Global Trade:3

Global Trade: Lessons

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Lessons Topics

Lesson 1The World Economy and Global Trade: An Overview and Stylized Facts on Global Trade

Lesson 2Theories of International Trade-I: The Ricardian Model: Labor Productivity and Comparative Advantage:

Lesson 3Theories of International Trade-II:The Heckscher-Ohlin Model: Factor Endowments and Comparative Advantage

Lesson 4Theories of International Trade-III:The Standard Trade Model and Gains from TradeCombination of Labor Productivity and Factor Endowments

Lesson 5Policy Instruments of International Trade: Tariffs, Export Subsidies, Import Quotas, Export Restraints

Lesson 6Policy Issues of International Trade: 1) Free Trade vs. Protectionism2) Liberalization in Developing Countries3) The Role of the World Trade Organization

TextsMain Text: Required:

1. International Economics: Theory & Policy, Krugman, P.R., and Obstfeld, M., 8th Edition, Pearson-Addison-Wesley.

Recommended:2. International Economics, Husted, S., and Melvin, M., 8th Edition, Addison-

Wesley.

3. International Economics, Gerber, J., 5th Edition, Addison-Wesley.

4. World Trade and Payments: An Introduction, Caves, R.E., Frankel, J.A., and Jones, R.W., 10th Edition, Pearson-Addison-Wesley.

5. The World Economy: International Trade, Yarbrough, B.V., and Yarbrough, R.M., 7th Edition, Thomson-South-Western.

6. Principles of Microeconomics, Only Chapter 3: Interdependence and the Gains from Trade, Mankiw, N.G., 5th Ed., South-Western Cengage Learning.

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Lesson 3 Lesson 3: Global trade theory-II: The Heckscher-Ohlin Model of

Comparative Advantage Procedure: The PowerPoint Presentation Duration: 60 minutes

OverviewThis lesson helps understand the Heckscher-Ohlin model of comparative advantage based on differences in resource endowments, and the relevant concepts and tools: the curved production possibility frontier, production and consumption decisions, and gains from trade.

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Lesson 3 (cont.)Outline List of Class needs: the text, a computer, and a notebook. Pre-class reading and preparation: Chapter 4 of the text.Activities and timing: Go over the entire presentation in 60

minutes and think about the main findings of the lesson. Draw the diagrams shown in the lesson.

Identification of Learning Objectives: Objective #3 from Section I

Identification of the Global Workforce Skills for the lesson: Skill point #3 in Section II

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Lesson 3 (cont.)Outline Lesson notes and suggestions for Instructors: Read

the relevant chapters in the recommended texts and look for online data for the latest figures of global trade.

Acknowledgment: The Course Developer took help of different sources as referred while preparing the study materials. When a considerable number of diagrams have been developed to enhance interest in the subject, many diagrams come from the required text for the convenience of the students.

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Comparative Advantage based on factor endowmentsIn the previous lesson, we saw how

comparative advantage determined the direction of trade based on simply and only labor productivity.

Canada exports forest products to the U.S. not because its lumberjacks are more productive relative to their U.S. counterparts than other Canadians but because sparsely populated Canada has more forested land per capita than the U.S.

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Comparative Advantage based on factor endowments (cont.)A realistic view of trade must allow for

the importance not just of labor, but of other factors of production such as land, capital, and mineral resources.

This lesson examines a model in which resource differences are the only source of international trade.

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Comparative Advantage based on factor endowments (cont.)Developed by two Swedish economists, Eli

Heckscher and Bertil Ohlin (Ohlin received the Nobel Prize in economics in 1977), the theory is called the Heckscher-Ohlin Model/Theory (Henceforth the HO model).

This model shows that comparative advantage is influenced by the interaction between nations’ resources and the technology of production.

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The Heckscher-Ohlin (HO) modelThe HO model argues that differences in

labor, labor skills, physical capital, land or other factors of production across countries create productive differences that explain why trade occurs.

