KOM, hap 5 and 6 RESOURES AND TRADE: THE HEKSHER-OHLIN MODEL Part 2 1 Effects of Trade on Real Factor Prices 2 Extending the Heckscher-Ohlin Model Effects of Trade on Factor Prices When Home exports computers and imports shoes, we learned that it is because the world relative price of computers rises as compared to the no-trade equilibrium. We have also established that the wage-rental ratio must fall in Home as a result of trade. The task now is to determine what happens on the Real Wage and Real Rental. This is important because this tells us w Who gains and who loses from the change in the relative price of computers w This assessment is made by asking the question: what is the change in the quantity of shoes and computers that each factor of production can purchase? 2
Effects of Trade on Factor Prices hange in the Real Rental due to Trade: w Because the labor/capital ratio increases in both industries, the marginal product of capital increases. There are more people to work with each unit of capital. w The rental rate of capital is determined by its marginal product. r = P *MPK and r = P S *MPK S w apital can move freely between industries in the long run. Thus, the rental rate is equalized across industries. w Rearranging the previous equations, MPK = r/p and MPK S = r/p S w Since both marginal products of capital increase, r/p and r/p S increase. 3 Effects of Trade on Factor Prices hange in the Real Rental w r/p measures the quantity of computers that can be purchased with the rental. w r/p S measures the quantity of shoes that can be bought with the rental. w Since r/p S and r/p must increase as well, capital owners are better off when the relative price of capital increases. w Generalization: w apital owners are better off when the relative price of capital increases. w omputers are the capital intensive industry and the relative price of capital has increased. An increase in the relative price of a good benefits the factor of production used intensively in producing that good. 4
Effects of Trade on Factor Prices hange in the Real Wage w Again we make use of the fact that the labor/capital ratio increases in both industries. w The law of diminishing returns tells us the marginal product of labor must decrease in both industries. w As before the wage is determined by the marginal product of labor and the price of goods. w = P *MPL and w = P S *MPL S w Rearranging MPL = w/p and MPL S = w/p S w Since MPL and MPL S decrease, w/p and w/p S decrease. 5 Effects of Trade on Factor Prices hange in the Real Wage w w/p is the quantity of computers that can be purchased with the wage. w w/p S is the quantity of shoes that can be purchased with the wage. w Since w/p and w/p S decrease, labor is worse off due to the increase in the price of computers. Generalization: The Stolper-Samuelson Theorem: In the long run when all factors are mobile, an increase in the relative price of a good will increase the real earnings of the factor used intensively in the production of that good and decrease the real earnings of the other factor. 6
Effects of Trade on Factor Prices Therefore, in the Heckscher-Ohlin model: The abundant factor gains from trade, and the scarce factor loses from trade. Recap: Home is capital abundant and Foreign is labor abundant; omputer uses intensively capital while shoes uses labor intensively; The Heckscher-Ohlin model predicts that the capital (labor) abundant country exports the capital (labor) intensive product; Stolper-Samuelson Theorem tells us that the real earnings to a factor must rise whenever this factor is used intensively in the production of the good whose price rises with trade, while the other factor loses from trade. It must mean that the abundant factor gains from trade and the other loses. 7 Effects of Trade on Factor Prices This result comes from magnification effects between the changes in the price of goods and changes in factor prices. Rental on capital is calculated by taking total sales revenue in each industry, subtracting the payments to labor, and dividing by the amount of capital: r r = = P Q wl K PS QS wl K S S Since the price of computers has risen, ΔP > 0 and ΔP S = 0, then. Δr ΔP Q ΔwL = K 0. Q Δr = S S ΔwL K S 8
Effects of Trade on Factor Prices We can rewrite the last two equations in percentage changes: Δr r Δr r ΔP = P P Q rk Δw wl = w rk Δw wl w rk w Thus, for an increase in P : Δw/w < 0 < ΔP /P < Δr/r ; real wage falls, real rental increases; w For a decrease in P : Δr/r < ΔP /P < 0 < Δw/w ; real rental rate falls, real wage increases. Do the same exercise for an increase and a decrease in P S. 9 Effects of Trade on Factor Prices These equations relating the changes in product prices to change in factor prices are called the magnification effect. w They show that changes in the prices of goods have magnified effects on the earnings of factors. w Even modest fluctuations in the relative prices of goods on world markets can lead to larger changes in the long-run earnings of both factors. This shows why some are opposed to trade and some support it! 10
Effects of Trade on Factor Prices Now you can make some predictions! Suppose a free trade agreement between anada and hina is proposed. Who among capital owners and workers would you predict are better off/worse off in anada? 11 Gains from Trade and Income Distribution Individual s gains from trade depend on what happens to factor prices, what happens to product prices and on individual s consumer pattern. Gains from trade due to imports becoming cheaper relative to exports are unevenly distributed across consumers due to differing consumption patterns. onsumers with lower income spend relatively more of their income on food and some manufactured goods (such as apparel), whereas consumers with higher income spend relatively more on services. Because food and manufactured goods are traded much more heavily than services, poorer consumers benefit much more from lower import prices than richer consumers. 12
Gains from Trade and Income Distribution The figure shows the relative gain and loss for a consumer at a given percentile of the country s income distribution relative to the median consumer in that country (at the 50th percentile of the income distribution). The figure shows the average across 40 countries. Although richer consumers gain relatively less than the median consumer (the relative gain is negative), their overall gain from trade is still positive. Source: Pablo D. Fajgelbaum and Amit K. Khandelwal, Measuring the Unequal Gains from Trade, The Quarterly Journal of Economics (2016), pp. 1113 1180. See also Measuring the Distributional Effects of Trade through the Expenditure hannel, voxeu.org (November 2015). 13 Growth and Output Is economic growth in hina good for the standard of living in the U.S.? Is growth in a country more or less valuable when it is integrated in the world economy? The standard trade model gives us precise answers to these questions. Question: How do levels of output change when the economy s resources change such as with growth? Rybczynski Theorem: If output prices are constant as 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. 14
