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Theories of International Trade
Mercantilists
advocated
protective tariff
to discourage
imports.
Important
questions of
trade concern
gains from
trade, patterns
of trade, and
terms of trade.
keep wages low, protecting agriculture and industry, keeping the trade balance
favourable and so on.
We are primarily concerned with mercantilist views on trade. The mercantilists
encouraged a favourable trade balance because by ensuring larger inflows of silver
and gold than outflows it helped stockpiling of these precious metals. And to keep
the trade balance as favourable as possible, the value of exports should be
maximized and that of imports minimized. They advocated protective tariffs to
discourage the imports of luxury items, and import of essential raw materials only
were viewed with less concern. In short, the mercantilist policies were all designed
and implemented to restrict and regulate international trade which was seen not as
a virtue in itself but rather as an instrument of building up a wealthy and powerful
nation.
Three Pertinent Questions Regarding Trade
The mercantilists missed the issues which really mattered in the case of
international trade. The economists who subsequently raised and tried to answer
these pertinent questions are known as classical economists. Among them were
such notables as Adam Smith, David Ricardo and John Stuart Mill. They raised
the following three sets of questions:
trade and what factors determine the division of these gains among the trading
partners? Or, to put it negatively, what is the cost of preventing free trade and
of trying to attain self-sufficiency?
trade? In other words, which goods should each trading country export and
import in order to reap the benefits of trade? And related to this is the
question: What factors determine the international allocation of factor of
production?
sold internationally) at which trade has to take place, if it is to be beneficial to
at least one country and harmful to none? Do such price ratios necessarily
exit?
Needless to say, these questions form the bedrock of the pure theory of
international trade.
Absolute and Comparative Advantage
The mercantilist ideas about regulating foreign trade by encouraging exports and
discouraging imports drew sharp reactions later from economists and political
philosophers. Noted among them were John Locke and David Hume. But the most
convincing rebuttal came from Adam Smith who epitomized the spirit of
individualism, dominant in the mid-eighteenth century. He brilliantly exposed the
fallacies of the mercantilist doctrine of regulated trade and demonstrated that free
international trade based on international division of labour could benefit all
trading partners.
The Theory of Absolute Advantage
Any theory of international trade must cope with answering two basic questions:
(a) what determines the patterns of trade, and (b) who gains from trade. Adam
Smith's answer draws on the idea of benefits from voluntary exchange following
Free trades
argued that
often two
countries could
make
themselves
better off by
trading than in
isolation.
In this theory,
costs refer to
labour cost of
production.
specialization based on the division of labour. The shoemaker and the tailor can
concentrate on their own lines of production and then exchange each other's goods.
This system of specialization and exchange could make both better off than when
each made both shoes and shirts. Adam Smith extended this principle of division
of labour to nations engaged in international exchange of goods and services. He
argued that under certain circumstances, to be elaborated below, two countries
could make themselves better off by trading than in isolation. His explanation
known as the theory of absolute advantage, though incomplete, is a brilliant
exposition of the virtues of free trade.
It should be understood that the advantages referred to by Adam Smith are based
on differences in the cost of production. Under the labour theory of value to which
classical economists, including Adam Smith, subscribed, the cost differences
translate into price differences in a straightforward fashion. Absolute cost
differences then must lead to absolute price differences which form the basis of
mutually profitable trade. Costs refer to labour costs of production. This implies
that other factors of production such as land and capital are used in some fixed
proportion to labour so that their identities could be merged with that of labour (as
a single input). Besides, the technology of production is such that for each unit of
output of any given good the amount of labour required is fixed irrespective of the
level of output. For example, if the unit cost of production of cloth is 5 labour
hours when the output of cloth is 10 units, then the unit cost would still be 5
labour-hours when the output is 100, 10,000 or 100,000 units. The constant unit
cost assumption applies to goods in the home country as well as the foreign
country, but the unit costs can vary across goods and between countries.
