TRADE: FACTOR AVAILABILITY AND FACTOR • realism of increasing costs

PROPORTIONS ARE KEY o several kinds of factor inputs

• Many industries incur rising, rather than o Different products use factor inputs in
constant, marginal opportunity costs different proportions
• This chapter presents the analysis of trade with • Variation in input proportions - increasing-cost
increasing marginal costs of production; ppc even if constant returns
Heckscher–Ohlin theory of trade • resources are released from cloth production
o different proportions
o cloth industry will release a lot of labor and
Production With Increasing Marginal Costs
not much land
• increasing marginal costs - one industry • law of diminishing returns
expands at expense of others o Adding so much labor to slowly changing
o increasing amounts of the other amounts of land causes gains in wheat
products must be given up to get each production to decline
extra unit of the expanding industry’s o fewer and fewer extra units of wheat
product production are gained by each extra unit of
• production-possibility curve (ppc) - bowed out lost cloth production
o 20 billion units of cloth, S1 slope shows
one extra cloth unit made giving up one What Production Combination Is Actually Chosen?
unit of wheat • Market price of cloth (In wheat): 2 W/C
o To push cloth production up to 60 billion o If OC of producing another unit of cloth <2
cloth units per year requires giving up W/C: make more cloth
o OC more than 2 W/C: make less cloth
wheat in amounts that rise to three
o OC equal to 2 W/C: right amount
wheat units for the last unit of cloth • Producing at S0 (40b cloth, 50b wheat, 2 W/C) –
• increasing costs of extra cloth are also price line slope 2 W/C
increasing costs of producing extra wheat o tangent to ppc at S0
• from a cloth-only economy at point S2 and shifts • relative price of cloth declines to 1 W/C
increasing amounts S2 of resources into o production will decrease
growing wheat, cost of an extra wheat unit rises o shifted into wheat production
• increasing marginal costs
• resulting curve is a supply curve for cloth Community Indifference Curves
• increasing MCs • indifference curve - combinations of
o two-product bowed-out ppc consumption quantities that lead to the same
o upward-sloping supply curve level of well-being or happiness

Bowed-Out Production-Possibility Curve

• derived from information on both total factor
(resource) supplies and the production functions
that indicate how factor inputs can be used

• consumption point depends on the budget

constraint facing the person:
• straight line showing combinations of cloth and
wheat that the individual is able to purchase with
this income:
o Slope of BC negative of price ratio PC/PW
• chooses consumption to be as well off as
possible - highest feasible indifference curve
o IC tangent to price line
• community indifference curves - well-being of a
whole group
• Higher national well-being does not mean that
each person is actually better off

Production and Consumption Together

• PPC bowed out
Without Trade
• self-sufficient
• relative price of cloth in US = 2 W/C
 o ROTW: import 40 billion units of wheat (55
consumed domestically, 15 produced), export
40 billion cloth units (100 – 60)
• Consider price line flatter or cheaper
o US producing above and to the left of S1
o trading large volumes of wheat for cloth
o rest of the world would not want to trade
o excess demand for imported cloth by the
United States would increase the relative
price

Demand and Supply Curves Again

• community indifference curves also can be
combined with the production possibility curves
to plot out demand curves for cloth or wheat
• 2 W/C: US to consume 40 billion cloth units
• 1 W/C: up to 60 billion
• Point S0 becomes A below (in 4.4A)

The Gains from Trade

• trade allows each country to consume at a point
• consumers, producers would want to shift (C1) beyond its own ability to produce
towards S0 • trade allows each country to achieve a higher
• economy begins at S1 (price set by slope of ppc) community indifference curve (I2 over I1)
o cloth looks cheap so they buy more cloth • terms of trade - price the country receives from
than 20 billion units and less wheat than foreign buyers for its export relative to the price
80 billion units that the country pays foreign sellers for its
o producers shift resources into cloth import
• US: relative price of wheat
With Trade o gain more if equilibrium relative price of
wheat were higher

Trade Affects Production and Consumption

• within country, output expands for the product
that the country exports
o growing industry expands by acquiring factor
resources from the other
o import-competing industry reduces its
domestic production
• more efficient world production
o each country expands output of the product
in which was lower-cost prod
o increase in world production of wheat (from
50 + 30 = 80 with no trade to 80 + 15 = 95 with
trade), while world cloth production is
unchanged at 120
• opening to trade also alters the quantities
consumed
o quantity consumed will increase
o relative price of the importable product
declines in each country
o real income rises in each country
o quantity consumed of the exportable product
could increase, stay the same, or decrease

What Determines the Trade Pattern?

• Product prices differ with no trade
• US cloth RP: 2 W/C; rest of the world (ROTW): 0.67 o Production conditions
W/C o Demand conditions differ
• US imports cloth, exports wheat o Some combination of these two
• trade tends to decrease the RP of cloth in the • basis for the United States to import cloth
United States and increase in the ROTW o high demand because of harsh climate or
• price ratio: results in fashion consciousness
o quantity of wheat exported by US = equal to o Production-side differences
the quantity of wheat imported ROTW • United States may have superior technology to
o quantity of cloth exported by ROTW = quantity produce wheat, secret from the rest of the world
of cloth imported by the United States o Comparative advantage
• ROTW: shift from no trade to free trade increases o Heckscher–Ohlin theory
the RP of cloth, prod increases
• 1 W/C THE HECKSCHER–OHLIN (H–O) THEORY
o US export 40 billion units of wheat (80 • Predicts a country exports the product (or
produced domestically S1, 40 consumed C1), products) that uses its relatively abundant
import 40 billion cloth units (60 – 20) factor(s) intensively and imports the product (or
products) that uses its relatively scarce factor(s)
intensively
• labor-abundant: country with higher ratio of
labor to other factors
• labor-intensive: product labor costs are a
greater share of its value
• If cloth costs 2 W/C in the United States and less
than 1 W/C elsewhere
o US has relatively less of the factors that cloth
uses intensively, more of the factors that
wheat uses intensively
o Land - factor that wheat uses more
intensively
o Labor - cloth uses more intensively
• H–O: US exports wheat, imports cloth because wheat
is land-intensive and cloth is labor-intensive

o land is relatively abundant, rent more

cheaply in US
o scarcity of labor should make the wage rate
higher so cloth is relatively expensive to
produce
• combination of the difference in relative factor
endowments and the pattern of factor intensities
that makes the US export wheat instead