We now examine more rigorously how a change in resources—holding the prices of cloth and food constant—affects the allocation of those factors of production across sectors and how it thus affects production responses. The aggregate employment of labor to capital can be written as a weighted average of the labor-capital employed in the cloth sector
and in the food sector :
(5A-1) L
K = KC K
LC KC + KF
K LF KF (LF/KF)
(LC/KC) L/K
w/r (slope = -(w/r)2)
CC2 CC1
w/r w/r
1/PF
1/PC FF
Labor input slope =
–(w/r) Capital input
CC Figure 5A-3
Determining the Wage-Rental Ratio
The two isoquants CCandFF show the inputs necessary to pro- duceone dollar’s worthof cloth and food, respectively. Since price must equal the cost of production, the inputs into each good must also cost one dollar. This means that the wage-rental ratio must equal minus the slope of a line tangent to both isoquants.
110 PART ONE International Trade Theory
Note that the weights in this average, and , add to 1, and are the proportions of capital employed in the cloth and food sectors. We have seen that a given relative price of cloth is associated with a given wage-rental ratio (so long as the economy produces both cloth and food), which, in turn, is associated with given labor-capital employment levels in both sectors . Now consider the effects of an increase in the economy’s labor supply Lat a given relative price of cloth: increases while and both remain constant. For equation (5A-1) to hold, the weight on the higher labor-capital ratio, , must increase. This implies an increase in the weight and a corresponding decrease in the weight . Thus, capital moves from the food sector to the cloth sector (since the total capital supply K remains constant in this example). Furthermore, since remains constant, the decrease in must also be associated with a decrease in labor employment in the food sector. This shows that the increase in the labor supply, at a given relative price of cloth, must be associated with movements of bothlabor and capital from the food sector to the cloth sector. The expansion of the economy’s production possibility frontier is so biased toward cloth that—at a constant relative price of cloth—the economy produces lessfood.
As the economy’s labor supply increases, the economy concentrates more and more of both factors in the labor-intensive cloth sector. If enough labor is added, then the economy specializes in cloth production and no longer produces any food. At that point, the one-to- one relationship between the relative goods price and the wage-rental ratio is broken; further increases in the labor supply Lare then associated with decreases in the wage-rental ratio along the CCcurve in Figure 5-7.
A similar process would occur if the economy’s capital supply were to increase—again holding the relative goods price fixed. So long as the economy produces both cloth and food, the economy responds to the increased capital supply by concentrating produc- tion in the food sector (which is capital-intensive): Both labor and capital move to the food sector. The economy experiences growth that is strongly biased toward food. At a certain point, the economy completely specializes in the food sector, and the one-to-one relation- ship between the relative goods price and the wage-rental ratio is broken once again. Further increases in the capital supply Kare then associated with increases in the wage-rental ratio along the FFcurve in Figure 5-7.
w/r PC/PF
PC/PF
w/r PC/PF
LF
KF LF/KF
KF/K
KC/K LC/KC
LF/KF LC/KC
L/K (LC/KCandLF/KF)
KF/K KC/K
FF
Labor input slope =
–(w/r)2 Capital input
CC2
CC1 slope = –(w/r)1 Figure 5A-4
A Rise in the Price of Cloth If the price of cloth rises, a smaller output is now worth one dollar;
so is replaced by . The implied wage-rental ratio must therefore rise from (w/r)1to (w/r)2.
CC2 CC1
111
6
c h a p t e r
The Standard Trade Model
P
revious chapters developed several different models of international trade, each of which makes different assumptions about the determinants of production possibilities. To bring out important points, each of these models leaves out aspects of reality that the others stress. These models are:• The Ricardian model.Production possibilities are determined by the alloca- tion of a single resource, labor, between sectors. This model conveys the essential idea of comparative advantage but does not allow us to talk about the distribution of income.
• The specific factors model.This model includes multiple factors of produc- tion, but some are specific to the sectors in which they are employed. It also captures the short-run consequences of trade on the distribution of income.
• The Heckscher-Ohlin model.The multiple factors of production in this model can move across sectors. Differences in resources (the availability of those factors at the country level) drive trade patterns. This model also captures the long-run consequences of trade on the distribution of income.
When we analyze real problems, we want to base our insights on a mixture of these models. For example, in the last two decades one of the central changes in world trade was the rapid growth in exports from newly industrializing economies. These countries experienced rapid productivity growth; to discuss the implications of this productivity growth, we may want to apply the Ricardian model of Chapter 3. The changing pattern of trade has differential effects on dif- ferent groups in the United States; to understand the effects of increased trade on the U.S. income distribution, we may want to apply the specific factors (for the short-run effects) or the Heckscher-Ohlin (for the long-run effects) models of Chapters 4 and 5.
In spite of the differences in their details, our models share a number of features:
1.The productive capacity of an economy can be summarized by its produc- tion possibility frontier, and differences in these frontiers give rise to trade.
2.Production possibilities determine a country’s relative supply schedule.
3.World equilibrium is determined by world relative demand and a worldrela- tive supply schedule that lies between the national relative supply schedules.
112 PART ONE International Trade Theory
Because of these common features, the models we have studied may be viewed as special cases of a more general model of a trading world economy.
There are many important issues in international economics whose analysis can be conducted in terms of this general model, with only the details depending on which special model you choose. These issues include the effects of shifts in world supply resulting from economic growth and simultaneous shifts in supply and demand resulting from tariffs and export subsidies.
This chapter stresses those insights from international trade theory that are not strongly dependent on the details of the economy’s supply side. We develop a standard model of a trading world economy, of which the models of Chapters 3 through 5 can be regarded as special cases, and use this model to ask how a variety of changes in underlying parameters affect the world economy.
LEARNING GOALS
After reading this chapter, you will be able to:
• Understand how the components of the standard trade model, production possibilities frontiers, isovalue lines, and indifference curves fit together to illustrate how trade patterns are established by a combination of supply-side and demand-side factors.
• Recognize how changes in the terms of trade and economic growth affect the welfare of nations engaged in international trade.
• Understand the effects of tariffs and subsidies on trade patterns and the wel- fare of trading nations and on the distribution of income within countries.
• Relate international borrowing and lending to the standard trade model, where goods are exchanged over time.
A Standard Model of a Trading Economy
Thestandard trade modelis built on four key relationships: (1) the relationship between the production possibility frontier and the relative supply curve; (2) the relationship between relative prices and relative demand; (3) the determination of world equilibrium by world relative supply and world relative demand; and (4) the effect of the terms of trade—the price of a country’s exports divided by the price of its imports—on a nation’s welfare.