Slides prepared by Thomas Bishop

Chapter 4

Review

Production Possibilities (cont.)

Production and Prices (cont.)

Factor Prices, Goods Prices and Factor Levels (cont.)

Factor Prices, Goods Prices and Factor Levels (cont.)

Factor Prices, Goods Prices

and Factor Levels (cont.)

Factor Prices, Goods Prices and Factor Levels (cont.)

• We have a relationship among factor prices and good prices and the levels of factors used in production:

• Stolper-Samuelson theorem: if the relative price of a good increases, then the real wage (or rate of return of the factor) used intensively in the production of that good increases, while the real wage (or rate of return of the other factor) decreases.– Pc/PF up (T/L)C up; (T/L)F up. – Marginal productivity of a factor increases as the level of that

factor used in production decreases: L down MPL up.– Under competition, the real wage/return is equal to the

marginal productivity of the factor: W/Pc=MPL

– Pc/PF up W/Pc up, W/PF up ;r/Pc down, r/PF down

Factor Prices, Goods Prices,

Factor Levels

and Output Levels (cont.)

Factor Prices, Goods Prices, Factor Levels and Output Levels

(cont.)

Key Points:

• Increase of total factor endowments (capital, labor) cannot affect factor return (rent, wage) in the 2-sector economy.

• Different from one-sector economy( depends on MP).• Because the labor-abundant country can produce more

of, and export, the labor-intensive good. • It can fully employ its labor while still paying the same

wages as a capital-abundant country.• However, increase of price ratio, of course, affect

industrial output share.

Production Possibilities (cont.)

An Example

• When the relative price of cloth increases, output of cloth increases. Also, K/L ratio in each industry increases as well.

• Example due to Pc up• C=KL; F=f(K,L)• Total labor=200, total K=30• C is labor intensive; F is capital

intensive.• S-S theorem: (K/L) increase in

both industry; Cloth industry expands while food shrinks.

K0 L0 KN LN

C 10 100

1/10

20 160

1/8

F 20 100

1/5

10 40

1/4

Trade in the Heckscher-Ohlin Model

• Suppose that the domestic country has an abundant amount of labor relative to the amount of land.– The domestic country is abundant in labor and the foreign

country is abundant in land: L/T > L*/ T*– Likewise, the domestic country is scarce in land and the foreign

country is scarce in labor.– However, the countries are assumed to have the same

technology and same consumer tastes.

• Because the domestic country is abundant in labor, it will be relatively efficient at producing cloth because cloth is labor intensive.

Excess Demand of Cloth when Autarky Price is the Same

Trade in the Heckscher-Ohlin Model (cont.)

Trade in the Heckscher-Ohlin Model (cont.)

Factor Price Equalization

• Unlike the Ricardian model, the Heckscher-Ohlin model predicts that factor prices will be equalized among countries that trade.

• Because relative prices are equalized and because of the direct relationship between relative prices and

factor prices, factor prices are also equalized. • Empirical Evidence