Lectures, 4

THE FACTOR ENDOWMENTS THEORY

The factor endowments theory (a.k.a. Heckscher-Ohlin theory, and the Modern Theory of International Trade) is a modern extension of the classical approach and attempts to explain the pattern of comparative advantage. Does this by hypothesizing that comparative advantage is ultimately due to international differences in relative factor endowments. Done for 4 reasons: 1. Natural extension of the classical theory which sees international factor immobility as the basis for trade. 2. Can define factor broadly. 3. Seems important in practice. 4. Very useful theoretically for linking trade to internal income distribution, growth, factor movements, and so on. The basic vehicle for developing this theory is the Heckscher-Ohlin-Samuelson model, a twocountry version of the standard two-sector neoclassical model. This model dominated international trade theory from the fifties into the eighties and remains central today, but its practical relevance has always been a central controversy in the field.

I.

The Heckscher-Ohlin-Samuelson Model

2x2x2 model. Two goods (A and B), two factors (K and L) and two countries (home and foreign).

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1. The production function. Consider the production process for one of the goods in one of the countries: A = FA(KA,LA), where FA is a neoclassical production function (CRS, strictly quasiconcave, etc.). Can utilize CRS to express FA in two other normalized forms. intensive extensive

Figure 4.1

Figure 4.2

2. Economics. Factors are paid the value of their marginal products, and profits are zero, i.e., prices = costs.

so

since {...} = 0 by cost minimization.

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and

Figure 4-3

Figure 4-4

Figure 4-5

Figure 4-6

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Duality between and kA.

Duality between F and c.

3. Two sectors: Factor-market clearing. Let B denote the second good, with an analogous production sector. Then RAkA + RBkB = k or RA + RB = 1 where RA / LA/L and RB / LB/L. 4. Two sectors: Relative factor intensity. A is relatively capital intensive [B is relatively labor intensive] if: kA() > kB(). Factor intensity reversal: aLA A + aLB B = L aKA A + aKB B = K

Figure 4-7 Figure 4-8.

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So reversals are associated with different degrees of substitutability of inputs across sectors. Note that a given k can correspond to only one pattern of relative factor intensities, and therefore so can a given PPF. In this sense reversals are global but not local phenomena. At a factor intensity reversal, k = kA = kB, so the capital and labor constraints are identical to each other and to the PPF, which is therefore linear.

Figure 4-9

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5. Two sectors: Relative commodity prices.

so:

Figure 4-10

Figure 4-11

Figure 4-12

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6. Two sectors: Comparative statics of price changes.

where ij denotes factor i's distributive share in sector j. Thus: Therefore

THE BASIC THEOREMS OF THE HECKSCHER-OHLIN-SAMUELSON MODEL Theorem I (Stolper-Samuelson): A (small) change in relative prices and in factor rewards will increase the real reward of the factor intensive in the production of the good whose relative price has risen and reduce the real reward of the other factor, provided that the economy remains diversified. i.e., if we call good A the relatively capital-intensive one, then

The theorem has already been proved by deriving:

Show geometric derivations in Figure 10, Figure 11 and Figure 12.

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Can also be intuitively understood by the reasoning underlying the algebra. [Explain in detail] Note that although the statement of the theorem and the algebra were in terms of differential changes, the basic reasoning and all the geometry could accommodate finite changes. Also factor endowments were not referred to, so they could be changing as well. But factor intensity reversals were excluded (by small changes in factor prices):

A movement from A to B produces the opposite redistribution from a movement from A to B' [though still have magnified price changes for factors].

Constant endowments will prevent a FIR from being encountered.

Figure 4-13

Theorem II (Global Stolper-Samuelson): Theorem I applies to finite price changes leaving the economy diversified, provided that endowments are held fixed or that the technology does not exhibit factor intensity reversals. Expand on the significance of the SS theorem. Contrast with the effect of price changes when the economy is specialized. Theorem III (Factor Price Equalization): For each P consistent with both goods being produced, there exists a cone H(P) of endowments such that all countries with endowments in H(P), and with the given technology, will have identical factor prices when freely trading at world prices P. The cone H(P) is of full dimensionality as long as it does not coincide with a factor-intensity reversal.

