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

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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.

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