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## Pure exchange economy*

Economy with 2 people (Adam & Eve) 2 commodities (Apples & Figs) Fixed supply of commodities (e.g., on a desert island) An Edgeworth Box depicts the distribution of goods between the two people.

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## Pure exchange economy

Each point in the box represents an allocation between Adam and Eve. Each point in the box fully exhausts the resources on the island. Adam consumes what Eve doesnt. Adams consumption of apples and figs increases as we move toward the northeast in the box. Eves consumption of apples and figs increases as we move toward the southwest in the box. At point v in the figure, Adams allocation of apples is Ox, and of figs is Ou. Eve consumes Ov of apples, and Ow of figs.
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## Pure exchange economy

Assume that Adam and Eve each have conventionally shaped indifference curves. Adams happiness increases as he consumes more; therefore his utility is higher for bundles toward the northeast in the Edgeworth Box. We can therefore draw standard indifference curves for Adam in this picture. Adam would get even higher utility by moving further to the northeast, outside of the Edgeworth Box, but he is constrained by the resources on the island. Similarly, Eves happiness increases as she consumes more; therefore her utility is higher for bundles toward the southwest in the Edgeworth Box. Eves indifference curves therefore are flipped around. Her utility is higher on E3 compared E2 or E1. 5

## Pure exchange economy

Suppose some arbitrary point in the Edgeworth Box is selected, for example point g. This provides an initial allocation of goods to Adam and Eve, and thus some initial level of utility.

## Pure exchange economy

We can now pose the following question: Is it possible to reallocate apples and figs between Adam and Eve to make Adam better off, while Eve is made no worse off? Allocation h is one possibility. We are moving along Eves indifference curve, so her utility remains unchanged. Adams utility clearly increases. Clearly, other allocations achieve this same goal, such as allocation p. Once we reach allocation p, we cannot raise Adams utility any more, while keeping Eves utility unchanged.

## Pure exchange economy

An allocation is Pareto efficient if the only way to make one person better off is to make another person worse off. Often used as the standard for evaluating desirability of an allocation of resources. Pareto inefficient allocations are wasteful. A Pareto improvement is a reallocation of resources that makes one person better off without making anyone else worse off.
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## Pure exchange economy

Many allocations are Pareto efficient. Three of them are illustrated -- allocations p, p1 and p2. Among these Pareto efficient allocations, some provide Adam with higher utility than others, and the opposite ones provide Eve with higher utility. In fact, there are a whole set of Pareto efficient points in the Edgeworth Box. The locus of all the set of Pareto efficient points is called the contract curve.
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## Pure exchange economy

Each of the Pareto efficient points is where an indifference curve of Adam is tangent to an indifference curve of Eve. Mathematically, the slopes of Adams and Eves indifference curves are equal. The (absolute value of) slope of the indifference curve indicates the rate at which the individual is willing to trade one good for another, know as the marginal rate of substitution (MRS). Pareto efficiency requires:

MRS

= MRS

Eve af
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Production economy
In pure exchange economy, assumed supplies of commodities were fixed. Now consider scenario where quantities can change. The production possibilities curve shows the maximum quantity of figs that can produced with any given quantity of apples.

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Production economy
For apple production to be increased, fig production must necessarily fall. The marginal rate of transformation (MRT) of apples for figs (MRTaf) shows the rate at which the economy can transform apples to fig leafs. It is the absolute value of the slope of the production possibilities curve. The marginal rate of transformation can be written in terms of marginal costs:

MCa MRTaf = MC f

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## Efficiency with variable production

With variable production, efficiency requires:

MRTaf = MRS

= MRS

Eve af

If this were not the case, it is possible to make one person better off with an adjustment production. Rewriting in terms of marginal costs, we then have:

## MCa Adam Eve = MRS af = MRS af MC f

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Firm Behavior*
Capital Marginal rate of technical substitution (K)x(MPPK) = - (L)x(MPPL) K/L = - MPPL/MPPK K/L = MRTS P Q1 0 L1 L1 Labor
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K1 K1

P K L

## Source: Nisit Panthmait

Capital

Non-intersecting Farther out from origin point Means greater quantities of outputs

K1 K1

P K L L1 L1 P Q1 Q2 Labor
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Q4 Q3

