Tutorial on General Equilibrium Analysis: Heckscher-Ohlin-Samuelson Trade Model - PowerPoint Presentation

1. Tutorial on General Equilibrium Analysis: Heckscher-Ohlin-Samuelson Trade ModelThe Microeconomics of International TradeECN230Roberto J. GarciaSchool of Economics and Business, NMBUSession 4

2. General equilibrium trade analysis IIHeckscher-Ohlin-Samuelson (H-O-S) modelModel specification and assumptionsSpecificationTwo countries: North and SouthTwo goods: agricultural (A) and manufactured (M)Two factors: labor (L) and capital (K)AssumptionsIdentical goods and factorsFactor mobility across sectors not across bordersProduction functions are identicalFactor endowments differFactor intensity in productionCompetitive marketsResources fully employed; world production = consumption Preferences can be same or different1

3. 2General equilibrium trade analysis IIBase situation – example 1Countries are initially closed to trade (autarky)Factor endowment differences Supply of labor: LN < LS Stock of capital: KN > KS Factor intensity in productionProduction of A (QA) is intensive in the use of LProduction of M (QM) is intensive in the use of KSame technology implies identical production functions QA = f(LA, KA) where ∂QA/∂LA > 0 but ∂QA2 / ∂LA2 < 0QM = g(LM, KM) where ∂QM/∂LM > 0 but ∂QM2 / ∂LM2 < 0Given market infoSectorsProduction PossibilitiesNorthSouthAgriculture (A)[Qmax]A<[Qmax]AManufacture (M)[Qmax]M>[Qmax]M

4. General equilibrium trade analysis IIRepresentation of the economiesStep 1. Production possibilities curves (PPC)North has an absolute advantage in production of MSouth has an absolute advantage in production of A3SouthNorth

5. General equilibrium trade analysis IIFactor pricesLN < LS implies [PL]N > [PL]S KN > KS implies [PK]N < [PK]S Relative factor prices: [PL//PK]N > [PL//PK]S Production costs given factor intensityLN < LS implies [PA]N > [PA]S KN > KS implies [PM]N < [PM]S Relative goods prices: [PA//PM]N > [PA//PM]S 4Step 2. Pre-trade productionSouthNorth

6. General equilibrium trade analysis IIStep 3. Pre-trade consumption Budget line is the consumption possibilities curveSuppose preferences for the goods is given as shown belowUtility maximization at tangency of SW and budget lineOptimal combination of A,M in consumption is at [Co], which includes [Co]A and [Co]M given prices and income5SouthNorth

7. General equilibrium trade analysis IIGeneral equilibrium, pre-trade situation in NorthClosed economy: production equals consumption[Qo] = [Co] implies [Qo]A = [Co]A and [Qo]M = [Co]M [PA / PM]N = ∆M/∆A = slope of PPC = slope of SW = slope of budget line6NorthAgricultural sectorManufacturing sector

8. General equilibrium trade analysis IIGeneral equilibrium, pre-trade in SouthClosed economy: production equals consumption[Qo] = [Co] implies [Qo]A = [Co]A and [Qo]M = [Co]M in S[PA / PM]S = ∆M/∆A = slope of PPC = slope of SW = slope of budget line7SouthAgricultural sectorManufacturing sector

9. General equilibrium trade analysis IIPartial equilibrium, pre-trade8NorthManufacturing sectorSouthAgricultural sector[PA/PM]N > [PA/PM]S [PM]N < [PM]S [PA]N > [PA]S

10. General equilibrium trade analysis IIPartial equilibrium, pre-trade9NorthManufacturing sectorSouthAgricultural sector[PA/PM]N > [PA/PM]S [PM]N < [PM]S [PA]N > [PA]S

11. General equilibrium trade analysis II10Step 4. Prices, pre-tradeBudget line: Y = PA CA + PM CM Slope of budget lineAt [Cmax]M, Y = 0 CA + PM [Cmax]M At [Cmax]A, Y = PA [Cmax]A + 0 CMY = Y implies: PM [Cmax]M = PA [Cmax]A [PA/ PM] = [Cmax]M / [Cmax]A = ∆M / ∆ADifferential in the ratio of prices, [PA/ PM] The steeper the price ratio, the higher is PA relative to PMPN = [PA / PM]N and PS = [PA / PM]S PN > PS: [PA ]N > [PA ]S and [PM]S > [PM]N TOT will be between the existing pre-trade prices

12. General equilibrium trade analysis IIStep 5.World prices, TOT and the price changes Prices in the agricultural sectorPrices in the manufacturing sector11

13. General equilibrium trade analysis IITOT is the ratio of world prices: [PA/PM]W Price changes in North: [PA/PM]N > [PA/PM]W ↓ PA from [PA]N to [PA]W ↑ PM from [PM]N to [PM]W 12North

14. General equilibrium trade analysis IIPrice changes in South: [PA/PM]S < [PA/PM]W ↑ PA from [PA]S to [PA]W ↓ PM from [PM]S to [PM]W 13South

15. General equilibrium trade analysis IITrade trianglesTOT: [PA/PM]W = [QM/QA]T Relative prices of A for M on the world marketThe quantity of A that must be traded to get a unit of M14NorthSouth

16. General equilibrium trade analysis IIStep 6. Welfare implicationsThe change in prices from pre-trade to the terms of trade increases purchasing power in both countries (outward shift in CPC or budget line) and raises utility (SW)The gains from trade results from the process of specialization and trade that improves efficiency and welfare Efficiency in resource allocationEfficiency in productionEfficiency in consumptionEfficiency in exchange15

17. General equilibrium trade analysis IIConcluding commentsGeneral lessons from the resultsPrice differentials create an incentive for tradeA cost-competitive country has a comparative advantage and will be a net exporting country in a free trade situation A high-cost country has a comparative disadvantage and will be a net importing country in a free trade situationSpecialization and trade result in gains that represent efficiency in resource use, production, consumption and exchangeThe optimal amount traded is determined by the TOT bringing all markets into equilibriumLimitations and weaknesses of the modelTrade based on factor endowment differences shifts focus of comparative advantage toward supply side factors Demand-side matters are important and likely to play more of a role in trade in the futureThe underlying assumptions are still important for the results16