Page 53 - DECO503_INTERNATIONAL_TRADE_AND_FINANCE_ENGLISH

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

4. The country is assumed to be labour-abundant and capital scarce. Notes
5. There is perfect competition in both the factor market as well as the commodity market.
6. International terms of trade remain fixed.
The fixed amount of labour and capital is shown by the Edgeworth box in Figure 4.5.
The origin of cloth isoquant (T and T ) is A and that of steel (S and S ) is B. Given the non-linear
0
1
1
0
contract curve sagging below, cloth is labour-intensive and steel is capital-intensive at all production
levels of cloth and steel. In the absence of trade, (i.e., autarky) the production takes place at Q on the
contract curve, where the cloth and steel isoquants, T T and S S are tangent to each other. The factor
0 0
0
0
price ratio at Q is represented by the line P P . At this point, the capital-labour ratio in cloth is equal
0 0
to the size of the angle QAC, and that of steel equal to the angle QBD.
In 1941, W.F. Stolper and Paul A. Samuelson worked out from the Heckscher-Ohlin
theory, a theorem of their own, concerning the effect of trade on income distribution.

When trade opens up, the country will move towards increased production of cloth (the labour-
intensive good) and reduced production of steel (the capital-intensive good). The production will
now take place at R where the higher cloth isoquant (T T ) is tangential to the lower steel isoquant
1 1
(S S ), and the new set of factor price ratio at R is indicated by the line P P . Note that P P is steeper
1 1
1
1
1
1
than P P . This indicates an increase in the capital-labour ratios in the production of both cloth and
0
0
steel. The capital-labour ratios in the production of both cloth and steel. The capital-labour ratio in
cloth has gone up from (the size of the angle) QAC to RAC, and in steel, it has gone up from QBD to
RBD.
Trade must increase the relative price of cloth which is exported by the country. This is obvious from
the following related graph (Figure 4.6). Point Q in Figure 4.6, corresponds to point Q in Figure 4.5.
Similarly the line P P in the former diagrams corresponds to the line P P in the latter diagram. The
0
0
0
0
production equilibrium point R (after trade) in Figure 4.5, has a correspondence with point R in
Figure 4.6. You will notice in Figure 4.6, the relative prices of cloth and steel are such that they
correspond to the line P P which is tangent to the transformation curve at point R. This would mean
0
0
that the price of cloth has gone up relative to steel.
P 0 O P 1
P 0
Steel
R
P
Cloth

Figure 4.6
As the cloth production expands the resources will be transferred from steel industry to cloth industry.
But the steel industry will release such quantities of capital that the cloth industry can only absorb at
lower price per unit of capital released. Consequently, the remuneration of capital will have to fall in
order that all the released capital is absorbed. On the other hand, the expanding cloth industry will
want to employ more labour than the amount of labour released by the contracting steel industry.
Consequently, the price of labour is bid higher, and the remuneration of labour will have to go up.

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