Capital intensive output expansion path Capital 4K1 G Labor intensive output expansion path P P Q1=10 0 L1 2L1 4L1 Labor
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2K1 K1

G Q2=20

Capital K B2 P K B1

The slope of isocost (or the factor price line) K/L = 0K/-0L = - (B1/r)/(B1/w) = w/r where r is labor wage, w is capital rental rate = MPPL/MPPK = MRTS At point P: B1 = rK + wL rK = B1 wL K = (B1/r) (w/r)L K/L = - w/r Q2 Q1 L L Labor
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H K1 P

L1

S-Isoquant K Ks

(K/L)s

S is capital-intensive (K/L)s > (K/L)c or (L/K)s < (L/K)c C is labor-intensive (L/K)s < (L/K)c or (K/L)s > (K/L)c (K/L)c

Kc Increasing K

C-Isoquant Oc
L IncreasingLs

Lc

L
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Increasing L

Ls

Os
Increasing K

Kc Increasing K

(K/L)c

Ks Isoquant

(K/L)s Oc
Increasing L

Lc

L
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## The Edgeworth Box:

L K Not Pareto Efficiency C4 C2 C1 C3 V C5 S5 S4 0c Contract curve: production efficiency locus with increasing opportunity cost S3 S2 S1 K L
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0s

## The Edgeworth Box:

L K C4 C2 C1 C3 Not Pareto Efficiency C5 V S1 S3 S5 0c Contract curve: production efficiency locus with constant opportunity cost S4 K L
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0s

S2

States: If a country can trade at world prices which differ from its autarky prices, that is , if pA pT then the country is - at least as well off under free trade as under autarky - will be better off if consumption and production choices are affected by the price changes
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uA C

DT

DA=QA

uT

QT pT
RuA(pt)

pA

F RA(pT) R(pT)

Illustration
DADT = total gains C uA DT DAD=exchange gains DDT= specialization gains

D DA=QA T Q

pT F
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C D1 Q1 u1 Q p p1 F
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## Worsening of TOT (p1<p)=> Smaller gains and smaller trade

Food production, QF

Isovalue lines Q

TT Cloth production, QC
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Food production, QF

Q1 VV1(PC/PF)1

Q2

TT

## VV2(PC/PF)2 Cloth production, QC

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Food production, QF

## TT Cloth exports Cloth production, QC

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Food production, QF

D2 D1

## Q1 Q2 VV1(PC/PF)1 TT VV2(PC/PF)2 Cloth production, QC

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Offer Curves
combinations of a countrys desired exports and imports at alternative terms of trade in which there is general equilibrium also known as reciprocal demand curves (J.S. Mills) measures of willingness to trade i.e. what a country is willing to offer in exchange for imports

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Y Y1 Y2 C P (PX/PY)1

X1

X2

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Y Y1 Y2 C P (PX/PY)1

X1

X2

(PX/PY)1

Y5
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X5

Y Y3 (PX/PY)1

Y4

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X5 X6

Y Y3 (PX/PY)1

Y4

## (PX/PY)2 Y X3 OCA X4 X (PX/PY)2 (PX/PY)1 Y6 Y5

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X5 X6

Offer Curves
Offer curves represent willingness to trade at alternative relative prices As the relative price of good X rises, Country A becomes willing to export more and import more Offer curves bow towards the import good axis

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## Deriving Country Bs Offer Curve

This will reflect Country Bs willingness to trade at alternative terms of trade Bs offer curve bows towards the axis of Bs imports

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(PX/PY)1

Y7 Y8 Y

p c X7 X8 X

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(PX/PY)1

Y7 Y8 Y

p c X7 X8 (PX/PY)1 X

Y9
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X9

(PX/PY)1

## Y10 (PX/PY)2 X10 (PX/PY)1 Y12 Y9 X9 X12 (PX/PY)2 OCB X11 X

Y11 Y

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The international terms of trade (that is, PX/PY) will be the slope of a line passing through the point where the offer curves intersect. This equilibrium satisfies the conditions for both countries demand and supply conditions

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Y OCA (PX/PY)E

OCB Y1

X1

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Y OCA (PX/PY)E

OCB Y1 If (PX/PY)E is the terms of trade, country A will desire to export X1 units, and country B will want to import X1 units

X1

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Y OCA (PX/PY)E

OCB Y1 If (PX/PY)E is the terms of trade, country A will desire to import Y1 units, and country B will want to export Y1 units

X1

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## How Do We Know Its Equilibrium?

