class 4

Question 1

Heckscher-Ohlin Model

Answer 1

An economic theory stating that countries export what they can most easily and abundantly produce.

Argues that trade occurs because:
- Countries have different relative abundance of factors of production/endowments
- Production of goods uses factors of production with different relative intensity depending on technology. It’s called the factor-proportions theory

The Heckscher-Ohlin model provides a useful framework to explain the rising skilled premium

Question 2

Heckscher-Ohlin Model assumptions

Answer 2

1. 2 countries
2. 2 goods: cloth measured in yards and food measured in calories
3. 2 factors of production: K and L
4. Mix of K and L varies across goods
5. The supply of L and K in each country is constant and varies across countries
6. All factors are mobile: In LR, both L and K can move across sectors, equalizing their returns (wage for L and rental rate for K) across sectors.

Question 3

Production Possibilities with the Heckscher-Ohlin Model

Answer 3

With more than 1 factor of production, the OC in production is no longer constant and the PPF is no longer a straight line.

Are constrained by both capital and labor. There are no substitution in the factors of production
aKcQc + aKfQf <= supply of capital available
aLcQc + aLfQl <= supply of labor available

Without factor substitution, the PPF is the interior of the 2 factor constraints since both goods are produced. PPF has a kinked shape

Question 4

Which sector is capital intensive?

Answer 4

Sépare les aL et aK des deux secteurs (c et f)
You take the relative amount of input requirements for c and f production:
aKc/aLc
aKf/aLf
Le plus grand va être f intensive (numérateur) et le plus petit va être l intensive

Assume that at any given factor prices, cloth production uses more labor relative to capital than food production uses: cloth is relatively labor intensive

Question 5

Production possibilities if inputs are substitutable

Answer 5

If producers can substitute one input for another in the production process, then the PPF becomes curves. But the OC of c still increases as producers make more c and vice-versa

Question 6

What does the country produces?

Answer 6

The economy produces at the point that maximizes the value of production given the prices it faces. The isovalue line will be tangent to the PPF.
This is the point on the highest possible isovalue line. It is a line representing a constant value of production, V:
At that point, the opportunity cost of cloth in terms of food is equal to the relative price of cloth, PC / PF.
The trade-off in production equals the trade-off according to market prices.

Question 7

Choosing the mix of inputs

Answer 7

Depends on the wage (for L) and the rental rate (for K)
As wage increases relative to rental rate, producers use less L and more K in the production

Question 8

Relative factor demand curve

Answer 8

On the graph: x = L/K, y = w/r
The relative factor demand curve for cloth CC lies outside that of food FF because at any given wage-rental ratio, cloth production uses a higher labor-capital ratio

Question 9

Factor prices and goods prices

Answer 9

In competitive markets, the price of a goods = cost of production, which depends on factor prices

An increase in wage should affect the price of cloth more than the price of food since cloth is the labor-intensive industry. Changes in w/r are tied to changes in Pc/Pw

Higher relative cost of Labor; Higher relative price of the Labor-intensive good.

If the relative price of cloth rises (Pc/Pf↑), the wage-rental ratio (w/r↑) must rise. This will cause the labor-capital ratio (Lc/Kc) used in the production of both goods to drop.

Question 10

What is the effect of an increase in the relative price of cloth on incomes?

Answer 10

Changes in relative prices have strong effects on income distribution

∆+ Pc/Pf → ∆+ w/r → ∆+ real income of workers (purchasing power)

∆+ Pc/Pf → ∆+ w/r → L/K drops for both goods

Question 11

Stolper-Samuelson theorem

Answer 11

If the relative price of a good increases, the the real wage or rental rate of the factor used intensively in the production of that good increases, while the real wage or rental rate of the other factor decreases.

Question 12

Distribution of income

Answer 12

Any change in the relative price of goods will alter the distribution of income.