Growth and Output In this example with food and cloth, we have increased the endowment in this country of the factor of production used intensively in cloth. Without knowing the technologies of both products, we do not know which factor has increased. At a given relative price of cloth, w/r and the ratio of labor to capital used in both sectors remain constant. Thus to expand cloth, the only way is to get resources from food. It is why food must contract at same relative prices. 15 The Effects of Economic Growth Is economic growth in hina good for the standard of living in the U.S. and in anada? Is growth in a country more or less valuable when it is integrated in the world economy? The standard trade model gives us precise answers to these questions. Growth is usually biased: it occurs in one sector more than others, causing relative supply to change. w Rapid growth has occurred in U.S. computer industries but relatively little growth has occurred in U.S. textile industries. anada has huge growth in the energy sector. w In the Ricardian model, technological progress in one sector causes biased growth. In the Heckscher-Ohlin model, an increase in one factor of production causes biased growth. 16
The Effects of Economic Growth 17 The Effects of Economic Growth 18
The Effects of Economic Growth Biased growth and the resulting change in relative supply causes a change in the terms of trade. Terms of trade: the price of a country s exports divided by the price of its imports. w Biased growth in the cloth industry (in either the home or foreign country) will lower the price of cloth relative to the price of food and lower the terms of trade for cloth exporters. w Biased growth in the food industry (in either the home or foreign country) will raise the price of cloth relative to the price of food and raise the terms of trade for cloth exporters. w Suppose that the home country exports cloth and imports food. 19 The Effects of Economic Growth If the Home country exports cloth and there is growth in that sector, it tends to drive the relative price of cloth down and thus to decrease Home s terms of trade. 20
The Effects of Economic Growth If growth occurs if the food sector, the price of food decreases reflected here by moving from 1 to 3. Since Home exports cloth, this corresponds to an increase in Home s terms of trade. 21 The Effects of Economic Growth Export-biased growth is growth that expands a country s production possibilities disproportionately in that country s export sector. w Biased growth in the food industry in the foreign country is exportbiased growth for the foreign country. Import-biased growth is growth that expands a country s production possibilities disproportionately in that country s import sector. w Biased growth in cloth production in the foreign country is importbiased growth for the foreign country. 22
The Effects of Economic Growth Export-biased growth reduces a country s terms of trade, reducing its welfare and increasing the welfare of foreign countries. Import-biased growth increases a country s terms of trade, increasing its welfare and decreasing the welfare of foreign countries. The standard trade model predicts that import-biased growth in hina would occur in sectors that compete with U.S. exports and reduce the U.S. terms of trade. But the data indicates that changes in the U.S. terms of trade have been small with no clear trend over the last few decades. w The terms of trade for hina have deteriorated over the past decade, suggesting their recent growth may have been export-biased. 23 The Effects of Economic Growth Evolution of the Terms of Trade for the United States and hina: Growth in hina has been export-biased. Source: World Development Indicators, World Bank. 24
Import Tariffs and Export Subsidies Import tariffs are taxes levied on imports Export subsidies are payments given to domestic producers that export. Both policies influence the terms of trade and therefore national welfare. Import tariffs and export subsidies drive a wedge between prices in world markets and prices in domestic markets. US and EU export subsidies in agriculture; import tariffs on hinese products in anada and in the US. We ll study tariffs and subsidies in details in a few weeks. The issue for today is that they can affect the terms of trade. 25 Import Tariffs and Export Subsidies The domestic country imposes a tariff on food imports. What is the effect on this country s terms of trade? w Domestic producers will receive a higher relative price of food, and therefore will be more willing to switch to food production: the relative supply curve will shift to RS 2. w Domestic consumers will pay a higher relative price of food, and therefore be more willing to switch to cloth consumption: the relative demand curve will shift to RD 2. If Home exports cloth, its terms of trade improve! For this to happen it must be a large country. Do the same exercise for export subsidy. 26
Import Tariffs and Export Subsidies Never forget that if terms of trade change in one country, they also change in the opposite direction with its direct trade partners. Even without direct trade, there is an effect on other countries: A foreign country may subsidize the export of a good that anada also exports, which will reduce its price in world markets and decrease the terms of trade for anada. When the EU subsidizes agricultural exports, it reduce the world price that anadian farmers also receive for their agricultural exports in world markets. A foreign country may put a tariff on an imported good that anada also imports, which will reduce its price in world markets and increase the terms of trade for anada. If the EU imposes tariffs on hina textiles reducing world price of textiles, it increases anadian terms of trade when anada also imports textiles from hina. 27 Import Tariffs and Export Subsidies Export subsidies by foreign countries on goods that anada also imports reduce the world price of anadian imports and increase the anada s terms of trade. anada also exports reduce the world price of anadian exports and decrease the anada s terms of trade. Import tariffs by foreign countries on goods that anada also exports reduce the world price of anadian exports and decrease anada s terms of trade. anada also imports reduce the world price of anadian imports and increase anada s terms of trade. 28