Let us now examine how the ratio of unit costs determines the ratio of goods
prices within a given country in the absence of trade. Hypothetical data on the
costs of production of two goods - cloth and food- in two countries, Thailand and
Japan are presented in Table 2.1 below :
Table 2.
Labour Costs of Production (Hours)
Country 1 unit of food 1 unit of cloth
Thailand 15 30
Japan 30 15
It is clear from Table 2.1 that to produce a unit of cloth Thailand requires twice as
much labour as to produce a unit of food. Therefore, in isolation (a situation
usually known as autarky) one unit of cloth will exchange for two units of food.
By analogous reasoning, the autarky price of a unit of food in Japan will be two
units of cloth.
Table: 2.
Country Price per Unit
Food Cloth
Thailand 1
unit of cloth
2 units of food
Japan 2 units of cloth 1
unit of food.
A trade on the
basis of
comparative
advantage is
profitable.
A country is
said to have
comparative
advantage in
production of
the good in
which its
opportunity
cost of
production is
lower.
1874). Interestingly, it remains one of the oldest and still serviceable theories in
economics.
What is then, comparative advantage? Let us recall that if a country can produce
all goods at lower unit (labour) costs than the other, the former is said to possess
absolute advantage in all goods. In this sense, the costs figures given in Table 2.
indicate, that Thailand has absolute advantage in the production of both food and
cloth. The point here is whether there can be a profitable trade in terms of
comparative advantage, a concept best understood if expressed in terms of
opportunity costs.
Table 2.3 : Labour Costs of Production (Hours)
Country 1 unit of food (a
) 1 unit of cloth (a
Thailand
Japan
Table 2.4 : Opportunity Costs of Production
Country 1 unit of food (a
) 1 unit of cloth (a
Thailand
Japan
The opportunity cost of food in terms of cloth is the amount of cloth given up in
order to release resources for producing an additional unit of food. The
opportunity costs of one good in terms of the other based on labour cost figures of
Table 2.3 are shown in Table 2.4. For example, to produce a unit of food in
Thailand will require 15 labour hours which, if released from the production of
cloth, will entail a sacrifice of
5
6
unit of cloth. Table 2.4 also shows that the
opportunity cost of food (in terms of cloth) is lower in Thailand than in Japan. On
the other hand, the opportunity cost of producing cloth is lower in Japan. And this
is so despite the fact that unit (labour) cost of producing food and cloth are both
lower in Thailand.
A country is said to have comparative advantage in production of the good in
which its opportunity cost of production is lower. Therefore, on the basis of Table
2.4, we can say that Thailand has comparative advantage in food and Japan in
cloth (although Japan has absolute advantage in both).
The theory of comparative advantage then asserts that a country will gain by
exporting the good in which it has comparative advantage, while importing the
good in which it has comparative disadvantage (higher opportunity costs). Note
that for the notion of comparative advantage to be meaningful there must be at
least two countries and at least two goods.
Gains from Trade in the Ricardian Model of Comparative Advantage
It can be easily shown that both the trading countries (here Thailand and Japan)
are better off by trade following the lines of specialization indicated by
comparative advantage. If Japan can import one unit of food from Thailand at a
Both the trading
countries are
shown to be
better off by
trade on the
basis of
comparative
advantage.
The total output
of food depends
on the amount
of cloth,
because supply
of labour and
a LC
/a LF
are
constant.
price lower than 1.33 units of cloth, it clearly stands to gain. On the other hand,
Thailand gains if it can import a unit of cloth at a price lower than 1.2 units of
food (Table 2.4). Let us suppose that the international price settles at 1 unit of
cloth for 1 unit of food (which is in the range indicated above). Then Japan gains
because through trade it gets 1 unit of food by sacrificing 1 unit of cloth, while
under autarky it has to give up 1.33 units of cloth to produce and consume one
unit of cloth. The additional 0.33 unit of cloth (saved) can be consumed or can be
exported to import more food or the country may even choose to consume the
same levels of food and cloth as under autarky, while the workers enjoy more
leisure. By similar reasoning, it can also be shown that at the given international
terms of exchange, Thailand too is better off through trade (exporting food and
importing cloth) than in autarky. It gets 1 unit of cloth for 1 unit of food by trade
and thus saves 0.2 unit of food which it can dispose of in three ways (or any
combination): consuming more food at home, exporting to Japan for more cloth, or
allowing the worker more leisure made possible by consuming the autarkic levels
of consumption of food and cloth.