Any terms of trade other than (PX/PY)E will result in
excess demand for one good excess supply in the other

## Therefore relative prices will adjust until (PX/PY)E is reached

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Disequilibrium
Y OCA (PX/PY)1

OCB

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Disequilibrium
Y OCA (PX/PY)1

Y1 Y2

OCB

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Disequilibrium
Y OCA (PX/PY)1

Y1 Y2

OCB At (PX/PY)1, country A wishes to import Y1 units, but country B is only interested in exporting Y2 units. That is, there is an excess demand for good Y. X
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Disequilibrium
Y OCA (PX/PY)1

OCB

X2

X1

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Disequilibrium
Y OCA (PX/PY)1

OCB At (PX/PY)1, country A wishes to export X1 units, but country B is only interested in importing X2 units. That is, there is an excess supply of good X. X2 X1 X
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Disequilibrium
Excess demand for Y causes PY to rise Excess supply of X causes PX to fall Thus, (PX/PY) falls In other words, the terms of trade line gets flatter, moving the countries in the direction of equilibrium

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## Moving Towards Equilibrium

Y (PX/PY)1 OCA

OCB

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Disequilibrium
Terms of trade lines that are flatter than (PX/PY)E, such as

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Disequilibrium
Y OCA (PX/PY)2

OCB

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Disequilibrium
Terms of trade lines that are flatter than (PX/PY)E will results in
an excess demand for good X an excess supply of good Y, and so

(PX/PY) will rise That is, the terms of trade line will get steeper until (PX/PY)E is reached

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Y OCA (PX/PY)2

OCB

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## A Note on the Terms of Trade

A countrys terms of trade is the price of its exports divided by the price of its imports, so a rising terms of trade is good news In this example, (PX/PY) is country As terms of trade, since A exports good X and imports Y (PY/PX) is country Bs terms of trade in this example

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## A Note on the Terms of Trade, continued

As As terms of trade (PX/PY) improve, Bs terms of trade (PY/PX) must be deteriorating and viceversa

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## Shifts of Offer Curves

Anything that causes country As willingness to trade to change will shift As offer curve
increased willingness to trade: OCA shifts right decreased willingness to trade: OCA shifts left

## These can be caused by

changes in demand conditions or changes in supply conditions

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Y OCA (PX/PY)E

OCB Y1

X1

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## Demand Changes in Country A

Y (PX/PY)E OCA OCA'

OCB

Increased demand for imports by Country A causes a rightward shift of As offer curve X
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## Demand Changes in Country A

Y (PX/PY)E OCA OCA' (PX/PY)E' OCB

Y2

Volume of trade increases, but As terms of trade go down. Bs terms of trade improve. X2 X
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Demand Changes in A
Any change that might make A demand more imports leads to a rightward OC shift, and thus
an increase in trade volume a decrease in As terms of trade

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Y OCA (PX/PY)E

OCB Y1

X1

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## Demand Changes in Country B

Y OCA (PX/PY)E OCB' OCB

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## Demand Changes in Country B

Y OCA (PX/PY)E' (PX/PY)E OCB' Y2 OCB

Volume of trade increases, but Country Bs terms of trade decrease (and As terms of trade improve). X2 X
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## Other Demand Changes

Any decrease in a countrys willingness to trade will shift its OC leftward or downward An example is when a country imposes an import tariff Tariffs therefore lead to decreased trade volume, but improve the imposing countrys terms of trade

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Y
A

(PX/PY)E

OCB Y1

X1

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Y
' A A

(PX/PY)E

OCB Y1

X1

75

Y
' A A X Y E'

(PX/PY)E OCB Y2

X2

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## Imposition of Tariff by Country A /P ) (P OC OC

Y
' A A X Y E'

(PX/PY)E OCB Y2 By imposing a tariff, Country A decreases trade volume, and improves its terms of trade (but Bs terms of trade deteriorate) X2 X
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Supply Changes
Changes in supply conditions will also shift a countrys offer curves around Examples include
productivity changes discovery of new resources

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## An Example: The Oil Shocks of the 1970s

