w/r)2

(w/r)1

Increasing Increasing

Combing Figures 4-2 and 4-3

Compare to Figure 4-4, page 71

(PT/PS)2

16Assumption #16

• Country A is relatively capital abundant, while B is labor abundant.

17K per Worker: Selected Countries

Country 1980 1990

Switzerland (highest) 57,061 73,459

United States (11th) 27,551 34,705

Columbia (27th of 51) 11,800 12,650

Sierra Leone (lowest) 178 223

1985 international prices. Item 4.2, page 91, 5th edition Husted & Melvin

18Quantity definition of factor abundance

• Country A is relatively capital abundant, if the ratio of its capital stock to its labor force (K/L) is greater than that of the other country:

LK

LK

B

B

A

A

19Price definition of factor abundance

• Country A is relatively capital abundant, if its wage-rental ratio (W/R) is higher than the other country’s wage-rental ratio:

RW

RW

B

B

A

A

20Strong factor abundance assumption

• If country A is relatively capital abundant, by the quantity definition, its wage-rental ratio (W/R) will be higher than the other country’s wage-rental ratio.

• That is, the price definition holds, too.

21

SOYBEANS, S (millions of bushels per year)

6

18

40 8 12

12

2

14

20

S is K-intensiveA is K-abundant

TE

XT

ILE

S, T

(mill

ions

of y

ards

per

yea

r)

America’s PPF

Increasing Opportunity Cost in A

10 16

22

20

50

40

10

TE

XT

ILE

S, T

(mill

ions

of y

ards

per

yea

r)


Britain’s PPF

Increasing Opportunity Cost in BT is L-intensiveB is L-abundant

24Assumption #17

• Tastes in the two countries are identical.– Given same GDP & prices, same choice

• Implies that supply conditions alone determine the direction of comparative advantage (CA).– Different tastes would imply different demand

– Could reverse the direction of CA.

26Rybczynski Theorem

• At constant world prices, if a country experiences an increase in the supply of one factor, it will produce more of the product intensive in that factor and less of the other.

– See Figure 4.5 , page 73, and 4.6, page 74 Krugman & Obstfeld

27

L__

K_

L_

K_

Labor used in _____________ production

Labor used in______production

O_Increasing

Increasing

Increas ingIncr

eas i

ngC

apita

l use

d in

___

____

_ pr

oduc

tion

Capital used in _____ production

1

__

__

O_

Which is the K-intensive industry?

Compare to Figure 4-5, page 73

28

LS

KS

LT

KT

Labor used in Soybean production

Labor used in Textile production

OSIncreasing

Increasing

Increas ingIncr

eas i

ngC

apita

l use

d in

Tex

tile

prod

uctio

nC

apital used in S production

1

S

T

OT

S is K intensive, T is L intensive

29

• How do the outputs of the two goods change when the economy’s resources change?

• Increase the amount of one factor, say K, and observe the results

Rybczynski Theorem

30

K2S

K2T

T

L2S

L2T

K1S

K1T

S1

L1S

L1T

1

L used in S production

L used in T production

Increasing

Increasing

Increas ingIncr

eas i

ngK

use

d in

T p

rodu

ctio

nK

used in S productionS2

O1S

O2S

2

OT

K increases. S (K int.) expands. S needs more labor. T must contract

31

21

PPF1 PPF2

Output ofT, QT

Output ofS, QS

Slope = -PS/PT

Slope = -PS/PT

Q2T

Q2S

Q1T

Q1S

An increase in K in Country A.

32

PPF1 PPF2

Output ofT, QT

Output ofS, QS

Slope = -PS/PT

Slope = -PS/PT

2Q2

T

Q2S

1Q1

T

Q1S

An increase in L in country B.

Compare to Figure 4-7, page 75. Now try it yourself – solve problem 2

33

• Also helps us to understand that an economy will tend to be more productive in industries that use its abundant factor intensively.

Rybczynski Theorem

35Heckscher-Ohlin Theorem

• A country will export the goods whose production is intensive in the factor with which that country is abundantly endowed.

36


18

0 13

12

15 a

TE

XT

ILE

S, T

(mill

ions

of y

ards

per

yea

r)

CIC0

Autarky in A

10 16

38

10

30

40 6.5

20

40

9

a

TE

XT

ILE

S, T

(mill

ions

of y

ards

per

yea

r)


Britain’s PPF

Autarky in B

CIC0

40

RD

RSA

RSB

12

3

Trade Leads to a Convergence of Relative Prices

Compare to Figure 4-8, page 77.

Relative price of S, ______

Relative qualityof S,

41

2

Relative price of S, PS/PT

Relative qualityof S, QS + Q*

S

QT + Q*T

RD

RSA

RSB

1

3

Trade Leads to a Convergence of Relative Prices

42

• With free trade, there will be one world relative price for S (PS/PT) and T (PT/PS).

• As PS/PT rises in Country A, their S industry expands while their T industry contracts.

• As PS/PT falls in Country B, their S industry contracts while their T industry expands.

• Tricky to draw the general equilibrium solution, so let’s try it together.

A Trade B

S S S

T T T

P P PP P P

43International Trade Equilibrium

• Incomplete specialization in Comparative Advantage good.

• Community Indifference Curve (CIC) & Terms of Trade line (ToT) tangent at consumption point

• Congruent trade triangles imply balanced trade.

45Stolper-Samuelson Theorem

• Free international trade benefits the abundant factor and harms the scarce factor.

46

• As PS/PT rises in Country A, PT/PS and w/r fall.

– Look back at Figure 4-4, or slide 15.

– A is K abundant (L scarce)

• As PS/PT falls in Country B, PT/PS and w/r rise.

– B is L abundant (K scarce)

A Trade B

S S S

T T T

P P PP P P

48Factor-Price Equalization (FPE) Theorem

• Given all the assumptions of the HO model, free trade will lead to the international equalization of individual factor prices.

– Look again at Figure 4-4, or slide 15.

• One relative price for T, PT/PS

• One wage-rental ratio, w/r

49Factor-Price Equalization?

“There isn’t any.” Why not?

1. Some goods are not produced in some countries.

2. Productivity (technology) does differ between countries.

3. Goods’ prices differ due to natural and artificial barriers to trade.

52Learning Objectives

• Examine the need to build a new model

• Understand five more assumptions

• Prove HO Theorem

• Prove Rybczynski Theorem

• Prove Factor-Price Equalization Theorem

• Prove Stolper-Samuelson Theorem

• Introduce Specific-Factors Model

53Specific-Factors Model

• Keep all HO assumptions except:

– one factor is immobile (say K)

• different rental rates for machines in S & T industries

• Labor still mobile, implying one wage, W

• W = VMPS = PS x MPLS

• Appendix 4.2, pages 118-120, Husted & Melvin. See Figures A4.5 and A4.6

54Specific-Factors Model

• W = VMPS = PS x MPLS

• W = VMPT = PT x MPLT

55The End of Chapter 4

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Classical Model