# Introduction

Comparative advantages will not be determined by differences in productivity, but by:

• differences in factor endowments between countries...
• differences in factor intensity in the production of different goods

The FPP will be concave (and not linear as in the Ricardian case). Why is that? Because we have two substitutable factors of production (and not 1) with decreasing marginal productivity. To see this take the extreme case where capital is fixed in both sectors. By reallocating labour to one sector you decrease its marginal productivity in the sector that increases employment and you increase the marginal productivity of labour in the sector that sees employment decrease. It therefore becomes increasingly costly in terms of opportunity cost to produce one more unit of the good whose output you have just increased.

There are two substitutable factors which are land and labour => concave FPP: the higher the share of clothing production increases, the higher the opportunity cost of clothing in terms of food.

The concavity of the PPF implies that there will rarely be full specialization in the HO model;

The economy produces at the point that maximizes the value of output, for the prices given to it;

The point of tangency between the PPF and the highest possible isovalue line...

Opportunity cost of clothing in terms of food is equal to the relative price of clothing.

In autarky: point Q = basket of production and consumption in equilibrium

FPP: Frontiers of Production Possibilities, the set of baskets of goods that the economy can produce using all its resources. Isovalue right: set of baskets of production corresponding, for a given price of goods, to a constant total value (${\displaystyle Y}$).

Output of the economy for a given relative price: point 1

Consumption of the economy: on CB which passes through point 1

In a free trade situation the quantities imported and exported are provided by the confrontation of the budget constraints and consumption choices of the two countries.

## Revealed preferences

Trade gains in the HO model: Revealed preference reasoning.

Source: figure 4.11 page 71 du KOM (2012)

In autarky: consumption basket in 2

Openness to trade: relative price of clothing rises, new production point in 1 and consumption basket somewhere in the new BC

Part of this line (the one in the coloured part) represents baskets that can be reached in free trade with a simultaneous consumption of both goods higher than in autarky.

# The Comparative Advantage: Heckscher-Ohlin Theorem

## Heckscher-Ohlin Theorem

Two factors of production: skilled and unskilled labour.

Two countries: The United States is relatively more abundant in skilled labour than Sri Lanka.

The ratio of skilled to unskilled workers is higher in the United States.

Two goods: Textiles and software - textiles is more intensive in unskilled labor...

Whatever the relative price of the factors (skilled versus unskilled wages), textiles always use relatively more unskilled workers than in software.

## Factor endowments and comparative advantage (the HO theorem)

An economy has a comparative advantage in the production of the good that uses relatively intensively the factor of production with which it is relatively well endowed.

## Empirical Evidence

Leontief's paradox (1953): Exports from the United States are relatively more labour-intensive, and imports relatively more capital-intensive, whereas the United States was at the time seen as the most capital-abundant country

Explanations : Not all workers are the same. And U.S. exports are more intensive in skilled workers and U.S. imports are more intensive in unskilled workers.

Not all unskilled workers are the same. US workers are more efficient than workers from the South. They have higher productivity. So finally the United States has an effective hourly labour input that is not so small. Adding differences in productivity (Ricardo) to an HO model explains a large part of world trade.

The predictions work better for North-South trade (exploiting differences) than for North-North trade (based on exploiting similarities and economies of scale). For example, China clearly exports low-skilled labour-intensive goods (clothing) to the North and imports mainly machinery and chemicals.

Preferences in the North that are heavily biased towards the consumption of more capital-intensive goods (differences in preferences as a determinant of trade).

No free trade at that time + end of WWII

## Predictions work best for trade between countries with very different relative endowments (e.g. North-South trade).

Source: KOM(2012) page 113, basé sur Romalis (2004)

# Factor Compensation: Stolper-Samuelson Theorem

## Some statements

1st statement:

« Trade liberalisation has pushed down wages for low-skilled workers in OECD countries »

Evolution of skilled versus unskilled wages in the United States.

2nd statement:

« If wages do not adjust, then unemployment rises as competition with imports from developing countries increases (globalisation of the last 20 years, etc.).) »

Relative differences in unemployment rates by level of education (high school/university) in OECD countries.

## Can commerce explain these claims? Yes!

The Stolper-Samuelson theorem allows us to understand this phenomenon.

## Can commerce explain this? Yes, they can!

The Stolper-Samuelson theorem allows us to understand this phenomenon.

## Stolper-Samuelson's Theorem

Conclusion: Relative price changes during trade opening have a significant impact on income distribution:

Stolper-Samuelson effect: Holders of the factor intensively used in the production of the good whose relative price rises see their real remuneration increase. Individuals who hold the other factor of production see their real income decrease.

With free trade there is a tendency to observe what is called factor price equalisation.

Why?

• Beyond a simple trade in goods, the HO model actually describes an implicit exchange of factor inputs.
• In the free trade equilibrium, the relative prices of goods and production technologies are the same in both countries (by assumption) and therefore the relative prices of factors must be the same. To see this remember that profits are zero in the long run, there is only one pair of w and r that can satisfy the conditions of zero profits:
${\displaystyle P_{x}=a_{LX}\times w+a_{KX}\times r}$ ; ${\displaystyle P_{y}=a_{LY}\times w+a_{KY}\times r}$

Problem: Although trade liberalisation is well advanced in many countries, significant differences in factor prices persist.

Factor price equalisation is mitigated by :

• No equalisation of goods prices: Presence of trade barriers.

