Page 48 - DECO503_INTERNATIONAL_TRADE_AND_FINANCE_ENGLISH

International Trade and Finance

Notes capital going up, and labour becoming abundant and the cost of labour going down. The K/L will
drop as a result.
In brief, we start with a low capital-labour ratio in country A and a high capital-labour ratio in
country B. This is before trade. But after trade capital ratio will rise in country A and fall in country B
until the capital ratios are equalized in the two countries. This is the process by which the factor
prices (capital-labour ratios) in the two countries are equalized as a result of trade. Note that this
factor-price equalization is brought about without the movement of factors of production between
the two countries. What brings about this factor-price equalization, then, is the international trade
mechanism. It is in this sense that we can argue that international trade in goods and services, is a
substitute for international labour and capital movements (or factor mobility). We shall now explore
the meaning and process of how this factor-price equalization will, in fact, be brought about. We will
do it with the help of Edgeworth-Bowley box diagrams.
The points of origin for Good X and Good Y are as shown in the diagram. Capital and labour are
measured along the horizontal and vertical sides of the above box diagram. Obviously, it is a labour
surplus country since it has more supply of labour than of capital.
There are three possibilities with regard to the capital-labour ratio (K/L) in the production of good X
and Good Y, and they are as follows :
(a) If the optimum-efficiency locus (or the contract curve) is a linear straight line, such as AB, the
capital-labour ratio in the two goods will be equal and remain so regardless of whether more of
X is produced or more of Y is produced. In other words, whether we produce at point 1 or 2 or
3 on the line AB, the capital-labour ratio in good X (K/L ) will be equal to the capital-labour
x
ratio in good Y(K/L ), which are shown by the equality of the angles of the size of H and G. (H
v
= G).

Labour Good Y
X N G B
Y 0 0
3 J
X 3
Capital 2 Y 1 Capital

X 2
1 Y 2
M H T X
X 1 0
A R Y 3 Y 0
Good X Labour

Figure 4.1 : Capital-Labour ratios in Good X and Good Y.
(b) If the contract curve is non-linear of the type represented by the line AFB (in Figure 4.1), Good
X will be a capital-intensive good and Good Y will be a labour-intensive good. Because K/L in
X (K/L represented by the size of the angle M) is higher than the K/L in Y (K/L represented
x y
by the size of the angle N).
(c) Finally, if the contract curve is non-linearly shaped like the sagging line ATB in the Figure, we
find that good X is labour-intensive (low K/L , equal to the size of the angle R) and good Y is
x
capital-intensive (higher K/L , equal to the size of the angle J).
v
Throughout what follows, we will assume that the contract curve is of the type represented by the
non-linear line ATB so that good X is labour intensive and good Y is capital intensive. Even if the
country had more capital and less labour, good X will remain labour-intensive and good Y capital-
intensive, so long as we have a contract curve of the shape of ATB as shown in Figure 4.1.

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