Question

Consider two countries, Home and Foreign, trading two goods, Rice and Car. The Home country is endowed with abundant capital relative to labor and hence has comparative advantage to specialize in Cars; whereas the Foreign country is endowed with abundant labor and specializes in Rice. Once they start trading, the price of car decreases, and the price of rice increases in the Foreign country. How would the decrease in the price of car affect the income of each of the following factors under each trade model in the Foreign country?

a. Ricardo Trade model i. Real wage earned by labor

b. The Specific-factors trade model i. Rental rate of capital ii. Rental rate of land iii. Real wage earned by labor

c. The Heckscher- Ohlin (H.O.) Trade model i. Rental rate of capital ii. Real wage earned by labor

d. Is there a gain from trade for the foreign country under the H.O. Model? Explain (you may use a graph to illustrate your answer)

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Answer 1

a) Ricardo Trade model i. Real wage earned by labor

The Ricardian theory of trade focuses on the comparative advantage of the nation.Ricardo asserted that even if a nation does not possess an absolute advantage, there are changes of gains through trade among the nations by comparative advantage. The Ricardian theory is based on differences in technology across nations.

Ricardian model shows that everyone could benefit from trade. This can be shown using an aggregate representation of welfare (national indifference curves) or by calculating the change in real wages to workers.

i) Real wage earned by labor

In his Theory of Profit, Ricardo stated that as real wages increase, real profits decrease because the revenue from the sale of manufactured goods is split between profits and wages. He said in his Essay on Profits, "Profits depend on high or low wages, wages on the price of necessaries, and the price of necessaries chiefly on the price of food."

b) The Specific-factors trade model i. Rental rate of capital ii. Rental rate of land iii. Real wage earned by labor

The specific factor (SF) model was originally discussed by Jacob Viner and it is a variant of the Ricardian model. Hence the model is sometimes referred to as the Ricardo-Viner model. The model was later developed and formalized mathematically by Ronald Jones (1971) and Michael Mussa (1974). Jones referred to it as the 2 good-3 factor model. Mussa developed a simple graphical depiction of the equilibrium which can be used to portray some of the model results. It is this view that is presented in most textbooks.

The model's name refers to its distinguishing feature; that one factor of production is assumed to be "specific" to a particular industry. A specific factor is one which is stuck in an industry or is immobile between industries in response to changes in market conditions. A factor may be immobile between industries for a number of reasons. Some factors may be specifically designed (in the case of capital) or specifically trained (in the case of labor) for use in a particular production process. In these cases it may be impossible, or at least difficult or costly, to move these factors across industries. See Sections 70-1 and 70-2 for more detailed reasons for factor immobility.

The specific factor model is designed to demonstrate the effects of trade in an economy in which one factor of production is specific to an industry. The most interesting results pertain to the changes in the distribution of income that would arise as a country moves to free trade.

The specific factor model assumes that an economy produces two goods using two factors of production, capital and labor, in a perfectly competitive market. One of the two factors of production, typically capital, is assumed to be specific to a particular industry

Basic Assumptions

Basic Assumptions

The specific factor model assumes that an economy produces two goods using two factors of production, capital and labor, in a perfectly competitive market. One of the two factors of production, typically capital, is assumed to be specific to a particular industry. That is, it is completely immobile. The second factor, labor, is assumed to be freely and costlessly mobile between the two industries. Because capital is immobile, one could assume that the capital in the two industries are different, or differentiated, and thus are not substitutable in production. Under this interpretation, it makes sense to imagine that there are really three factors of production: labor, specific capital in industry one, and specific capital in industry two.

These assumptions place the specific factor model squarely between an immobile factor model and the Heckscher-Ohlin model. In an immobile factor model, all of the factors of production are specific to an industry and cannot be moved. In a Heckscher-Ohlin model, both factors are assumed to be freely mobile; that is, neither factor is specific to an industry. Since the mobility of factors in response to any economic change is likely to rise over time, we can interpret the immobile factor model results as short-run effects, the specific factor model results as medium-run effects and the Heckscher-Ohlin model results as long-run effects.

Production of good one requires the input of labor and industry-one specific capital. Production of good two requires labor and industry-two specific capital. There is a fixed endowment of sector-specific capital in each industry as well as a fixed endowment of labor. Full employment of labor is assumed, which implies that the sum of the labor used in each industry equals the labor endowment. Full employment of sector-specific capital is also assumed, however, in this case the sum of the capital used in all of the firms within the industry must equal the endowment of sector-specific capital.

