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Standard Trade Theory - Overview - ECONDad

The document provides an overview of standard trade theory including the Ricardian model of comparative advantage and the Heckscher-Ohlin model of factor proportions. It discusses how factor price equalization occurs as trade increases, equalizing wages between countries. Multinational enterprises can take advantage of factor price differences through foreign direct investment.

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232 views2 pages

Standard Trade Theory - Overview - ECONDad

The document provides an overview of standard trade theory including the Ricardian model of comparative advantage and the Heckscher-Ohlin model of factor proportions. It discusses how factor price equalization occurs as trade increases, equalizing wages between countries. Multinational enterprises can take advantage of factor price differences through foreign direct investment.

Uploaded by

diy with Oshinix
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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2/11/2017 StandardTradeTheoryOverviewECONDad

StandardTradeTheoryOverview
BasicElementsandImplicationsofthe"Standard"TradeTheory
August27,2011

Authors
SteppEric

Abstract
ThisKnolprovidesanoverviewofthestandardtradetheoryineconomics.TheRicardianmodelof
comparativeadvantage,theHeckscherOhlinmodeloffactorproportions,andmultinationalenterprise
foreigndirectinvestmentareexplained.Factorpriceequalizationisalsoaddressed.

TradeTheoryOverview

DavidRicardoshowedthattwocountrieswhoengageintradecanbenefitthroughspecializationineach
countryscomparativeadvantage.Thisspecializationincreasesproductionpastwhateachcountrycould
produceonitsownproductionpossibilityfrontier.TheHeckscherOhlinmodel(HOmodel)fortradetakes
theRicardianmodelofcomparativeadvantageandmakesitmorerealisticbyaddingcapital(K)asafactor
ofproductionandthefactorproportionsoftwofactorsofproduction(capitalandlabor).Simply,acountrywill
tendtospecializein,andexport,thatgoodwhichembodiesrelativelymoreofthatcountrysrelative
abundantfactor(laborintensivevisviscapitalintensive).

SincetheHOmodeldealswithtwofactorsinsteadofone,thepatternoftradeisdeterminedbythe
abundanceofonefactoroveranotherfactorrelativetoanothercountry.Todetermineacountrysmaximum
ofcapitaltospend,thetotalamountofcapitalvalueisdividedbythepriceperunitofcapitalusedto
manufactureoneunitofgood:A/PK.Todetermineacountrysmaximumlabortohire,thetotalamountof
valueisdividedbythewagerate:A/w.Bysubstitutingcapitalandlabor,wereabletoplotthemaximum
levels.

ThisisthecountrysproductionfunctionY=F{K,L}.Theproductionfunctionshowshowcapitalandlaborare
substitutedwhencapitalcostsrise,morelaborisusedforproduction,andviceversa.Overlayingdemand
isoquantswillleaveonedemandisoquantthattouchestheproductionfunctiontangentially,whichiswhere
outputismaximizedforagivencostinautarky.However,twocountrytrademeansacomparisonofthe
productionfunctionsbetweentwocountries.Acountryiscapitalabundant(e.g.US)iftheK/Lratioishigha
countryislaborabundant(e.g.ROW)iftheK/Lratioislow.Acountrywillexportofwhatitrelativelyhas
more,withrelationtothefactorintensityofthegoods.TheUSwouldbeconsideredcapitalintensiveifatany
wage/rentalratio=(K/L)Kint>(K/L)Lint.ROWwouldbeconsideredlaborintensiveifatanywage/rentalratio
=(K/L)Lint>(K/L)Kint.

FactorPriceEqualization

https://econdad.wordpress.com/article/standardtradetheoryoverview26oz2653mjrfl9/ 1/2
2/11/2017 StandardTradeTheoryOverviewECONDad

Afundamentalimplicationofthestandardtradetheoryisfactorpriceequalization.Simply,moremovement
towardsopenbordersequalsclosermovementtowageparity.Whentradeisopen,pricesequalizebetween
countriesbecauseofarbitrage.Productionusesbothcapitalandlabor,regardlessofanindustrysfactor
intensity.Asacountryswitchesproductiontoitsmorefactorintensiveindustryduetospecialization,the
abundantfactorisusedmoreproportionally(andatadiminishingreturn)thanthelessabundantfactor.And
asacountrydecreasesproductionfromitslessfactorintensiveindustry,thelessabundantfactorwillbe
releasedintotheeconomymoreproportionallythanthemoreabundantfactor.Inacapitalintensivecountry,
returnstocapitalwilldiminish.Inalaborintensivecountry,wageswillrise.Themarginalrateof
transformationfromthefactorintensiveindustrycreatesaconcaveproductionpossibilityfrontier.

Thedifferentconcaveshapebetweenthetwocountriesisthedisparityinprices.Asproductionmovesupor
downthePPFtomeetproduction,thewage/rentalratiochangesduetotheconcavenatureofthePPFs.
Theslopescreatedbythenewproductionpointarethewage/rentalratios,andastheslopeschange,they
moveclosertobeingidentical.

Note:Slopesandanglesnotexact.

WorkersintheUnitedStateshaveseenthisphenomenonfirsthandoverthelast30years.Americanwages
werehigherthancomparedtoROW,becauseAmericancapitalwasmuchcheaper.AsEuropeand
SoutheastAsiabegandevelopingtheirownmultinationalenterprises,thecostofcapitalstartedtogodown
fortheseregionsrelativetotheUnitedStates.Sincethe1980sthisforcedthestagnationofAmerican
wagesasforeignwagesbegantorise,relativetotheircostsofcapital.

Additionally,multinationalenterprisesexhibitthesameeffectwithregardstoforeigndirectinvestment(FDI).
MNEstakecostdifferentialsrelativetooutputdifferentialsintoaccountwhendecidingonmovingor
expandingproductionoverseas.Differencesinthecapitaltolaborabundancebetweentwonationsprovide
thedifferencesinquantitytolaboroutput.Therefore,movementofproductionoverseasisfeasibleifcostof
laborislowerthantheproductivityratio.Forexample,ifthedifferentialsbetweenUSandROWwere:
(US)Q/L=(ROW)9*Q/L

AUSfirmwouldmoveproductionoverseasifcostsoflaborwerebelow1/9thecostoflaborinUS.

https://econdad.wordpress.com/article/standardtradetheoryoverview26oz2653mjrfl9/ 2/2

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