Factor Endowments and the Commodity Composition of Trade 1

Factor Endowments and the Commodity Composition of Trade 1

Chapter Outline

I.Introduction

unanswered questions

What determines a country’s comparative advantage?

How does international trade affect industrial structure?

How does international trade affect payments or returns to the factor of production?

How does international trade affect the distribution of income?

comparative advantage and business

profits from trade

FDI

II.The Factor-Proportions Theory

A.Assumptions of the Factor-Proportions Theory

two countries, two goods

perfect competition

free trade

incomplete specialization

equal tastes and preferences

two factors of production

constant returns to scale

domestic mobility of factors

no migration of factors

capital intensive and labor intensive

capital abundant and labor abundant

Tables 3.1 and 3.2

B.The Factor-Proportions Theorem

comparative advantage

PASSPORT: U.S.— China Trade — Table 3.3

III.Factor-Price Equalization and the Distribution of Income

A.Factor-Price Equalization

changes in industrial structure

changes in factor prices

long-run tendency

PASSPORT: Changes in the K/L Ratio Over Time: South Korea and India — Table 3.4

B.Trade and the Distribution of Income

gains and losses

small effects

PASSPORT: Trade Adjustment Assistance

IV.The Specific Factors Model

mobile vs. specific factors

increases gains to the specific factor in the comparative advantage industry

increases losses to the specific factor in the comparative disadvantage industry

The price of the mobile factor increases but its welfare is indeterminate.

Figure 3.1

PASSPORT: Patterns in U.S. Trade — Figure 3.2 and Table 3.5

V.Empirical Evidence on the Factor-Proportions Theory

A.The Leontief Paradox

Leontief found that U.S. exports were labor intensive

result still holds for a two-factor test

B.Explanations of the Leontief Paradox

natural resources

trade barriers

human capital

R&D

PASSPORT: Relative Factor Endowments for Selected Countries — Table 3.6

C.International Trade Not Explained by the Factor-Proportions Theory

Teaching Notes and Tips

I.Introduction

Notes

The introduction does two things. It emphasizes that Chapter 3 is a continuation of Chapter 2. Chapter 2 left us vague on what causes a country to have a lower opportunity cost in this or that product. The purpose of the chapter is to explain international differences in opportunity costs.

Teaching Tip

Go back a step and emphasize that the theory to be covered will help explain the world pattern of production or what is produced where. Once you know this, then the world pattern of trade is just an extension of that. As a result, this is one of the more “practical” chapters in the book.

II.The Factor-Portions Theory

Notes

The section starts with the standard assumptions of the factor-proportions theory. There are some terms to define such as constant returns to scale, capital intensive, labor intensive, capital abundant, labor abundant, and the K/L ratio. From the assumptions, the basic factor-proportions theory almost explains itself. The Passport and Table 3.5 on “Patterns in U.S. Trade” add some data to the theory. Finally, you can emphasize that comparative advantage can change as the relative supplies of factors of production change as in the boxed feature Passport: “Changes in the K/L Ratio Over Time: South Korea and India.”

Teaching Tip

Take some class time to carefully look at the factor endowment data in Table 3.2. It not only helps to explain trade patterns but as a bonus, it helps to explain the world distribution of income. A substantial part of the difference between rich and poor countries is the abundance of capital with which each country is endowed.

III.Factor-Price Equalization and the Distribution of Income

Notes

The first part of the section extends the example used in explaining the factor-proportions theory to factor-price equalization. Trade causes changes in industrial structure. As resources move from the contracting industry to the expanding industry, the K/L ratio mismatch influences the returns to capital and labor. The abundant factor gains and the scarce factor loses. It’s a short step from here to the Stopler-Samuelson theorem and changes in the distribution of income. Trade Adjustment Assistance is a logical political reaction to the process.

Teaching Tip

The processes described in the section work, just much more slowly. What is usually going on here is as follows. Profits in the comparative disadvantage industry start declining which reduces the amount of capital flowing into the industry. As the capital eventually is depreciated the owners of capital close the plants. This process may take decades, not months. At the same time, capital is flowing freely into the comparative advantage industry and it is expanding. Labor slowly drifts out of the comparative disadvantage industry into other occupations and new workers are moving into the expanding comparative advantage industry.

IV.The Specific-Factors Model

Notes

In this section the students get a chance to see what happens if factors cannot easily move from one part of the economy to another. Not unrealistically, the example focuses on breaking capital into two sector-specific types. You easily get the result that the capital that is sector specific in the comparative disadvantage industry is worse off even in a capital-abundant country.

Teaching Tip

This section can be used to introduce why owners of capital in comparative disadvantage industries fight so hard for government assistance. If they could just pick up their capital and move to the comparative advantage industry, they wouldn’t worry about government help.