Ricardian Comparative Advantage & the Extent of Specialization
As we have seen, Ricardo assumed constant average and marginal costs of
production irrespective of the levels of output (by assuming constant labour
productivities for all scales of output). We now want to explore what implication
does this assumption have for the extent of specialization in each country, and in
the process we will examine Ricardian conclusions diagrammatically. Let a LF
and a LC
be the amount of labour needed to produce a unit of food and a unit of
cloth respectively. With a fixed supply of labour, L, and these input co-efficients,
the total output of food (Q F
) and of cloth (Q C
) are technologically related in the
following way :
a
LF
LC
or, Q
F
a
LF
a
LC
a
LF
Clearly Q F
depends linearly on the amount of Q C
produced, because a LC
/a LF
is
a constant (by assumption). The relation is diagrammatically expressed in Fig 2.
by the linear production possibilities curve, AB. The slope of the line indicates
constant opportunity cost of one good in terms of the other (considering labour
costs only). For example , if a LC
=18 and a LF
=15, then to produce every
additional unit of cloth the country must sacrifice 1.2 (=18÷15) units of food. In
the absence of trade, therefore, one unit of cloth will exchange for 1.2 units of
food in Thailand (see Table 2.4).
Note that with the constant production possibilities curve like AB, the internal
(pre-trade) price ratio is solely determined by the slope of the production
possibilities curve (i.e by the relative labour productivities in the two goods). The
demand (the taste pattern) had no role to play in the relative price determination as
long both the goods are consumed. Apparently this sounds odd. In Fig. 2.1 two
indifference curves (representing two different taste patterns) are tangent to AB at
points R and R'. Clearly, if the taste patterns change, the country may shift the
consumption (and production) point from R to R', and the price ratio remains the
Free trade
makes both
countries better
off, by
expanding the
consumption
opportunity sets
of both.
to reflect the fact that cloth is cheaper in Japan, while food is cheaper in Thailand
(because
As stated before. there exists an opportunity for mutually beneficial trade, if
Thailand exports food and Japan exports cloth. But at what price? Clearly the
price of cloth should be somewhere between absolute values of slopes of the two
linear production possibilities curves (AB and AB), i.e. between
OA
OB
and
OA*
OB*
. The Ricardian model does not offer any mechanism for unique price
determination. But whatever price is established in equilibrium, it must exhibit two
features : (i) the relative equilibrium price of cloth (and so also the equilibrium
price of food) must be the same in the two countries, and (ii) it should be such that
the value of exports of each country at the price must be matched by the value of
imports from the other.
To see diagrammatically that comparative cost difference can lead to mutually
profitable trade, let us go back to Fig. 2.2. In each country, the production and
consumption possibilities before trade are the same (only what is produced can be
consumed). After trade, the consumption possibilities set gets larger, though the
sets of production possibilities remain unaltered. For example if the equilibrium
price ratio is 1:1, then the consumption possibilities set for Thailand is AOC
rather AOB (and AOC is larger than AOB). Similarly the consumption
possibilities set for Japan after trade is given by BOC which is larger than
BOA, representing pre-trade consumption possibilities. Not surprisingly, free
trade can make both countries better off, because of the expansion of the
consumption opportunity sets. But while the technology difference may not lead to
complete specialization in consumption, it may do so in production. Usually
Thailand will completely specialize in the production of food (consuming cloth
from imports only) and Japan in cloth (meeting need for food entirely from
imports), because not doing so amounts to giving up an opportunity for
betterment. As we shall see later, the only exception to the conclusion of complete
specialization and the Ricardian assumptions to the situation is when one of the
two trading countries is much larger than the other.