Lets think of OPEC as one country Lets also think of the industrial countries as one country OPEC effectively decreased its willingness to trade Presumably this shifted OPECs offer curve to the left, increasing OPECs terms of trade and decreasing the industrial countries

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## Oil Shocks of the 1970s

OCOPEC Other stuff (PX/PY)pre-shock

OCIC Y1

X1

Oil

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## Oil Shocks of the 1970s

Other Stuff OCOPEC' OCOPEC (PX/PY)E

OCIC Y1

X1

Oil

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## Oil Shocks of the 1970s

Other Stuff OCOPEC
'

OCOPEC

Y1 Y2

X2 X1

Oil

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## Oil Shocks of the 1970s

Other Stuff OCOPEC
'

OCOPEC

## (PX/PY)post-shock (PX/PY)pre-shock OCIC

Y1 Y2 OPECs terms of trade should have improved, and the industrial countries should have worsened

X2 X1

Oil

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## Oil Shocks of the 1970s: Changes in the Terms of Trade

Oil-Exporting Countries 21 29 70 87 119 97 55 Industrial Countries 110 108 97 96 87 91 105

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## Offer Curves and Small Countries

Small countries: those that are too small to affect world prices (and therefore the terms of trade) by their own actions From the small countrys perspective, the restof-worlds OC is a straight line

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Y OCsmall OCROW

Y1

X1

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Y OCsmall OCROW

X1

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## Small Countries and Offer Curves OC

OCsmall'
small

OCROW

Y1

If the small country imposes a tariff on ROW products, it has no effect on the terms of trade

X1

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## Small Countries and Offer Curves OC

OCsmall'
small

OCROW

Y1

If the small country imposes a tariff on ROW products, it has no effect on the terms of trade This is the definition of a small country X1 X
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## Small Countries and Offer Curves

Q: What is the optimal tariff for a small country? A: No tariff at all - tariffs reduce trade volume, but dont improve the terms of trade This is really the same point we made earlier: free trade is especially helpful to small developing countries

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6
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## A Model of a Two-Factor Economy

How do the outputs of the two goods change when the economys resources change?
Rybczynski Theorem (effect):
If a factor of production (T or L) increases, then the supply of the good that uses this factor intensively increases and the supply of the other good decreases for any given commodity prices. The reverse is also true.

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## A Model of a Two-Factor Economy

Increasing Labor used in food production Land used in cloth production LF OF Land used in food production

Increasing

Increasing

TC F

C TF

OC

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## A Model of a Two-Factor Economy

Figure 4-6: An Increase in the Supply of Land
Land used in cloth production Increasing Labor used in food production L2 F L1 F O2 F Land used in food production

Increasing

O1 F

Increasing

T1 C T2 C F2 OC

1 2 F1 L1 C

T1 F T2 F

## Labor used in cloth production L2C Increasing

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Introduction
Recall our assertion that one of the sources of comparative advantage is differences in factor endowments. We will formalize this assertion using the Heckscher-Ohlin-Samuelson model. Difference in relative factor abundance difference in relative commodity prices trade based on comparative advantage.

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Key Questions
1. How does factor abundance affect the pattern of trade? 2. Does trade affect factor-price difference between countries? 3. What is the link between commodity and factor prices? 4. Is there a link between factor supply and outputs?

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Core Theorems
The Heckscher-Ohlin Theorem
The effect of endowments on pattern of trade.

## The Factor-Price Equalization Theorem

The effect of trade on factor prices.

## The Stolper-Samuelson Theorem

The effect of goods prices on factor prices.

## The Rybczynski Theorem

The effect of endowments on output.

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Assumptions
2x2x2 - 2 Countries, 2 Goods, 2 Factors Perfect competition, homogeneous and mobile (within the economy) factors, full employment. Diminishing returns to a single factor. Common technology between countries. Different factor endowments. Different factor intensities in industries. Identical preferences. (Why?)

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Definitions
1. Factor intensity or factor proportions. The proportion of factors used in production of any one final good, e.g: If:
KY K X < LY LX X is a capital-intensive good.

the

## Y is a labor-intensive good. (Why?)

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2. Factor abundance. The relative quantities of factors of production in a country. Physical definition is based on the total amounts of factors: Home is relatively capital * * ( K L) > ( K L ) abundant compared to Foreign. Price definition uses wage/rental ratios: Home is relatively capital abundant compared to Foreign. (Why?) ( w r ) > ( w* r * )

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## Starting with this question:

Are the gains from trade distributed evenly across all factors? The answer to this question is shown by the Stolper-Samuelson Theorem.