V.Empirical Evidence on the Factor-Proportions Theory

Notes

The section starts with the puzzle introduced by the Leontief Paradox. The discussion of the resolution of the paradox focuses on the empirical problems caused by the assumption that labor is homogeneous. The resolution of the paradox is mostly about separating out the role of human capital. R&D is discussed as a separate factor of production. Data on various resource endowments for developed countries is given in Table 3.6 to put some numbers with the concepts.

Teaching Tip

This is a perfect example of how economic knowledge accumulates. A logical theory fails an empirical test. Further tests of the theory reveal that the basic thinking isn’t incorrect but the theory is incomplete. The theoretical and empirical work lead to a deeper understanding of the phenomenon being studied.

Brief Answers to Problems and Questions for Review

1.The factor-proportions theory provides an extension of the trade model presented in Chapter 2 by providing an understanding of why each country has a comparative advantage or disadvantage in various goods. This understanding of the causes of comparative advantage is based on a country’s relative endowment of the factors of production.

2.The assumptions of the factor-proportions theory are as follows: There are two countries, and each country produces two goods. The production and consumption of the goods are conducted under perfect competition in the product and factor markets. This means that firms are price takers and their individual actions cannot influence conditions in their respective markets. The prices of the two goods and the prices paid to the factors of production are determined by supply and demand in each market. In the long run, the prices of the goods are equal to their respective costs of production. There are no transportation costs, tariffs, or other obstructions to the free flow of goods between the two countries. The introduction of international trade does not cause complete specialization in the production of one of the goods in either country. Both countries will continue to produce both goods. Consumers in the two countries have equal tastes and preferences. This means that when the price of machines in terms of cloth is the same in the two countries, both countries will consume the same proportion of the two goods. Both countries are endowed with two homogeneous factors of production, capital (K) and labor (L) and both resources are employed in the production of the two goods. The technology available to produce the two goods is the same in both countries and each good is produced under constant returns to scale. Labor and capital are mobile domestically. This means that within each country labor and capital can flow freely from one industry to the other. As a result, both industries within a country will pay the same wage rate and the same return to capital. Labor and capital cannot move internationally between countries. This allows for differences in wage rates and the return to capital between the two countries. It also rules out the possibility of eliminating wage differences between countries through migration. The production techniques available to produce machines and cloth in both countries are such that the production of machines is everywhere capital intensive and the production of cloth is everywhere labor intensive.

3.A labor-intensive good is one that requires a substantial amount of labor relative to capital or that is produced with a lower capital-to-labor ratio than another good. A labor-abundant country is a country that has a capital-to-labor ratio that is smaller than the capital-to-labor ratio in another country.

4.The basic determinant of comparative advantage and trade in the factor-proportions theory is that a country will have a comparative advantage in and export goods whose production intensively uses its relatively abundant factor of production. Also, a country will have a comparative disadvantage in and import goods whose production intensively uses its relatively scarce factor of production.

5.The capital stock per worker from the Penn World Tables provides information on the relative abundance of capital and labor in various countries. This relative abundance can be used to determine if a country is relatively capital abundant or labor abundant when compared to another country. This information is an empirical estimate of the capital-to-labor ratio in various countries.

6.a.Country C is relatively capital abundant.

b.Country B is relatively labor abundant.

c.Country C will have a comparative advantage in the production of steel because steel production intensively uses its relatively abundant factor of production.

1. The introduction of international trade sets in motion market forces that cause a change in the relative price of traded goods. As the relative price of the export good increases, this causes a change in the industrial structure of the country. The industry producing the comparative advantage good expands its production. The comparative disadvantage industry would decrease its production. This would cause changes in the prices paid to the factors of production. The price of the abundant factor would increase and the price of the scarce factor would fall.

8.Under the assumption that the factors of production remain fully employed both before and after trade, the real income of the scarce factor and the abundant factor move in the same direction as factor prices. The percentage of national income that the abundant factor receives would increase and the percentage of national income that the scarce factor receives would decrease. As a result, international trade has discernible effects on the distribution of income within a trading country.

9.This implies that labor is the scarce factor of production in Country A, since a country will have a comparative disadvantage and import goods whose production intensively uses its relatively scarce factor of production. Relative wages within the country will fall, since as trade opens up the price paid to the abundant factor in a country would rise, and the price paid to the scarce factor would fall. In general, capital owners will support free trade and labor will oppose free trade, since the percentage of national income that the abundant factor receives would increase and the percentage of national income that the scarce factor receives would decrease.