The model assumes that firms choose an output level to maximize profit, taking prices and wages as given. The equilibrium condition will have firms choosing an output level, and hence labor usage level, such that the market determined wage is equal to the value of the marginal product of the last unit of labor. The value of the marginal product is the increment to revenue that a firm will obtain by adding another unit of labor to its production process. It is found as the product of the price of the good in the market and the marginal product of labor. Production is assumed to display diminishing returns because the fixed stock of capital means that each additional worker has less capital to work with in production. This means that each additional unit of labor will add a smaller increment to output, and since the output price is fixed, the value of the marginal product declines as labor usage rises. When all firms behave in this way, the allocation of labor between the two industries is uniquely determined.

The production possibilities frontier will exhibit increasing opportunity costs. This is because expansion of one industry is possible by transferring labor out of the other industry, which must therefore contract. Due to the diminishing returns to labor, each additional unit of labor switched will have a smaller effect on the expanding industry and a larger effect on the contracting industry. This means that the graph of the PPF in the specific factor model will look similar to the PPF in the variable proportion Heckscher-Ohlin model. However, in relation to a model in which both factors were freely mobile, the specific factor model PPF will lie on the interior. This is because the lack of mobility by one factor, inhibits firms from taking full advantage of efficiency improvements that can arise when both factors can be freely reallocated.

Specific factor model result

The specific factor model is used to demonstrate the effects of economic changes on labor allocation, output levels and factor returns. Many types of economic changes can be considered including a movement to free trade, the implementation of a tariff or quota, growth of the labor or capital endowment, or technological changes. This section will focus on effects that result from a change in prices. In an international trade context, prices might change when a country liberalizes trade or when it puts into place additional barriers to trade.

The real effects of the price change on wages and rents is somewhat more difficult to explain but is decidedly more important. Remember that absolute increases in the wage, or the rental rate on capital, does not guarantee that the recipient of that income is better-off, since the price of one of the goods is also rising. Thus, the more relevant variables to consider are the real returns to capital (real rents) in each industry and the real return to labor (real wages).

Ronald Jones (1971) derived a magnification effect for prices in the specific factor model which demonstrated the effects on the real returns to capital and labor in response to changes in output prices. In the case of an increase in the price of an export good, and the decrease in the price of an import good, as when a country moves to free trade, the magnification effect predicts the following impacts,

1) the real return to capital in the export industry will rise with respect to purchases of both exports and imports,

2) the real return to capital in the import-competing industry will fall with respect to purchases of both exports and imports,

3) the real wage to workers in both industries will rise with respect to purchases of the import good and will fall with respect to purchases of the export good.

c.) The Heckscher- Ohlin (H.O.) Trade model i. Rental rate of capital ii. Real wage earned by labor

The Heckscher-Ohlin (Factor Proportions) Model

The Heckscher-Ohlin (H-O; aka the factor proportions) model is one of the most important models of international trade. It expands upon the Ricardian model largely by introducing a second factor of production. In its two-by-two-by-two variant, meaning two goods, two factors, and two countries, it represents one of the simplest general equilibrium models that allows for interactions across factor markets, goods markets, and national markets simultaneously.

Assumptions of the Heckscher Ohlin Model

There are two factors – capital and labor. There is a constraint in factors i.e., the factors are limited to the funding (endowment) of the country. Countries have similar production technology. Countries will share the same technologies

i) Rental rate of capital

  capital intensive, the rental rate on capital would rise, while the wage rate would fall.

ii) Real wage earned by labor

In the Heckscher-Ohlin (H-O) model, there are only two distinct groups of individuals: those who earn their income from labor (workers) and those who earn their income from capital (capitalists). In actuality, many individuals may earn income from both sources. For example, a worker who has deposits in a pension plan that invests in mutual funds has current wage income, but changes in rental rates will affect his or her future capital income. This person’s income stream thus depends on both the return to labor and the return to capital.

For the moment, we shall consider the distributive effects on workers who depend solely on labor income and capitalists who depend solely on capital income. Later we shall consider what happens if individuals receive income from both d) Is there a gain from trade for the foreign country under the H.O. Model? Explain (you may use a graph to illustrate your answer)sources

d) Is there a gain from trade for the foreign country under the H.O. Model

The so-called Heckscher-Ohlin theory explains the pattern of international trade as determined by the relative land, labour, and capital endowments of countries: a country will tend to have a relative cost advantage when producing goods that maximize the use of its relatively abundant factors of production (thus countries with cheap labour are best suited to export products that require significant amounts of labour).

Heckscher and Ohlin did not require production technology to vary between countries, so the H-O model has identical production technology everywhere. ... Countries have comparative advantages in those goods for which the required factors of production are relatively abundant and cheap locally. Heckscher-Ohlin asserts that differences in comparative advantage come from differences in factor abundance and in the factor intensity of goods.