The Theory of Factor Proportions

Lecture 5
Evolution of Trade Theories
Mercantilism
Absolute Advantage
Comparative Advantage
Factor proportion Trade
International Product Cycle
New Trade Theory
National Competitive Advantage

Factor proportions theory
Heckscher (1919) - Olin (1933) Theory
Export goods that intensively use factor endowments which are locally abundant
Corollary: import goods made from locally scarce factors
Note: Factor endowments can be impacted by government policy - minimum wage
Patterns of trade are determined by differences in factor endowments - not productivity
Remember, focus on relative advantage, not absolute advantage

Factor proportions theory
… trade theory holding that countries produce and export those goods that require resources (factors) that are abundant (and thus cheapest) and import those goods that require resources that are in short supply
Example:
Australia – lot of land and a small population (relative to its size)
So what should it export and import?

Factor Proportions Trade Theory
Considers Two Factors of Production
Labor
Capital

Factor proportions theory
The Assumptions
There are two nations (1&2), two commodities (X&Y), two factors of production (labor & capital).
Used to illustrate the theory in a two-dimensional figure.
Both nations use the same technology in production.
Means both nations have access to and use the same general production techniques.
Commodity X is labor intensive and Y is capital intensive in both nations.
Means the labor-capital ratio (L/K) is higher for X than Y in both nations at the same relative factor prices.

Factor proportions theory
Both commodities are produced under constant returns to scale in both nations.
Means that increasing the amount of L and K will increase output in the same proportion
There is incomplete specialization in production in both nations.
Means that even with free trade both nations continue to produce both commodities. This implies neither nation is very small.
Tastes are equal in both nations.
Means demand preferences are identical in both nations. When relative prices are equal in the two nations, both consume X&Y in the same proportion.

Factor proportions theory
There is perfect competition in both commodities and factor markets in both nations.
Means that producers, consumers, and traders of X&Y in both nations are each too small to affect prices of commodities. Also, in the L-R commodity prices equal their costs, leaving no economic profit.
There is perfect factor mobility within each nation but no international factor mobility.
Means K&L are free to move from areas and industries of lower earnings to those of higher earnings until earnings are the same in all areas, uses and industries of the nation. International differences in earnings persist due to zero international factor mobility in the absence of international trade.

Factor proportions theory
There are no transportation costs, tariffs, or other obstructions to the free flow of international trade.
Means specialization in production proceeds until relative (and absolute) commodity prices are the same in both nations with trade. If transportation costs and tariffs were allowed, specialization would proceed only until prices differed by no more than the costs and tariffs on each until of the commodity traded.

Factor proportions theory
All resources are fully employed in both nations.
Means there are no unemployed resources in either nation.
International trade between the two nations is balanced.
Means that the total value of each nation’s exports equals the total value of the nation’s imports.

Factor Proportions Trade Theory
A country that is relatively labor abundant (capital abundant) should specialize in the production and export of that product which is relatively labor intensive (capital intensive)

The Theory Contains Four Core Propositions
Factor endowments and trade patterns
Factor price equalization
Distribution of income
Factor growth and output patterns

The Factor-Proportions Theory
EXAMPLE:
U.S. (capital abundant) has comparative advantage in the production of machines (capital intensive).
India (labor abundant) has comparative advantage in production of cloth (labor intensive).

The Factor-Proportions Theory
Factor-proportions theorem
A country will have a comparative advantage (disadvantage) and export (import) goods whose production intensively uses its relatively abundant (scarce) factor of production.

The Factor-Proportions Theory
The U.S. imports goods from countries where labor in the abundant factor.
The U.S. exports goods that are capital intensive.
Gains from trade are realized when a country exports goods based on its comparative advantage and imports goods based on comparative disadvantage.

Factor endowments and trade patterns
Natural resource version:
USA is relatively well endowed with
land. Therefore USA exports farm (land-intensive) products. Singapore is relatively well endowed with marine traffic locational resources. Therefore, Singapore exports shipping, marine insurance, ship repair plus many derivative services.

Factor endowments & trade patterns
Developed resource version:
Japan, USA, France & Germany are
relatively well endowed, after histories
of much investment, with non-human
productive resources or capital.
Therefore, they export capital-intensive
manufactured goods.

Factor endowments & trade patterns
Do they? France and USA are the world’s
two biggest exporters of agricultural
products. Land intensive?
Leontief (Nobel laureate) discovered (1960s)
after extensive data crunching that the USA
exports labor intensive goods; to Japan?
To China? To Luxembourg? To India?

Factor endowments & trade patterns
Try to explain that one.
Maybe US labor is (was) human capital
intensive. US endowment of capital
intensive labor is (was) relatively large by
international standards.
Hence, labor intensive exports were really human capital intensive. Try that one on the shop floor at Toyota City!

Factor Endowments
Although land, capital and highly skilled
labor may be relatively abundant in the
United States & other developed countries,
labor in general is relatively scarce.
This has many implications with respect to trade policy, income distribution and other
matters.

Factor price equalization
Labor:
Through intense global competition,
wages and the return to capital tend to
equalize across trading nations. Is this
true? Are your wages determined in
Bangladesh? Are low-skilled US workers
vulnerable? Many who were on the streets
of Seattle & Honolulu think so.

Factor Price Equalization & Productivity
A useful abstraction: visualize a worker as
an embodiment of natural and acquired
skills or sources of productivity. The skills
are heterogeneous; some are highly
competitive internationally, others are
company or geographically specific.
Globalization transforms the specific into
global, but the transformation is incomplete.

Factor Price Equalization & Productivity
High tech skills tend to be global and to
correlate with mobility.
Medium and low tech skills tend to be more local and less mobile.
However, a major exception may
be many low tech skills in the First World
which are highly substitutable for skills
that exist widely in the Third World.

Factor Price Equalization & Productivity
Due to opportunity differentials, low-skill
labor in the First World embodies, on average, a greater concentration of skill units than that embodied in Third World labor.
If this is true, wages of low-skilled labor will remain higher in the First World, even if
global competition forces relative
equalization.

Factor price equalization
Capital:
Heavy investment in a country, whether
by its own residents or through foreign
direct investment (FDI) leads to falling
returns. Resulting excess capacity in Asian
countries caused falling returns & inability
to pay off loans. Asia ceased to be a
better investment than developed countries.

Trade & income distribution
Free trade:
Land is abundant in USA, scarce in JPN.
Free trade enables USA to share its land
globally, in an environment in which land
is not so abundant. Hence, US farm income
rises. However, US abundance swamps
JPN’s scarcity causing JPN’s farm income
to fall.

Trade & income distribution
Protection:
Protection of JPN’s agricultural sector
creates a local monopoly, free of USA’s
abundant competition and raises JPN’s
farm income (lowers USA’s income).
Of course, JPN’s consumers pay more.
Farmers and related industries win;
consumers & others lose.

Trade & income distribution
Industrial products:
JPN’s automobiles & consumer electronic
products and USA’s software, hardware &
entertainment output are produced by
industries relatively well endowed with
key inputs. Owners of these key inputs
profit from globalization if exporters, but
lose if importers.

Factor growth & output
The down side:
In a small country, world goods prices
are set by large, global markets. Hence,
if, for example, population (labor force)
rises, labor-intensive industries will
grow and capital-intensive industries
will shrink.