10.The criteria the government uses to determine if a firm and workers have been adversely impacted by imports are that workers have been totally or partially laid off; sales or production have declined; and increased imports have contributed importantly to worker layoffs.

11.When a country has specific factors of production used to produce various goods as trade opens up, the effect of specific factors is that the owners of the specific capital used to produce the good in which the country has a comparative advantage benefit as the industry expands production. The owners of the specific factors used to produce the good in which the country has a comparative disadvantage lose as production contracts. The income effect on the mobile or variable factor is indeterminate and depends to the consumption pattern of society.

12The existence of specific factors can help explain why some groups resist free trade. In general, owners of the abundant factor of production in a country should be in favor of freer international trade, while owners of the scarce factor of production would favor trade restrictions. With specific factors of production, both capital and labor in the industry with a comparative disadvantage suffer losses and may resist free trade.

13.The Leontief paradox is the empirical finding that U.S. industries with trade surpluses were more labor intensive than U.S. industries with trade deficits. This finding is contrary to the factor-proportions theory. A number of possible explanations for the perverse result have been given over the years including: some imports are not based on an abundance of labor or capital but depends on the country’s possession of natural resources and U.S. trade policy may have biased the results. The paradox tends to be resolved by considering human capital and technology as separate factors of production.

Multiple-Choice Questions

1.Constant returns to scale implies:

a.as the amount of labor and capital doubles the resulting output remains the same.

b.as the amount of labor and capital doubles the resulting output more than doubles.

*c.as the amount of labor and capital doubles the resulting output doubles.

1. as the amount of labor and capital doubles the resulting output increases by a very small amount.

2.Which of the following is not an assumption of the factor-proportions theory?

a.The same technology in both countries

b.Constant returns to scale

*c.Complete specialization

1. Equal tastes and preferences in both countries

3.Which of the following is not an assumption of the factor-proportions theory?

a.Perfect competition in the product and factor markets

b.Homogeneous labor and capital in both countries

*c.Different tastes and preferences between countries

d.Constant returns to scale

4.When we say that steel is capital intensive with respect to wheat, this means that:

a.more capital is used in the production of steel than for wheat.

b.less labor is used in the production of steel than for wheat.

c.a lower capital-to-labor ratio is used in the production of steel than wheat.

*d.a higher capital-to-labor ratio is used in the production of steel than wheat.

5.When we say that wheat is labor intensive with respect to automobiles, this means that:

a.more capital is used in the production of automobiles than wheat.

b.less labor is used in the production of automobiles than wheat.

c.a lower capital-to-labor ratio is used in the production of automobiles than wheat.

*d.a higher capital-to-labor ratio is used in the production of automobiles than wheat.

6.A country is said to be relatively abundant in capital if it has:

a.a greater absolute amount of capital.

b.a smaller absolute amount of labor.

*c.a higher capital-to-labor ratio.

d.a lower capital-to-labor ratio.

7.Which of the following statements is false?

a.Poor countries tend to have a low K/L ratio.

b.Rich countries tend to have a high K/L ratio.

c.The K/L ratio is important in determining the productivity of labor.

*d.The productivity of labor rises as the K/L falls.

8.The factor-proportions theory of international trade predicts:

a.who benefits and who loses from trade.

b.which factors are abundant.

c.the income distribution effects of trade.

*d.which goods will be exported.

9.The factor-proportions theory identifies the source of comparative advantage as:

*a.differences in relative factor endowments between countries.

b.similarities in tastes.

c.identical production methods.

d.similar factor endowments.

10.According to the factor-proportions theory, the source of comparative advantage is a country’s:

a.physical size.

b.population.

c.advertising.

*d.factor endowments.

11.In the factor-proportions theory, international trade is caused by country differences in:

a.technology.

b.tastes and preferences.

*c.factor endowments.

d.the degree of competition.

12.The factor-proportions theory is a simplification of international trade between countries because it is explained using:

a.two countries.

b.two goods.

c.two factors of production.

*d.all of the above

13.In the factor-proportions theory:

a.the production possibilities frontier is bowed in toward the origin.

b.labor is the only factor of production.

c.the country with the largest amount of labor will have a comparative advantage in labor-intensive products.

*d.the country’s comparative advantage depends on its relative endowment of

the various factors of production.

14.The factor-proportions theory states that a country will have a comparative advantage in and produce the product whose production is relatively intensive in the:

a.tastes and preferences in which the country is relatively abundant.

b.technology in which the country is relatively abundant.

*c.factor of production in which the country is relatively abundant.

d.advertising in which the country is relatively abundant.

15.The factor-proportions theory of international trade implies that countries would tend to:

a.export products that intensively utilize their scarce factor of production.

b.import products that intensively utilize their abundant factor of production.