MCQ’s (Tick (√) the correct [most appv.] answer)
A. rejected all trade and advocated a closed economy
B. encouraged exports and discouraged imports
C. wanted to make the country wealth
D. both B and C
E. None of the above.
A. comparative costs differ between them
B. price differ between them
C. A and B being true, they fail to settle on the terms of exchange
D. A and B being true, they agree on the terms of exchange
None of the above.
goods within a country determined
A. solely by technology
B. solely by taste patterns
C. partly by taste patterns
D. all of the above.
A. the average cost (AC) equals marginal cost (MC)
D. we have usually complete specialization
two countries. Therefore,
A. trade will case until price change for one reason or another
B. trade will continue
C. trade will be balanced
D. Both B & C
E. None.
Broad Questions :
advantage in cloth. Does it imply that B has comparative advantage in food?
Demonstrate with an example.
Short Questions
possible. Why? Was wealth a means to an end, or an end in itself?
a necessary condition.” Do you agree? why?
without ever considering the demand conditions.” Do you agree?
opportunity sets.
The relative size
is irrelevant for
explaining trade
patterns, but not
so for terms of
exchange.
Ricardian scheme. The really crucial factor is the difference in technologies. Let
us see why the size and taste differences don't really matter, as long as the
technology (represented by the labour productions) remains the same. As we have
seen, taste differences play no role in price formation, their only role being
determination of relative quantities consumed. The size of the labour force
determines the position of the production possibility curves of the two countries. If
the technology is the same, their slope will be the same, and therefore price
differences will not emerge. We can then say that technology differences lead to
cost difference irrespective of similarity or otherwise of tastes and size of the
countries concerned. But this statement should be carefully interpreted. If one of
the two countries are uniformly superior to the other in technology, relative cost
differences will not appear. To see why, suppose that Thailand can produce a unit
of output of either commodity with 20% fewer labour hours that would be
required in Japan. For simplicity assume that Japan and Thailand have labour
force of the same size. Then the production possibilities curve for Thailand will be
uniformly outward by 20% (compared to that for Japan), but there will be no
difference in their slopes. Therefore, the effect of 20% superiority is like that of
having a 20% larger labour force in Thailand with the same labour productivity in
the two countries. Pre-trade relative price being the same, there is no opportunity
to gain from trade.
Relative Size of Countries and the Extent of Specialization
We have just seen why the relative sizes of the countries (measured in terms of
relative sizes of the labour force) do not influence the patterns of trade. It should
be emphasized however that while the relative size is irrelevant for trade patterns,
it is not so for determining the international terms of exchange, i.e. the terms of
trade. If one country is much larger than the other, the international price may not
lie strictly between the cost ratios in each country. It could be that the equilibrium
terms of trade will be identical to those prevailing in the larger country before
trade, implying that the larger country derives no benefit from free trade (though
the smaller country does). 'Bigness' is then not necessarily a boon; and in fact, the
opposite may be true in the field of international trade.
Fig 2.
When can this happen? Consider two countries, India and Nepal. India has
comparative advantage in the production of tea, while Nepal has this advantage in
timber. India being a very big country compared to Nepal, it cannot hope to meet
all its demand for timber through imports from Nepal (assume that there are only
two countries in the world, India and Nepal). Therefore, India must produce along
with tea perhaps a large quantity of timber too. But then the price of timber must
reflect the costs of production at home which implies that the international price
Ricardian
theory is robust:
it is valid even
when non-
labour costs are
included.
