Page 57 - DECO503_INTERNATIONAL_TRADE_AND_FINANCE_ENGLISH

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

The production possibility curve of country A is AB that of country B is CD. We assume that steel is Notes
the capital intensive good and cloth is the labour intensive good. Suppose, the two countries produced
the goods in the same proportion—along the ray OR— then country A would produce at Q and
1
country B at Q , on their respective production possibility curves. Note that the slope of country A’s
2
production-possibility curve at Q , is steeper than the corresponding slope of country B at Q . Similarly,
1
2
the commodity price line P P is steeper than the line P P . All this implies that steel is cheaper in
1 1 2 2
country A and cloth is cheaper in country B, if the two countries are producing at Q and Q respectively.
2
1
Country A would, therefore, tend to expand production of steel and country B would do so for cloth.
This means that country A, a capital abundant country, has a production bias in favour of capital-
intensive good, steel, while the labour-abundant country, country B, has a bias in favour of producing
the labour intensive good, viz. cloth.
Does it follow from this that country A would export steel and country B would export cloth ? The
answer depends very much upon the demand factors. This gives rise to two possibilities : (1) if the
consumption bias and the production bias are towards the same direction, then country A would
import rather than export steel, and country B would import rather than export cloth. The Heckscher-
Ohlin prediction would then be invalid, (2) if the consumption and production biases are in the
opposite direction, then the Heckscher-Ohlin prediction will be valid, viz. country A would export
steel and country B would export cloth. Let us illustrate these two cases.

P

A
Steel H IC A

C
E
IC
IC B
D F B

Cloth P

Figure 4.9 : Consumption and production biases in opposite direction.

After the establishment of trade between the two countries, country A’s production shifts to point A
(towards greater production of steel), and country B’s production shifts to point B (towards greater
production of cloth). This means that the capital surplus country (country A) specializes in the
production of the capital-intensive good (steel), and the labour surplus country (country B) specializes
in the production of the labour-intensive commodity (cloth). There is greater degree of specialization
but by no means complete specialization, in the two countries, because of the diminishing returns to
scale conditions in the two countries in respect of both the goods.
The line PP stands for the international terms of trade line, which is also the relative factor price ratio
line after trade is established between the two countries. (Note incidentally that factor prices will be
equalized as a result of trade. We shall discuss this later under factor price equalization theorem,
which is the second proposition of the Modern theory of international trade).
If, and only if, the demand biases in the two countries are such that we have an indifference curve
like IC in Figure 4.9A, the Heckscher-Ohlin theorem will hold good. The two countries produce at
points A and B but consume at point C. It is important that consumption point, such as point C, must
lie to the right of point A but to the left of point B in order for Heckscher-Ohlin prediction to be valid.
In this case, it has happened in Figure 4.9. Country A exports an amount of steel equal to the size AE

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