Pc/Pf increases →w/r increases → L/K decreases
income of workers (w) relative to that of capital owners (r) increase

purchasing power of workers increase as wages (w) increase in both goods
purchasing power of capital owners decrease as real rents (r) decrease in both goods

Changes in relative prices have strong effects on income distribution. Owners of one factor of production gain (labor here) while owners of the other factor of production (capital here) are worse off.

Question 13

Rybczynski theorem

Answer 13

If output prices are held constant and the amount of a factor of production increases, then the supply of the good that uses this factor intensively increases and the supply of the other good decreases.

Question 14

Increase in Labor supply

Answer 14

An increase in the supply of labor in the economy shifts the economy’s production possibility frontier outward for both goods, but disproportionately in the direction of cloth production (x). It’s a biased expansion of production possibilities
For an unchanged relative price of cloth, food production declines!

Question 15

Trade in the Heckscher-Ohlin 2 factor Model. Countries are assumed to have:

Answer 15

• identical technologies: each has a comparative advantage in producing the good that relatively intensively uses the factors of production in which the country is relatively well endowed

-identical tastes: they will consume cloth to food in the same ratio when faced with the same relative price of cloth under free trade  identical RD curve

Question 16

Relative prices with trade

Answer 16

Like the Ricardian model, the Heckscher-Ohlin model predicts a convergence of relative prices with trade.

Question 17

Relative prices and the pattern of trade

Answer 17

(Home will be relatively more efficient at producing cloth because cloth is relatively labor intensive.
Home will have a larger relative supply of cloth to food than Foreign.)

The rise in the relative price of cloth in Home leads to a rise in the relative production of cloth and a fall in relative consumption of cloth. Home becomes an exporter of cloth and an importer of food.

The decline in the relative price of cloth in Foreign leads it to become an importer of cloth and an exporter of food.

Question 18

Changes in relative prices affect the real income of labor and capital.

Answer 18

A rise in the price of cloth in Home raises the purchasing power of labor in terms of both goods while lowering the purchasing power of capital owners in terms of both goods (slide 26).
A rise in the price of food has the reverse effect.

Question 19

international trade can affect the distribution of income

Answer 19

Owners of a country’s abundant factors gain from trade, but owners of a country’s scarce factors lose.
Factors of production that are used intensively by the import-competing industry are hurt by the opening of trade – regardless of the industry in which they are employed.
Still overall trade expands consumption possibilities  it is still possible to make everybody better off!

Like the specific factors model, the Heckscher-Ohlin model predicts that trade will affect the distribution of income.

This would explain the observed increase in the skill premium in developed skill-abundant countries.
In this case, trade would have been bad for low-skilled workers in developed countries.

Question 20

Main differences between Heckscher-Ohlin model and the specifi-factors model

Answer 20

Specific factor model: losers are factors that are specific to import competing sectors in the short run (ex: cloth workers who need time to learn another job)
Heckscher-Ohlin model: no factor is sector-specific in the long run (all factors are mobile between sectors), yet factors used intensively in the import-competing sector lose out even in the long run.

Question 21

Skill-Biased Technological Change and Income Inequality

Answer 21

The LL and HH curves show the skilled-unskilled employment ratio as a function of the skilled-unskilled wage ratio in the low-tech and high-tech sectors. The high-tech sector is more skill-intensive than the low-tech sector, so the HH curve is shifted out relative to the LL curve.

With SBTC, there are larger productivity gains in the high-tech sector, so relative wage of skilled workers increases.
Even though skilled labor becomes relatively more expensive, producers in both sectors respond to the skill-biased technological change by increasing their employment of skilled workers relative to unskilled workers . It induces larger productivity gains.
The trade explanation predicts an opposite response for employment in both sectors . Trade does not increase the skill premium.

Question 22

Factor Price Equalization across countries

Answer 22

Main prediction from the model:
1 - Free trade equalizes relative output prices.
2 – Therefore, due to the connection between output prices and factor prices, factor prices are also equalized.