Classical Trade Model And Factor Intensity Economics Essay

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5/12/16 Economics Reference this

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The Ricardian model’s main focus is on comparative advantage, one of the most central ideas in international trade theory. This theory states that countries should specialize in the production of what they produce best, thus completely specializing instead of producing a wide variety of goods. The neo classical model or Heckcher-Ohlin theory differs from this, it stresses that countries should produce and export goods that require factors that are abundantly available. This theory then differs from those assumptions of comparative and absolute advantage since they only focus on the productivity of the production of a good. On the other hand, the Heckcher-Ohlin theory states that a country should concentrate production and exports based on the factors that are abundantly available to them and thus the cheapest to produce.

The main idea of the model centre’s itself around the differences in factor endowment, the variations of factors (Land, Labour, Capital and Entrepreneurship) that a country have and can then make use of for manufacturing. These factors of production determine a countries comparative advantage, so a country then has a comparative advantage in the goods that are richly local and available to them, this then allows for trade flow. A country must also take into consideration costs, if a good requires local inputs that are abundantly available to that country then production is going to be cheaper, rather than engaging in the production of goods that are locally scarce. This introduces the concept of factor intensity, where producers use different ratios of factors of production in order to produce different goods. A country has been seen to use this concept if that country has a comparative advantage in a good whose production is intensive in the factors that are copiously available. To illustrate an example we could take oil refining for instance, this can be said to be capital intensive as it is expensive to produce, on the contrary if we take the production of clothing as an example this can be said to be labour intensive.

To outline this factor abundance theory, and give a better understanding of its main features we can look at its general structure/assumptions made:

General Structure/assumptions of Neo Classical Model (Factor Abundance Theory) [1] 

2 x 2 x 2 model (two countries, two final goods, two factors of production capital and labour)

This model has variable factor proportions between countries: so that countries which are extremely developed have a comparatively high ratio of capital to labour in relation to developing countries. This then makes the developed country capital intense/abundant relative to the developing country, and makes the developing country labour intense/abundant relative to the developed nation.

Constant returns to scale : double input = double output ( X = 2, Y = 4)

Identical Production technology everywhere

Input factors capital and labour (K&L) are mobile between sectors, but not between countries.

All markets characterized by perfect competition, no barriers for trade, and no transport costs.

Demand structure is the same, homothetic preferences

Available amount of factors of production may differ (endowment may differ). These differences in factor abundance will give rise to international trade flows.

Main Results of Neo Classical Trade Theory [2] 

These assumptions have given light to certain named conclusions, and have formed the main results of the neo classical trade model. They are as follows:

Factor Price Equalization Theorem

International trade of goods between two countries leads to an equalisation of the rewards of the factors of production the two countries. E.g. equal in capital rental rate (workers in each country are paid the same)

Stopler – Samuelson Theorem

An increase in the price of a final good increases the reward to the factors of production, used intensively in the production of that good. E.g. if the price of a final good (paper) increases, then the price of wood would also increase

Rybczynski Theorem

An increase in the supply in a factor of production (K,L) results in the increase in the output of the final good that uses this factor of production relatively intensively. E.g. workers used intensively so will therefore result in an increase of output.

Heckscher – Ohlin Theorem

A country will export the good which intensively uses the relatively abundant factor of production.

In tackling this question as to why Marks and Spencer may switch manufacturing to a less developed country, the main focus will be upon the Factor Equalisation Theorem. This theorem suggests that when the prices of the output goods in this case clothing are equalised between countries as they come closer to trade, then the prices of the factors (capital and labour) will also be equalised between nations. This equalisation happens as a result of the countries being price takers due to perfect competition. Ohlin makes it clear that he himself did not actually think that the rewards for the factors of production would b equalised between two countries, just that there is likeliness that they would become more equal. [3] This becomes understandable when we know that the factors of production that are in abundance in one country are scarce in the other.