The marginal
rate of
transformation
is opportunity
cost of
cloth in terms of
food.
which will prevail is the pre-trade relative price in India. In Fig. 2.3, the slope of
the line GD reflects the pre-trade and post-trade relative price of tea in India. At
the consumption point (P), India's demand for timber is PQ, of which only PR can
be obtained from Nepal. The rest (RQ) must be produced domestically. Therefore,
India produces at S (rather than at D under complete specialization) and consumes
at P. The result is incomplete specialization in Tea, a consequence of (its) relative
size.
Comparative Advantage under a More General Theory of Production
We have shown that a country enjoys comparative advantage in the Ricardian
sense, if its relative opportunity costs of production is lower than that of the other
country in a certain commodity. The opportunity costs were, however, calculated
on the basis of labour costs alone, because the classical economists believed in the
labour theory of value. Furthermore, the labour costs of production of a unit of
any commodity was constant over the entire range of output. As a result, output of
a commodity could be expanded at a constant opportunity cost.
The dependence of the classical notion of comparative advantage on the labour
theory of value as well as (on) the assumption of constant opportunity costs in a
major drawback. Labour theory of value is too restrictive, while the constant
opportunity cost assumption is empirically questionable. Therefore, it is important
to ask: Does the basic conclusion of the Ricardian theory of comparative
advantage remain valid, even after the notion of Ricardian opportunity cost is
replaced by a more general notion in which non-labour factors of production are
explicitly taken into account and factor substitution is allowed? Fortunately, the
answer is 'yes', because in the 1930s Gottfried Haberler has shown that the
principal prediction of the Ricardian theory about trade patterns stands unaffected
even when production takes place under increasing opportunity costs with many
factors of production cooperating. Despite the changed assumption about the
nature of production processes, it is still true that a country will export the
commodity in which it has a comparative advantage and import the one in which it
has a comparative disadvantage.
Recall that the opportunity cost of cloth (in terms of food) is the amount of food
that must be given up in order to produce an additional unit of cloth (When all
factors of production are fully and efficiently employed in the production of either
or both the goods). When the units of food sacrificed for an additional unit of cloth
go on increasing as the amount of cloth production increases, we have a situation
of increasing opportunity costs. In this case, the production possibilities curve will
be concave to the origin as shown by MN in Fig. 2.4.
The (absolute) slope of MN at any point
shows the rate at which food can be
transformed into cloth in the technological
sense. This rate is called the marginal rate
of transformation (MRT) in production. For
example, the (absolute) slope of MN is
greater at R' than at R, indicating that more
food needs to be sacrificed to increase cloth
production at R' than at R. In other words,
the marginal rate of transformation (which
is nothing but the opportunity cost of cloth
This tendency
of the relative
price of cloth to
change under
the impact of
trade flows will
continue until
the price is the
same in both the
countries and
the trade is
balanced.
In panel (a) of Fig 2.5, the common production and consumption point in pre-trade
equilibrium for Thailand is shown by point E. The corresponding equilibrium
point for Japan is E* (panel (b) of Fig 2.5). The common slope of Thailand's
production possibilities curve (MN) and one of its social indifference curve 1 at E
is different from the corresponding common slope at E* (tangent lines have not
been drawn). In fact, the tangent line at E will be steeper than that at E*. This
means that the pre-trade equilibrium price of cloth is higher in Thailand than in
Japan. Alternatively we can say that before trade food is cheaper in Thailand than
in Japan. The law of comparative advantage would dictate that Japan exports
cloth and Thailand food. But we are yet to examine whether this trade pattern can
make both the countries better off than before trade.
Both Thailand and Japan will in fact, be better off if they can trade with each other
at a price ratio falling in a range whose limits are set by the (absolute) slopes of
the tangents at E and E*. Let us suppose that the slope at E is such that 1unit of
cloth exchanges for 6 units of food (i.e. the relative price of cloth P C
is 6).