(transport costs, etc.), restrictive trade policies

• Different production technologies
• Savings in different production cones (not fully diversified)
• Factors of production not perfectly mobile between sectors

Although factor price equalisation is not observed, many observers attribute the rise in inequality between skilled and unskilled workers in the OECD to the growth in international trade and in particular the development of North-South trade.

Two arguments put this conclusion into perspective:

1. Most empirical studies show a very small impact of trade on the decline in the relative wages of unskilled workers in the OECD.

• Trade with PvD accounts for only 3 to 8% of GDP, North-South trade accounts for only a small % of the total expenditure of rich countries.
• Trade with PvD accounts for only 10-30% of the relative fall in unskilled workers' wages
• Most of the fall in the relative wages of the unskilled is explained by technological progress biased towards the skilled worker.

2. Problem with Stolper Samuelson's prediction in PvD. With trade, the relative wages of the unskilled are expected to rise when in reality they often fall. No evidence of a reduction in inequality ...

• A new explanation for technological progress
• For middle-income countries, there is a negative impact of their trade with countries relatively more abundant in unskilled labour (China and India for example) but the contribution of this trade to the fall in relative unskilled wages in middle-income countries is small.

## Can commerce explain this? Not so fast...

The Stolper-Samuelson theorem allows us to understand this phenomenon.

## Changes in the relative employment of skilled/unskilled workers in the United States

Corresponds more to the expected effect of technical progress than to the expansion of North-South trade.

Source: KOM(2012) page 105

Attention: this does not mean that international trade has nothing to do with it!

• Trade openness influences technological change because it intensifies competition and the search for competitiveness by saving on low-skilled labour (true for North-South trade but also North-North and South-South trade!).
• Development of the outsourcing phenomenon: outsourcing of certain tasks of the production process often intensive in low-skilled workers and therefore loss of jobs in the North and bias in the South towards skilled workers because these tasks are still more intensive in skilled work than the average of other industries in the country. Thus, it favours the increase of inequalities within the North as well as the South.

# Factor Growth and Comparative Advantage: Rybczynski's Theorem

## Rybczynski effect

The Rybczynsk effect corresponds to the increase in endowment in one factor of production is accompanied by an increase in the production of the good that is intensive in that factor and a decrease in the production of the good that is intensive in the other factor of production.

But why do relative prices of goods not change when the supply of a factor of production changes?

Because the prices of goods are fixed on international markets.

And if the prices of goods do not change, the prices of the factors of production will not change, although there is an increase in the supply of one of the factors of production (zero-profit conditions).

The production quantities of each good adjust to accommodate the increased supply of the factors

There will also be what is known as the amplification effect. The percentage increase in food production is greater than the percentage increase in the amount of land initially available.

Why? We have constant returns to scale, factor prices have not changed, so we are going to commit land and labour in the same proportions as before in both sectors. But all the additional land + the land freed up by the garment sector is now used to make food. So the increase in land use in the food sector is necessarily higher than the increase in the original land. It follows that the percentage increase in production is higher than the percentage increase in the original land.

## Example 1: "Mariel Boatlift" - cf. Feenstra and Taylor p. 143-145

"Mariel Boatlift": 125,000 Cuban refugees arrived in Miami between May and September 1980, representing a 20% increase in the Cuban population in Miami and 7% of the city's population.

It was expected that the wages of the workers, especially low-skilled workers (the migrants themselves being less qualified than the workers already settled in Miami), would fall.

In fact, the wages of low-skilled workers in Miami followed the national trend over the period and reoriented production

Rybczynski effect in an open trade economy.

Note: if the economy is closed, immigration causes wages to fall and industries all become more labour-intensive... see slide 26. If open economy, prices of goods and therefore prices of given factors, quantity adjustment...

impact on Miami's industrial structure of Cuban migrants? Rybczynski...

Rybczynski effect:

The fact that increasing factor endowments can bias production opportunities is a key to understanding how differences in factor endowments can lead to international trade.

An economy with a relatively large amount of arable land relative to its labour endowment will gain more from producing food than one with a low land/labour ratio.

As a general rule: an economy will be relatively efficient in producing goods that make relatively intensive use of the factors of production with which it is relatively well endowed.

## Example 2

Let 2 economies (Home and Foreign), 2 goods (shoes - S and computers - C), 2 factors of production (labour - ${\displaystyle L}$ and capital - ${\displaystyle K}$ ).

Assumptions: Home country relatively more capital-intensive, computer relatively more capital-intensive in its production.

Autarky balance (production and consumption): ${\displaystyle A}$ for ${\displaystyle H}$ and ${\displaystyle A^{*}}$ for ${\displaystyle F}$.

Source: Feenstra et Taylor 2012, page 93.

Openness to trade in goods, relative prices of free trade strictly between the two relative prices of autarky: ${\displaystyle ({\frac {P_{c}}{P_{s}}})^{A}<({\frac {P_{c}}{P_{s}}})^{W}<({\frac {P_{c}^{*}}{P_{s}^{*}}})^{A^{*}}}$

• Production : ${\displaystyle B}$ for Home and ${\displaystyle B^{*}}$ for Foreign
• Consumption: ${\displaystyle C}$ for Home and ${\displaystyle C^{*}}$ for Foreign
Source: Feenstra et Taylor 2012, pages 95 et 96.

# Summary

Heckscher-Ohlin Theorem:

• Explains who exports what in a world with differences in factor endowments (one exports the good whose production is relatively intensive in the factor in which the country is relatively abundant)