Page 49 - DECO503_INTERNATIONAL_TRADE_AND_FINANCE_ENGLISH

Unit 4 : Modern Theories of International Trade : Theorem of Factor Price Equalization, H-O Theory, Kravis and...

This would mean that in our model (i) country A is a labour-surplus country and country B is capital- Notes
surplus country, (ii) good X is labour-intensive and good Y is capital-intensive in both the countries,
regardless of the differences in factor proportions and factor prices in the two countries. We shall
now turn to the process of factor-price equalization between the two countries, as a result of the
opening of trade between them. We will first show what happens in the two countries, using separate
graphs, and later on put them together in one composite graph.
Labour-Surplus Country’s Case

This is shown (In Figure 4.2)

The box ADBC shows factor supplies in country A, a labour surplus country. The contract curve has
the shape of ATB. The production isoquants, X and X , are for good X; and Y Y are the isoquants for
1
0
1
0
food Y. Before trade, the country produces at point T, where X is tangent to Y at factor price ratio
0
0
represented by the line P P . At this point (point T) the capital-labour ratio in good X (K/L ) is equal
0 0 x
to the size of the angle TAC, and the capital-labour ratio in good Y(K/L ) is equal to the size of the
y
angle TBD. The size of TBD is more than the size of TAC, which shows that good Y is capital-intensive
and good X is labour-intensive (or K/L > K/L ).
y x
Labour
D B
P X 1 Good Y
1
Y 1 (K-good)
Capital P 0 F P 1
Capital
T X 0
Y P 0
0
A Good X Labour C
(L-good)
Figure 4.2 : Increase in Capital-Labour Ratio in Labour Surplus Country.
Once trade is opened, this country would specialize in the production (and exports) of good X. This
would result in a rightward shift along the contract curve from, say, point T to point F. In moving
from point T to F, there is an increase in the production of X and a decrease in the production of Y,
which is indicated by an upward movement of the X isoquant and a downward movement of the X
isoquant and a downward movement of the Y isoquant. From F we have drawn two rays—FA and
FB which would indicate the new capital-labour ratios in the production of X and Y goods at point F.
In moving from point T to F, there has been an increase in the capital-labour ratio in X production
(from the angle TAC to FAC) as well as Y production (from the angle TBD to FBD). You will, therefore,
notice that in country A (a labour surplus country) the capital-labour ratio in both goods production
has gone up after the establishment of trade. This is indicated by the change in the slope of factor
price line from P P to P P after trade.
0 0 1 1
Capital-Surplus Country’s Case

The box ABCD in Figure 4.3, represents factor supplies in country B, a capital surplus country.
Country A produced at point T before the introduction of trade. The capital-labour ratio in the
production of X was equal to the angle TAC, and in the production of Y it was equal to TBD. Trade
results in specialization towards increased production of Y (the capital intensive good), and, therefore,
the point of production shifts from point T to, say, point F. As a result of this production-shift, we
find that the capital-labour ratios in the production of both X and Y have gone down in this country.
In respect of X, the capital-labour ratio has decreased from the angle TAC to FAC; and in respect of Y;
it has decreased from TBD to FBD. The change in capital-labour ratios in the production of both X
and Y is indicated by the change in the slope of the relative factor-price ratio line from P P to P P .
0 0 1 1

LOVELY PROFESSIONAL UNIVERSITY 43