RESOURCES, COMPARATIVE

ADVANTAGES AND INCOME

DISTRIBUTION

Chapter 4
Model of two-factor
Economy
 In chapter 3, we assume that there is one
factors of production: labor
 In chapter 4, we will assume that

◦ There are two factors of production: labor and

capital.
◦ 2 countries: Home and Foreign
◦ 2 goods: Cloth and Food
Other assumptions
 Cloth is Labor-Intensive product: which
means that to produce Cloth, we have to
many units of labor.
 Food is Capital Intensive Product: which

means that to produce Food, we will use

many units of Capital.
Other asumptions for Home
Country
 aLC: labor units required to produce 1 unit of
Cloth.
 aLF: labor units required to produce 1 unit of

Food.
 aTC: Capital units required to produce 1 unit

of Cloth.
 aTF: Capital units required to produce 1 unit

of Food.
 L : Total Units of Labor
 T: Total units of Capital
Home country
 aLC*Qc + aLF*QF = L
 aTC*Qc + aTF*QF = T

  QF = L/aLF – aLC/aLF * Qc (1)

 And: QF = T/aTF – aTC/aTF * Qc (2)
 Because Cloth is Labor intensive product, we

use more labor than land in producing Cloth.

Or in relative terms:
aLC/aLF > aTC/aTF
 The slope of equation (1) is higher than the
slope of equation (2).
Production Possibilities
(cont.)

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Home country
 Conclusion: In a two-factor economy, the PPF is
a curve, not a straight line.
 Put:
V : Total Value of Production
Pc : Price of Cloth
PF : Price of Food
Total value equation will be:
V = Qc*Pc + QF*PF
Or QF = V/ PF - Pc/PF*Qc (Iso-Value Line)
When the total value of production increases (V ↑), the Iso
Value Line shifts out  this makes up an Iso-Value Map.
Production Possibilities
(cont.)

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Optimal Choice of the Home
country
 Home country will maximize satisfaction at
the point E where the Iso-value Line is just
tangent to the PPF curve.
Production and Prices (cont.)

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THE HECKSCHER-OHLIN THEORY
 The H-O Theory: A labor abundant country can
benefit from international trade if it specializes in
producing and exporting the Labor-Intensive
Product.
EX: Vietnam can benefit from trade if it choose to produce
and export labor-intensive products such as: shoes, cloth,
etc.
 A Capital abundant country can benefit from trade
if it specializes in producing and exporting the
Capital Intensive products.
EX: Germany produces and exports cars, drills,
machines, etc.
International Trade, Wage and
Productivity
 True or false?
◦ In China: Wage rate: $0.5/ hour
◦ In the US: wage rate: $8 /hour
◦  There is no chance for the U.S to get benefits from
trade with China  True or False?
 We need to consider productivity in two countries.
 What if Productivity in China is 3
products/worker/hour and in the U.S, 100
products/worker/hour?
  Gain from trade comes from differences in
productivity between the two countries.
Relationship between Wage and
Productivity
 Review some concepts:
◦ Profit is maximized when : MR = MC
◦ Or Profit is max when: ∆TR/∆Q = ∆TC/∆Q
◦ Marginal Productivity of Labor MPL = ∆Q/∆L
 When using more ∆L  total cost increases by ∆TC with:
∆TC = ∆L* W (W: labor wage)
  MC = ∆TC/∆Q = (∆L* W) /∆Q = W/ MPL

 Profit is max  MC = MR = P

  MPL = W/P = real wage

  Countries that enjoy low wages often have low

productivities.
Substitution between Labor input
and Capital (Land) Input
 Ex: Food production (Figure 4-4)
 In order to produce one unit of Food we use aLF
units of Labor and aTF units of Capital Land.
 However, we can substitute some of labor units
used by some units of Capital while keeping the
same amount of quantity.
  This means we can increase aTL while reduce
aTF providing the quantity to be unchanged.
  The negative relation between aLF and aTF.
Input Possibilities

In the production of
each unit of food, unit
factor requirements of
land and labor are not
constant in the
Heckscher-Ohlin
model
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Choosing Mix of Inputs
 Denote: w : labor wage and r: unit price of land
capital.
 If the relative factor price (w/r) increases, using labor

becomes more expensive than using capital  firms

will substitute labor use (L) for capital use (T)  the
ratio of Land use over labor (T/L) increases.
  There is a positive relation between (w/r) and

land-labor ratio (T/L)

 This relation is expressed in the figure 4-5.

 CC line: production of Cloth (labor-intensive product)

 FF line: production of Food production (Land intensive

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

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Stolper Samuelson Theorem
 When Home country specializes in producing
Cloth, demand for labor increases as Cloth is
Labor-Intensive product  Wage w increases
 (w/r) ↑  cost of production increases 
Pc ↑  Pc/PF ↑.
 So there is a positive relation between the relative price
of Cloth (Pc/PF) and relative factor price of labor
(w/r).
 This relation is expresses by the SS curve in

the figure 4-6 and figure 4-7.

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

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

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Stolper Samuelson Theorem
 When the relative price of Cloth (labor-
intensive product) increases, it leads to 3
consequences:
◦ A rise in income of workers relative to that of land
owners (w/r)
◦ A rise in the ratio of land to labor (T/L) in both
industries.
◦ A rise in the marginal product of labor MPL.
Resources and Output: Rybczynski
theorem
 The Edgeworth Box:
◦ Assumptions:
 Home country is the Labor-abundant
 Cloth is labor-intensive product
 Food is Capital Land-intensive product
 L: total units of labor
 T : Total units of land.
 The Edgeworth Box is illustrated in the figure 4-8: Allocation of Resources.
 When land resource increases from T1 to T2:
◦ Land used to make Cloth reduces
◦ Labor used to make Cloth reduces
◦  Production of Cloth reduces
◦ Land used to make Food increases
◦ Labor used to make Food increases
◦  Production of Food increases.
 Conclusion: when capital resource increases it will increase the
production of capital –intensive product and reduce the production of
labor –intensive product. (Rybczynski theorem)
Factor
Prices,
Goods
Prices,
Factor
Levels
and
Output
Levels
(cont.)

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Factor Prices,
Goods Prices,

Factor Levels
and Output
Levels (cont.)

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Biased Expansion of Production
Possibility
 When Land Capital resource increases , the
PPF will shifts out more to the direction of
production of Food.
 When Labor resource increases, the PPF curve

shifts out more to the direction of production

of Cloth.
Factor Prices, Goods Prices,
Factor Levels and Output Levels
(cont.)

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Factor –Price Equalization
 Before trade:
◦ The relative price of Cloth in Home country is (Pc/P F)A
◦ The relative price of Cloth in Foreign country is (Pc/P F)B
 When Home country specializes in production of
Cloth, demand for labor ↑  (w/r) ↑  Production cost
increases ↑  (Pc/PF)A ↑  Point A moves to A’ .
 When Foreign country specializes in production of

Food, demand for Land ↑  r ↑  (w/r) ↓  Production

cost of Cloth reduces ↓  (Pc/PF)A ↓  Point B moves to B’ .
  Specialization in producing a good will lead to the

equalization of the price of that good between the two countries.

This is called the equalization of factor prices.
 END OF CHAPTER 4