The preferences of all consumers in the world are identical.
The preferences of any individual are such that the Marginal Rate of Substitution is independent of the scale of consumption.
The MRS of Wine for Cheese is the additional amount of Wine that would keep the individual's level of happiness unchanged even after the consumption of Cheese is reduced by one unit. Under this assumption, if the amounts of Cheese and Wine being consumed are, say, doubled, then the MRS remains unchanged. In other words, the MRS does not change if the ratio of the amounts of Cheese and Wine consumed, Cheese / Wine, does not change.
Technological knowledge is the same in both countries
Goods are produced (with land and labor) using technologies that satisfy Constant Returns to Scale.
That is, if the producer of a commodity, say, doubles the amounts used of all resources, then the amount produced will have to double also.
The Heckscher-Ohlin Assumptions—Factor Abundance
Home has a higher ratio of labor to land than Foreign does.
That is, if T H , T F , L H , and L F denote the amounts of T (land or territory) and L (labor) that Home and Foreign are endowed with, then L H / T H > L F / T F . L/T may be informally interpreted as the number of workers per acre of land.
Home is said to be the “labor-abundant” country and Foreign is the “land-abundant” country.
The Heckscher-Ohlin Assumptions—Factor Intensities
The production of food is land-intensive and the production of cloth is labor-intensive
That is, the number of workers per acre (L/T) is always higher in cloth production than in food production
Let w be the nominal price (or, wage) of labor. Let r be the nominal price (or, rent) of land
Then w/r is the relative price of labor (in units of land) and
r/w is the relative price of land (in units of labor)
Example: If w = $10 per hour for one worker and r = $100 per hour for one acre of land, then the relative wage for one worker is 1/10 acres of land and the relative rent on an acre of land is 10 hours of labor.
Real Price of X , in units of Y , is equal to Nominal Price of X / Nominal Price of Y
So, if w is the nominal wage and P is the nominal price of a cup of coffee, then the real wage is w / P .
For example, if w is $ 8 per hour and P is $ 2 , then the real wage is w / P = 8/2 = 4 cups of coffee per hour, as in the previous slide.
Factor Prices and Goods Prices As labor becomes more expensive relative to land, cloth, which is labor-intensive in production, finds itself at a disadvantage and becomes relatively more expensive compared to food As both Home and Foreign use the same technologies, the same FPGP curve is applicable in both countries Wage-rent ratio, w/r Relative price of cloth, P C /P F FPGP 5 17
Factor Prices and Input Choices As labor becomes relatively more expensive, relatively more land is used in production … But the number of acres of land per worker is always higher in food production, reflecting the assumption that food production is land intensive … of both food and cloth As labor becomes relatively more expensive, relatively more land is used in production … Wage-rent ratio, w/r Acres of Land per worker, T/L Cloth production Food production 4 12 5
Factor Prices and Input Choices As both Home and Foreign use the same technologies, these two curves must be true in both countries. When w/r = 5, cloth producers use 4 acres per worker in both countries and food producers use 12 acres per worker in both countries. Therefore, Foreign, which has more land per worker than Home, must produce relatively more food … Wage-rent ratio, w/r Acres of Land per worker, T/L Cloth production Food production 4 12 5
From the FPGP Curve in Fig. 4-3 , any particular value of w/r is linked to a specific value of P C / P F .
Therefore, if the same w/r prevails in the two countries, then the same P C / P F must also prevail in the two countries. And at that common value of P C / P F …
Q F / Q C must be higher in Foreign than in Home . Equivalently,
Q C / Q F must be higher in Home than in Foreign .
Relative Supplies In Figure 4-2 , we saw that at w/r = 5, Foreign must produce relatively more food and Home must produce relatively more cloth. In Figure 4-3 we saw that w/r =5 corresponds to P C /P F = 17. Therefore, Home must produce relatively more cloth at P C /P F = 17, or indeed at any other relative price. As cloth becomes more expensive relative to food, the output of cloth will increase relative to food, Therefore, the relative supply curves slope upward. Relative price of cloth, P C /P F Yards of cloth produced per calorie of food produced, Q C /Q F RS FOREIGN RS HOME 17
Relative Demands The H-O assumptions about preferences imply that that consumer behavior can be summarized by this Relative Demand curve and that the same curve is true in both Home and Foreign 17 3 Relative price of cloth, P C /P F Yards of cloth consumed per calorie of food consumed, Q C /Q F
Let’s say that Alex consumes 3 times as many yards of cloth as calories of food (relative demand is Q C /Q F = 3) when a yard of cloth is 17 times as expensive as a calorie of food (relative price P C /P F = 17)
If Alex’s income changes, his relative demand should not change because MRS is independent of the scale of consumption
Since identical preferences have been assumed, if the relative price of cloth is P C /P F = 17, then Betty’s relative demand must also be Q C /Q F = 3 irrespective of Betty’s income
Therefore, the same relative demand curve represents everybody
Therefore, the same relative demand curve represents both Home and Foreign
Relative Supplies and Demands The relative supplies and demands can be combined to find the autarky relative prices in Home and Foreign Clearly, they are different Therefore, trade will occur if it is allowed Since Home and Foreign differ only in their relative factor endowments, that difference must be the reason why trade occurs RS HOME RS FOREIGN RD Foreign Home Relative price of cloth, P C /P F Yards of cloth produced per calorie of food produced, Q C /Q F
Note that the (relative) price of the labor-intensive good (cloth), P C /P F , is higher in the land-abundant (and, therefore, labor-scarce) country ( Foreign ).
Factor Prices and Goods Prices Fig. 4-8 showed that, in autarky, the relative price of cloth is higher in Foreign Fig. 4-3 then shows that, in autarky, the relative price of labor must also be higher in Foreign Free trade makes the relative price of labor the same in both countries Wage-rent ratio, w/r Relative price of cloth, P C /P F FPGP Foreign Foreign Home Home Free Trade Free Trade
In general, the real payment to a resource is equal to its productivity (or, marginal product)
This is the main conclusion of the Marginal Productivity Theory of Income Distribution
Factor Use and Factor Productivity—Labor-Abundant Country
We saw earlier that when autarky ends and free trade begins w/r rises in the labor-abundant country ( Home ). Therefore,
Fewer workers would be used per acre of land (in cloth production and in food production)
See Figure 4-2
Factor Use and Factor Productivity —Labor-Abundant Country
This increases the productivity of Labor (because each worker would now have more land to work with) …
… and decreases the productivity of Land (because each acre of land is now being utilized by fewer workers)
w/P C and w/P F both increase, and
r/P C and r/P F both decrease.
Resource Use and Resource Productivity—Cloth Production These curves reflect Diminishing Returns to each resource, which, in turn, is a consequence of the assumption of Constant Returns to Scale Similar curves can be drawn for food production Acres of land per worker, T/L Marginal Productivity Marginal Productivity of Land = Real Rent, r/P C Marginal Productivity of Labor = Real Wage, w/P C
Factor Use and Factor Productivity —Land-Abundant Country
Similarly, when autarky ends and free trade begins w/r falls in the land-abundant country (Foreign).
Therefore, more workers are used per acre of land (in both cloth and food production)
Since both countries use the same technology, the equalization of w/r implies that the number of workers used per acre of land in the production of, say, cloth will also become the same in both countries