Therefore Thailand has to sacrifice 6 units of food for a unit of cloth. We make a
corresponding assumption about the pre-trade cloth price in Japan. Specifically we
assume that in pre-trade equilibrium one unit of cloth exchanges for 2 units of
food in Japan. In other words, in equilibrium Japan is willing (and able) to
sacrifice 2 units of food for a unit of cloth. If we denote the relative price of cloth
by P C
, then on the basis of the above, we can write
Thailand
Japan
If trade begins, Thailand will export food and Japan cloth. As the trade flows
continue, the relative price of cloth in Thailand will tend to fall (the relative price
of food tends to rise). Resources in Thailand will, therefore, be withdrawn from
the production of cloth and used in the production of more food. This is a natural
response of profit maximizing producers to changing relative prices. The opposite
happens in Japan. Trade tends to increase the relative price of cloth (because it
exports cloth decreasing domestic cloth supply and imports food augmenting
domestic food availability). This makes cloth production more profitable at the
margin than before. Resources are reallocated such that some of the resources
engaged in food production are now used for increasing cloth production.
This tendency of the relative price of cloth to change under the impact of trade
flows will continue until the price is the same in both countries and trade is
balanced (the values of each country's exports and imports are equal). Let us
suppose that the equilibrium international price ratio is such that 1 unit of cloth
exchanges for 5 units of food (note that this is in between the pre-trade price
ratios). In Fig. 2.5, the common international price ratio is shown by the common
(absolute) slope of line KG (Thailand) and KG (Japan). The production point in
Thailand has shifted from E (before trade) to Q (after trade); it has increased the
production of food in which it has comparative advantage and decreased the
production of cloth in which it has comparative disadvantage. The opposite must
have happened in Japan. Its production point shifts from E* (before trade) to R*
(after trade), thus increasing the production of cloth in which it enjoys
comparative advantage.
The welfare
level is
indicated by
social
indifference
curve.
The principle of
comparative
advantage
remains valid as
an explanation
of the trade
patterns, even
under
increasing
opportunity
costs.
Fig. 2.
It is easy to see that both countries gain because trade opens up the possibility for
each country to trade at a price ratio different from that prevailing in each country
before trade. The total gain for each can be split into two components, namely, the
consumption gain (due to reallocation of consumption alone) and the production
gain (due to reallocation of production alone). Take the case of Thailand. Even if
there were no scope for reallocation of production after trade (i.e. if production
were kept frozen at E), it can gain by trading at the international price indicated by
line KG. To see how, imagine a line parallel to KG which passes through the point
E. The line will represent new consumption possibilities opened up for Thailand
even though production is fixed at E. It should be clear from the diagram that
Thailand can reach a higher level of social welfare than attained at E simply by
reallocation of consumption to a point on the new consumption frontier. This
represents the consumption gain. Production gain arises from the possibility of
production reallocation according to comparative (cost) advantage. If production
reallocation is possible and production shifts from E to Q, the consumption
opportunity line now becomes KG (which is further out from the line imaged
above). This represents a larger consumption opportunity set. The welfare level
attained now is indicated by social indifference curve 2 (point R). The increase in
welfare in this second step is the production gain. The total gain in welfare is
represented by the climb from social indifference curve 1 to 2. It is now easy to
see that the other country (Japan) also gains from trade by moving from a lower
social indifference curve 1* to a higher one (2*).
In summary, we can say that under the increasing cost situation also, the trade
pattern can be explained as in the simple Ricardian model in terms of comparative
advantage.
Haberler has aptly remarked, the principle of comparative advantage remains valid
as an explanation of the trade patterns in the same way as "a building remains
after the scaffolding, having served its purpose, is removed." The building
remains, but some of its old features are gone; trade no longer leads to complete
specialization and the price ratio is no longer dictated by technology alone.
According to
the Heckscher-
Ohlin theory,
countries
usually export
those goods that
use their
abundant
factors
intensively.
Answer: 1.C, 2.A, 3.A, 4.C, 5.D
Lesson 3 : The Heckscher Ohlin Model and Related
Theorems
Lesson Objectives:
After studying this lesson, you will be able to
explain the Heckscher-Ohlin model;
explain the Rybczynski theorem;
appreciate the Stolper Samuelson theorem and
understand the Factor Price Equalization theorem.