Prices are equalised due to the assumption of perfect competition, if markets for clothing were open on the international market, the prices that they charge for clothing will be the same in both countries. Because of this reason, the factors of production will also be the same for both countries. In relation to the question, based on the factor equalisation theorem, production can switch to a different country solely on the concept of factor intensity. Moving production to a less developed country may be because labour is abundant in that country, therefore more efficient in the production of clothing. Even though both countries produce the same output at the same wage rate, there are differing amounts of capital and labour being used. To distinguish the amounts of labour and capital used we use the isoquant/isocost framework that is derived from the Cobb Douglas production function.

Cobb Douglas Production Function

Y = Kyαy Ly1-αy

Y – Production level of output Y

K – Amount of capital used in manufacturing sector

L – Amount of labour used in manufacturing sector

αy – parameters (measure of capital intensity)

This equation allows the substitution of one input for another, that is to produce the same level of output with different combinations of inputs, in principle; an infinite number of possibilities are available in order to produce the same level of output. We can also form an Isoquant graphical figure which is derived from this function; in unit terms the Cobb Douglas becomes the isoquant.

Figure 1 shows an isoquant, which depicts all possible efficient combination of capital and labour able to produce giving the same level of output. Taking into account the concept of factor intensity, the country wants to produce using the factor that is abundantly available to them giving them leverage and making production more efficient on their part. Figure 2 shows the same isoquant but with the isocost lines added. Because we are looking at the production of clothing, which is labour intensive, we would prefer to be using labour as the main factor of production, meaning we would want a new optimal point (point B) where more labour is used than capital. Figure 2 shows this change in optimality making the isocost line flatter, the first move is that the isocost line pivots/rotates due to a lower wage rate, secondly it moves parallel until intersection point (becomes tangent) and shifts down until new optimal point (point B) at lower wage rate. Point A shows the point where capital is high (capital intensive), and point B is the complete opposite where labour is high (labour intensive). At point B, the production of clothing in the developing country is efficient and best suited as it is a labour intensive country.

To conclude I will give the limitations of the model and then go on to relate the question and model in real life terms.

Limitations/Criticisms of model

Lieontief paradox – argues with the main propositions made.

Found that the US, despite having a relative abundance of capital, tended to export labour intensive goods and import capital intensive goods.

That technology is the same

The factor equalization theorem applies only for most advanced countries. Wage discrepancies are not normally in the scope of the H-O model analysis

Identical production function

The standard Heckscher-Ohlin model assumes that the production functions are identical for all countries concerned. This means that all countries are in the same level of production and have the same technology. This is highly unrealistic.

No unemployment

Unemployment is the vital question in any trade conflict. Heckscher-Ohlin theory excludes unemployment

This question is related to clothing and production, therefore we assume that it refers to labour as its main factor of production, thus taking into consideration the concept of factor intensity we can say that it is labour intensive, furthermore unskilled labour intensive. The majority of exports and main share of production has been found to originate in that of the developing world. The high labour intensiveness of the industry has meant there is very strong encouragement for companies to shift production to a lower labour cost area. These labour costs heavily weigh the choice in which location to manufacture; strong financial incentives push production ideas into relocating this labour intense production process to a low labour cost area. The production of these goods in a developing country would have its competitive advantages for example cheaper raw materials and cheaper labour costs. From this we can build upon the idea of cost minimisation, the main incentive for a country is to lower its costs and maximise its profits based on production decisions. In reality, the factor equalisation theorem does not hold, wages are not equal between countries. In the UK we have a minimum wage, and if we take a less developed country such as Vietnam this minimum wage is nonexistent and workers in the garment sector are paid as little as 49 cents. [4] 

Companies such as Marks and Spencer are in business to profit maximise through cost minimisation, moving to a less developed country for manufacturing is cheaper for the company itself due to the country being labour intensive and the goods produced need this high labour intensity. Under pressure to keep prices low, most retailers look for cheaper sources of clothes than cut profit margins, therefore relocate and base their relocation on quota allocation, delivery time, infrastructure and most importantly labour costs. So an incentive to relocate to produce goods at a lower cost seems the cheaper, efficient and best move to make.

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