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Unit Isoquants
We have already introduced the concept of an isoquant. With CRTS, each unit is produced in the same way (holding factor prices constant). Since all isoquants look the same, we can summarize by depicting the isoquant for the quantity which sells for \$1. We call this a unit isoquant.

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K
Slope =

K L

a KX

X1

Slope =
a LX

w r

L
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## Determining Factor Intensities

At any given wage/rental ratio, the factor intensities of X and Y are determined by costminimizing behavior. What if the wage/rental ratio changes?
At different relative factor prices producers use different cost-minimization techniques but relative factor-intensities of sectors do not reverse (by assumption).

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X1

Slope =

KX LX

Y1
a KX

Slope =

KY LY

a KY

Slope =
a LX a LY

w r

L
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## Output and Factor Prices

Assuming both goods are produced, we have defined a unique relationship between output prices and factor prices. Consider, given the same factor prices, the cost of output of X and Y represented by the unit isoquants must be the same. (Why?) Under perfect competition, costs equal prices, hence prices must be equal (\$1).

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Stolper-Samuelson Theorem
Theorem: Under certain circumstances, an increase in the relative price of a good will unambiguously increase the real return to the factor used relatively intensively in the production of that good, while real return to the other factor will be reduced in terms of both goods.

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K X'1

X1

Slope =

KX LX

Y1
Slope = KY LY

Slope =

w r

Slope =

w' r'

L
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An increase in relative price of X shifts its unit-value isoquant inward (why?). This alters the relative factor prices. That is, the relative rental (reward to intensively used capital in X) rises. Note the effect on factor intensity ratios in each industry. What is the magnitude of the increase in the rental in relation to the increase of the price of X?

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## Why is this Important?

Free trade can hurt some factors of production while providing gains for others. Therefore, there are political economy implications of uneven distribution of gains from free trade. Note the contrast with the results of the Ricardian model.

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## International Trade & the World Economy; Charles van Marrewijk

Application: globalization, low wages, and unemployment The Stolper-Samuelson result was at the center of the globalization debate; rising wage inequality in USA, rising unemployment in EU
United States
340 290 240 190
6000 14000 12000 10000 8000

4000 2000 0

## International Trade & the World Economy; Charles van Marrewijk

Application: globalization, low wages, and unemployment Argument: rising imports from low-wage unskilled-labor countries reduces unskilled-labor intensive final goods price, thus reducing wage rate for unskilled workers (USA) or increasing unemployment (EU)
France
3000

2000

1000

Unemployment
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## Imports from low -w age countries

Exercises
Using a unit isoquant diagram like the one built in class today, show the effect of: An increase in the price of Y when Y is relatively capital-intensive. A decrease in the price of X when X is relatively labor-intensive.

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Next Question:
If absolute/relative endowment of factors changes in one country, what are the implications for trade? The answers to this question is shown by the Rybczynski Theorems.

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Rybczynski Theorem
Theorem: Under certain circumstances, an increase in one factor endowment will cause the output of the good intensive in that factor to increase by a greater proportion, and will reduce the output of the other good.

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X1

Slope =

KX LX

Slope =

K L

Slope =

K L'

X'1

Y1

Slope =

KY LY

Y'1
Slope = w r

L
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Adding the labor and capital used in X and Y together gives us the total endowment available to the economy. We then increased the endowment of labor. Y is labor-intensive. Relative output prices are fixed, and therefore so are factor prices, and therefore factor intensities (why?). Output of Y must increase as a consequence, and output of X must fall.

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## Why is this Important?

Recall our argument for immiserizing growth. We now know why accumulation of a factor will lead to biased growth. As we shall see, the result also underlies the a new explanation for the pattern of trade: the Heckscher-Ohlin Theorem.

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Exercises
Using a unit isoquant diagram like the one built in class today, show the effect of: An increase in the endowment of capital when Y is relatively capital-intensive. A decrease in the endowment of labor when X is relatively labor-intensive.

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## Where Are We?

