Chapter 4
Trade: Factor Availability and Factor Proportions Are Key
Overview
This chapter continues the analysis of international trade in a two-product economy. It picks up
from the end of Chapter 3, where it was noted that the assumption of constant marginal cost and
the implication that countries will completely specialize in producing only one (or a few)
product(s) are unrealistic. In the modern theory of international trade, we use the assumption of
increasing marginal costs—as one industry expands at the expense of others, increasing amounts
of other goods must be given up to obtain each extra unit of the expanding output. Increasing
marginal cost results in a bowed-out production possibility curve. This is linked to
upward-sloping supply curves for each product. Increasing marginal costs arise because some
resources are better suited to producing one good rather than the other (including differences in
factor input proportions between the two products—Appendix B shows this explicitly). The
market price ratio determines which production point will actually be chosen. Production will be
driven to levels at which the marginal (or opportunity) cost of producing another unit just equals
the price at which the output can be sold. On the graph this is a tangency between the production
possibility curve and the price line whose slope reflects the market price ratio.
The second key analytical tool that we need is a way to picture demand for two products at the
same time. For individuals this can be done using indifference curves and income or budget
lines. The chapter reviews (or summarizes) the basics of indifference curves (levels of well-being
or happiness or utility, bowed shape, infinite number of which only a few are usually pictured). It
then indicates that we are going to use community indifference curves, even though there are
serious questions about them. At the least, they are reasonable for depicting national demand
patterns for two goods simultaneously. Under certain assumptions they also provide information
on national well-being or welfare, but this use is more debatable.
Putting the production possibility curve together with the community indifference curves results
in a picture of an entire (two-product) economy. The chapter shows the equilibrium with no trade
(a tangency of a community indifference curve with the production possibility curve). It then
shows two countries whose no-trade price ratios differ. When trade is opened between the two
countries, an equilibrium international price ratio is established that clears the international
markets for the two goods. Production in each country shifts to the tangency with the new price
line (whose slope shows the equilibrium international price), and each country trades along the
price line to a consumption point determined by a tangency between the price line and a
community indifference curve. The right-angle triangle between the production point and the
consumption point is a trade triangle showing export and import quantities for each country. (The
chapter also indicates how the graph can be used to derive a demand curve for cloth, so that the
analysis is shown to be consistent with the supply-demand analysis from Chapter 2.)
The graph can be used to show that each country gains from trade. Trade allows each country to
consume beyond its ability to produce (shown by the production possibility curve). Trade allows
each country to reach a higher community indifference curve. How much the country gains from
trade depends on the country’s terms of trade—the price of its exports relative to the price of its
imports. The graph also shows the effects on the production and consumption quantities for each
good in each country.
The chapter ends by returning to the first of the four key questions about trade—what determines
the pattern of trade. While demand differences might explain some trade, most analysis focuses
on production-side differences. If demand is neutral, then the trade pattern is determined by
production-side differences that cause no-trade price ratios to differ. In our graph, these
differences skew one country’s production possibility curve toward producing wheat and the
other country’s toward producing cloth. The skewness could arise for two reasons. First,
production technologies or resource productivities may differ between countries. This
explanation is the one used in the Ricardian approach, and we will return to it in Chapter 7. But,
for the remainder of this chapter and the next chapter, we ignore technology or resource
productivity differences, and instead focus on the second reason—differences in resource
availability and resource use.
The skewness of production possibility curves can arise because resource availability differs
between countries and the use of these factors in producing differs between products. These
differences in factor endowments and factor proportions lead to the Heckscher-Ohlin theory of
trade patterns—countries export the products that use their abundant factors intensively (and
import the products that use their scarce factors intensively). With no trade the relatively
abundant production factors will be relatively cheap, so that the product that uses these factors
relatively intensively will have a low no-trade price. As trade is opened, this product is exported.
Tips
China is prominent in the news and of majorinterest to many students. This chapter has the first
of four boxes throughout the text that “Focus on China.” China provides a real world example of
a shift from (almost) no international trade in the late 1970s to substantial international trade by
the mid-1990s and up to today.
If you use offer curves to show the determination of the equilibrium international price ratio, you
can assign and cover the material in Appendix C.