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Proof is by construction of H(P). Since P is consistent with both goods being produced, P = WA(W) for some W $ 0. Then let H(P) = {v | v $ 0 and v = A(W)x for some x $ 0}. If W is not at a factor intensity reversal, A(W) is non-singular, so H(P) is two dimensional; if this is a reversal, H(P) is a ray through the origin. Illustrate and show how H(P) need not be unique if there are factor-intensity reversals. Theorem IV (Global Univalence): If there are no factor-intensity reversals, any two countries with the common technology must have equal factor prices if freely trading at a common world price and if both countries diversify. i.e., there is a global univalence between factor rewards and commodity costs in the absence of factor-intensity reversals. This follows immediately from our earlier result that PB/PA is strictly monotone in w/r, except at a factor intensity reversal. This also immediately implies the following, since the comparative advantage theorem applies to this model. Theorem V (Partial Equalization): If there are no factor-intensity reversals and if two countries share the same technology, relative factor prices will be more nearly equal in free trade than in autarky, provided that autarky equilibrium is unique in each country.

Theorem VI (Rybczynski): At constant relative commodity prices, a (small) change in factor endowments will increase, relative to both factors, the output of the good making relatively intensive use of the factor with the relatively enlarged endowment, and reduce the output of the other good, relative to both factors, provided that the economy remains diversified. Thus, if A is relatively capital intensive,

and

Can be proved from the factor constraints:

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From theorem III, a small change in endowments at constant P cannot change W, because the economy remains in H(P). Thus the aij are constant, and differentiation gives:

from which the theorem follows at once. (Here KA = aKAA/K, so that KB + KA = 1, etc.) Give the intuitive argument. Note that the argument applies to any finite change which leaves E in H(P). If there is no FIR, so H(P) is unique, this means any finite change leaving the economy diversified. Theorem VII (Global Rybczynski): Theorem VI applies to any finite change in endowments leaving the economy diversified, provided that there is no factor intensity reversal. Geometrically:

Figure 4-14

Figure 4-15

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Contrast with case of complete specialization. Like SS, a case where more than one sector makes a big difference. Path of outputs if the K stock expands, at constant commodity prices, if the A sector is initially Kintensive, and if FIRs:

Figure 4-16

Figure 4-17

The basic goal of H.O. theory is to explain trade patterns; this is done in the H.O. theorem, which relates trade to factor abundance. To do this, need a definition of factor abundance. Have two: Q - Def.: A country is capital abundant relative to another if it has more K per worker. P - Def.: A country is capital abundant relative to another if it would have a higher wage-rental ratio in autarky. The second definition obviously embodies more information than the first. Have a version of the H.O. theorem corresponding to each.

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Theorem VIII (Quantity Version of H. O.): Suppose that two countries have: (a) Identical homothetic demands, (b) identical HOS technologies, with (c) no FIRs. Then in any free trade equilibrium (with some trade) each country will export the good that makes relatively intensive use of that country's relatively Q-abundant factor. Can be proved via the Rybczynski theorem. Suppose that the two countries trade and establish a common world price P. Then assumption (c) implies at most a unique diversification cone H(P). Theorem VII implies that the relatively capital abundant country produces a higher A/B ratio, if both countries' endowments are in H(P) [by assumption (b)], calling the relatively capital intensive good A. Both countries' endowments cannot lie outside H(P) and on the same side of H(P), or they would both specialize in the same good and there would be no trade. Thus if a country's endowment is outside of H(P) it must specialize in the good that makes intensive use of its abundant factor. Thus the capital abundant country produces the higher A/B ratio, regardless of the pattern of specialization. By (a) the two countries consume the two goods in the same proportions. Thus the theorem follows. Note that if the two countries are separated by an odd number of FIRs the theorem's conclusion will hold for one country but not the other; if there are an even number of separating FIRs the theorem's conclusions may or may not hold. But in all cases each country exports its abundant factor in the sense that its bundle of exports embodies in its production a more intensive bundle of the services of the abundant factor that did its bundle of imports where produced. Note also the role of demand. This motivates the price version using the P-def. of abundance.

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Theorem IX (Price Version of H. O.): Suppose that two countries have: (a) identical (HOS) technologies, with (b) no FIRs. Then each country has a comparative advantage in the good making relatively intensive use of the country's relatively P-abundant factor. Thus each country will export that good in free trade, if: (c) Autarky equilibrium is unique in each country. Proof of the first part follows directly from Theorem IV; the proof of the second part follows directly from the comparative advantage theorem, since the HOS model satisfies all the other requirements of that theorem. A demand reversal is said to occur if the two definitions of abundance differ. Note that in this case theorem IX applies. Also free trade necessarily features factor price equalization and the presence of FIRs in the technology becomes irrelevant. This requires relative endowments to be similar, and tastes different. If, on the other hand, K/L in the two countries is sufficiently diverse, no pattern of tastes can produce a demand reversal, and factor price equalization is impossible. Discuss the implications of HO + SS for the effects of free trade on the internal distribution of income in each country and the implications of HO + RYB for the effects of economic growth on a country's offer curve. Use reciprocal demand to infer the effects on the terms of trade, and discuss the possibility of immiserizing growth.