Countries have a relative abundance of factors of production. Production processes use factors of production with relative intensity.

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The HO model (cont.)Assumptions: The supply of labor services and land in

each country is constant. Only two goods are important for production and consumption: cloth and food.

Only two countries are modeled: domestic and foreign.

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The HO model (cont.)Definitions:

aTC = hectares of land used to produce one m2 of cloth

aLC = hours of labor used to produce one m2 of cloth aTF = hectares of land used to produce one calorie of

food aLF = hours of labor used to produce one calorie of

food L = total amount of labor services available for

production T = total amount of land (terrain) available for

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The HO model: The PPF

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The HO model: The PPF (cont.)Let’s assume that each unit of cloth production

uses labor services intensively and each unit of food production uses land intensively: ◦ aLC /aTC > aLF/aTF

◦Or aLC /aLF > aTC /aTF

◦Or, we consider the total resources used in each industry and say that cloth production is labor intensive and food production is land intensive if LC /TC > LF /TF.

This assumption influences the slope of the production possibility frontier:

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The PPF without factor substitution

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The PPF with factor substitutionActually, the opportunity cost of producing

cloth in terms of food is not constant. It’s low when the economy produces a low amount of cloth and a high amount of food. It’s high when the economy produces a high amount of cloth and a low amount of food.

Why? Because when the economy devotes all resources towards the production of a single good, the marginal productivity of those resources tends to be low so that the (opportunity) cost of production tends to be high.

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The PPF with factor substitution (cont.)

In this case, some of the resources could be used more effectively in the production of another good

If producers can substitute one input for another in the production process, then the PPF becomes curved.

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The PPF with factor substitution (cont.)

If land can be substituted for labor and vice versa, the PPF no longer has a kink. But it remains true that the opportunity cost of cloth in terms of food rises as the economy’s production mix shifts toward cloth and away from food.

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Prices and productionThe PPF describes what an economy can produce,

but to determine what the economy does produce, we must determine the prices of goods.

In general, the economy should produce at the point that maximizes the value of production, V:

V = PCQC + PFQF

where PC is the price of cloth and PF is the price of food.

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Prices and production (cont.)Let us define an isovalue line as a line

representing a constant value of production, V.

V = PCQC + PFQF

PFQF = V – PCQC

QF = V/PF – (PC /PF)QC

The slope of an isovalue line is – (PC /PF)

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Prices and production (cont.)

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The economy produces at the point that maximizes the value of production given the prices it faces; this is the point that is on the highest possible isovalue line. At this point, the opportunity cost of cloth in terms of food is equal to the relative price of cloth, PC /PF

The HO model and tradeSuppose that the domestic country is

abundant in labor services and the foreign country is abundant in land: L/T > L*/ T*. Recall that food production is land intensive and cloth production is labor intensive.

Because the domestic country is abundant in labor services, it will be relatively efficient at producing cloth because cloth is labor intensive.

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The HO model and trade (cont.)Since cloth is a labor intensive good, the

domestic country’s PPF will allow a higher ratio of cloth to food relative to the foreign county’s PPF.

At each relative price, the domestic country will produce a higher ratio of cloth to food than the foreign country.

The domestic country will have a higher relative supply of cloth than the foreign country.

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The HO model and trade (cont.)An economy is predicted to be relatively

efficient at (have a comparative advantage in) producing goods that are intensive in its abundant factors of production.

An economy is predicted to export goods that are intensive in its abundant factors of production and import goods that are intensive in its scarce factors of production.

This proposition is called the Heckscher-Ohlin theorem.

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Summary pointsLimitation of comparative advantage

based on only labor productivityThe Heckscher-Ohlin model: Comparative

advantage based on factor endowmentsFactor substitution and the curved PPFIsovalue line and the production decisionPredicting who will export and who will

import.

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Activity/Homework

1. Give at least three examples where the HO model can be applied.

2. Discuss the trade of computers and garments between the U.S. and Bangladesh in the light of the HO model.

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