We have talked about the standard assumptions in the factor-proportion (HOS) model of trade. We defined factor intensities. We defined factor abundance. We have demonstrated the relationships between goods prices and factor prices, and between factor endowments and outputs.

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Next Question
How do different relative factor endowments affect the pattern of trade? The answer to this question lies in the Heckscher-Ohlin theorem.

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Setup
Suppose that the Foreign economy and the home economy have identical endowments of capital and labor, so that: Given that technology is the same, what must the transformation loci look like? Given the same preferences, what does this imply about autarky prices and the pattern of comparative advantage?
( K L) = ( K * L* )

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Y*

MRT=MRS

MRT*=MRS*

X*
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Let us assume that production of X is capitalintensive, while production of Y is labor intensive. Now suppose that the stock of capital was to grow in Home while the stock of labor was to grow in Foreign. How would the transformation loci change? Hint: Think about the implications of the Rybczynski Theorem.

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Y*
MRT*=MRS*

MRT=MRS

X*
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Given the different relative factor endowments , ( K L) > ( K * L* ) at any given relative commodity price, Foreign produces relatively more Y to X than Home:

(Y X )Foreign were to produce the < (Y * X * ) If Home and same proportion of Y to X, i.e. then the relative price of X would be much lower in Home than in Foreign: (Y X) =(Y* X*)

( PX PY ) < ( PX

PY )
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By our definition, Foreign has a comparative advantage in Y, while Home has a comparative advantage in X. Those CA are sourced from different relative factor endowments, since that is the only difference between Home and Foreign. Thus we can formulate the HO theorem which links relative factor endowments and the pattern of trade:

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Heckscher-Ohlin Theorem
Definition: Each country exports the commodity which requires for its production the relatively intensive use of the factor found in relative abundance in that country

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Geometric Explanation
Consider the demand and supply pattern in each economy at Home autarky prices and at Foreign autarky prices. We find that at Home autarky prices, Foreign has an excess demand for X and an excess supply of Y, and vice versa. At a world relative price determined by the interaction of these excess demands, we have international equilibrium.

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Y
I*

MRT

MRT

X
131

MRT*

MRT*

X
132

I*

TOT

TOT

X
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## 7 UB 6 ppfB prB 4 exportf ppfA autB

For A price of manufactures rises: capital abundant A produces even more capital intensive manufactures and exports these in exchange for food

Food

exportm

0 0 1 2 3 4 5 6
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Manufactures

## Why is this Important?

We have now completed our story about why trade occurs. We identified three causes: Technology, Preferences, Relative Factor Abundance If there are differences in any of these features, a pattern of comparative advantage will exist. In the real world, there are differences in all of these features.

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## International Trade & the World Economy; Charles van Marrewijk

Application: the Summers-Heston data Hypothetical production/worker in autarky using Summers-Heston data
b. hypothetical autarky production per worker

food

Austria Bolivia

Norway

Zambia

0 0 1
manufactures

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## International Trade & the World Economy; Charles van Marrewijk

Application: the Summers-Heston data Hypothetical production/worker in free trade w. Summers-Heston data
1
hypothetical production per worker with trade consumption expansion path Austria consumption point

0 0 1
manufactures

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## And the last question

How does trade affect incomes across different countries? The answer to this question is given by the Factor-Price Equalization Theorem. This theorem is one of the most startling and controversial results in international economics.

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Consider the consequences of moving from autarky to a trading equilibrium:
increases specialization Changing demand for factors changes: PCA PNCA Abundant factor's reward w r Scarce factor's reward become more similar between countries Equalization of factor prices

w r
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## Factor-Price Equalization Theorem

States that under certain circumstances free trade in goods will equalize both absolute and relative factor prices across countries. Commodity trade can be seen as a perfect substitute for international factor mobility (because equalization of factor prices could be achieved directly through mobility).

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Intuition
We have shown that there is a unique relationship between the relative factor price and the relative output price (see following diagram). With free trade in homogeneous goods, the law of one price prevails. Therefore each country has the same relative output prices, and the same relative factor prices.

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X1

Slope =

KX LX

Y1
a KX

A
Slope = KY LY

a KY

Slope =
a LX a LY

w r

L
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Empirical Support
What are the political economy implications of FPE? Empirical support for the factor price equalization theorem is not very strong. Why do you think this is the case?

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