The Heckscher-Ohlin Model
Neither David Ricardo nor other classical economists provided any clear-out
answer to the question : What is the ultimate determinant of comparative
advantage? Ricardo emphasized differences in technology, but there was no
explicit explanation of why such differences should arise, except implying
indirectly that they might be due to climatic differences between countries.
As we have seen before, even though two countries can differ (in the Ricardian
model) in respect of taste, technology and size of the productive labour force,
Ricardo found only the technological differences crucial for trade, the other two
being irrelevant, if the technologies did not differ. By adding more factors of
production, the Heckscher-Ohlin model brings to the fore a fourth kind of
difference, namely, that the proportions in which two countries are endowed with
various factors of production can vary. Two noted Swedish economists, Eli
Heckscher (1879-1952) and Berfil Ohlin (1899-1979) emphasized these
differences in factor proportions in their explanation of comparative advantage
and trade. Their ideas revolve around two key assumptions :
(i) Production of different goods require different factor proportions ; and
(ii) Countries vary in respect of their endowed factor abundance.
According to the Heckscher-Ohlin theory, countries usually export those goods
that use their abundant factors intensively. For this reason, the Heckscher-Ohlin
theory is also called the factor-proportions theory. Its plausibility is almost
immediate when we see that labour abundant countries like Korea and Taiwan
export footwear, textiles and sugar (labour-intensive goods), while the land
abundant countries like Australia, Canada and Argentina export meat, wheat, and
wool (land-intensive products).
Assumptions of the Heckscher-Ohlin (H-O) Model
Like all models (because they need abstractions), the H-O model too is based on
several simplifying assumptions, not all of which are required for the validity of all
the propositions of the general H-O model. These are:
having two homogeneous factors of production (capital and labour) and
producing two goods (cloth and steel). This is why the model is also referred
to as the 2x2x2 model.
Trade can lead
to the equality
of relative
commodity
prices between
nations.
Perfect
competition will
drive the
producer of
each good to
select only one
input ratio (one
technique) for
any given level
of output.
produced with identical production technologies in each country. Moreover,
the production functions exhibit constant returns to scale. This implies that a
proportionate increase in all inputs will lead to the same proportionate
increase in all output. The production function in the two countries being
identical, this will ensure that the producer of a commodity in the two
countries will use exactly the same quantities of labour and capital for a unit
of the commodity, if they face the same factor price ratio.
compared to the other (say, steel). This means that whatever the wage-rental
ratio, cloth uses more labour per unit of capital than steel. This assumption is
needed to rule out any possibility of factor-intensity reversal, which is
particularly damaging to H-O conclusions. Factor intensity reversal occurs
when, for example, cloth is labour-intensive at lower wage-rental ratios, but
become capital-intensive at high wage rental ratios.
perfectly competitive markets.
factors are absolutely free to move between industries of the same country.
By contrast factors are assumed to be completely immobile between
countries.
identical.
tariffs, quotas and exchange control.
assumption, trade can lead to the equality of relative commodity prices
between nations.
Meaning of Factor Intensity and Factor abundance
Assume that two goods, cloth and steel, are produced in each country by one
technique alone. For instance, a unit of cloth requires 8 units of labour and 2 units
of capital, while a unit of steel requires 2 units of labour and 8 units of capital.
These input requirement data are presented in Table 2.6.
Table 2.
Commodity Input per unit of output Capital Labour
Cloth Capital (K) Labour (L)
Steel 8 2 8 ÷ 2=
Clearly the capital-labour ratio in the production of cloth is lower than in the
production of steel (
<4). Since there is only one process by which each good
can be produced, we can unambiguously say that steel is more capital-intensive
than cloth. Or equivalently, cloth is more labour-intensive than steel.
A difficulty may apparently arise if cloth and steel can be produced using many
possible techniques (e.g., along a smooth isoquant). But even here we can apply
