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National Production Possibilities

Production possibilities frontier生产可能性曲线

A theoretical method of representing the total productive capabilities of a nation used in the formulation of classical and modern trade theory.

Please look at Figure 5.2 and cover the words.

1. initially produces and consumes 2. specialize in… and shifts production from

… to … 3. exports(v) …in exchange for imports(n) of

… 4. consuming the same amount of wheat but

15 more units of cloth than at original point A.

These frontiers depict what each nation could produce in isolation---without trade(autarky).

The slope represents the price ratio of good x to y, that is, -slope= Px/Py.

Opportunity cost is the forgone value of a factor of production in its next-best use. Nations should specialize in the good where it can produce at a lower opportunity cost.

Are both countries better off as a result of trade?

Yes. The point where a country produces and the

point where it consumes are now different. This allows each country to consume beyond their own production possibilities frontier. Society’s welfare, which is normally measured in its ability to consume more wheat, cloth, or any other goods or services, is increased through trade.

Division of Labor

Adam Smith’s explanation of how industrial societies can increase output using the same labor-hours as in preindustrial society.

Smith extended this specialization of the efforts of a worker to the specialization of a nation.

Comparative Advantage

How countries that seemingly had no obvious reason for trade could individually specialize in producing what they did best and trade products they did not produce.

Gains from Trade

The theory of comparative advantage argued that nations could improve the welfare of their populations through international trade. A nation could actually achieve consumption levels beyond what it could produce by itself.

Ⅰ.The background of factor endowment theory(1)

Heckscher-Ohlin Model is a famous proposition about the pattern of trade between two economies each of which enjoys its respective comparative advantages. Factor endowment theory was firstly initiated by a Swedish Economist, Professor Eli Heckscher, who was working in University of Stockholm, in 1919 when Heckscher published a research paper in Swedish The Effect of Foreign Trade on the Distribution of Income.

Ⅰ.The background of factor endowment theory(2)

After that another Swedish economist Bertil Ohlin, who was once the student of Heckscher in University of Stockholm, inherited and developed the essentialities of the theory introduced by Heckscher. In Heckscher’s words, “My then pupil, Bertil Ohlin, followed up my attempt and reshaped it”. Ohlin’s results were first published in his doctoral dissertation in Swedish, Theory of Trade in 1924, and afterward, far more fully in his well known book in the Harvard Economic Series, Interregional and International Trade in 1933.

For almost thirty years from 1919 till 1949 few scholars in the academic circle of international trade had known Eli Hechscher but most of them would be very much familiar with a famous name Bertil Ohlin so that during that period of time people once mentioned the theory of factor endowment as “Ohlin model”.

Heckscher and his paper did not popularize at least for two reasons. Firstly, Heckscher had his academic activities mostly in Sweden and the paper was published in Swedish. But we know that Swedish is not as widely spread as English. Secondly, the paper was published in 1919 when the World War One just ended. The interests of the major powers in the world at that time were not on the issues of trade theory.

The Basic Idea of the Theory The basic idea of the theory is that countries di

ffer in their relative stocks of the different factors of production, and that these differential factor supplies influence the costs of producing particular goods. Differences in production costs lead to the comparative advantages of a country in international trade. For example, a country with an abundant supply of capital and little labor, and therefore has a comparative advantage in capital, produces and exports such capital-intensive goods.

Factor endowment theory breaks away from the classical labor value theory and tries to explain the reason of international trade in an entirely new way. Heckscher-Ohlin theory holds that comparative advantages enjoyed by different countries are the pre-requisite of trade. These comparative advantages, however, do not come from the relative differences in labor inputs of production as the classical economists described. It is the differences in a country’s production factor endowment that determines the production costs of different countries and thus their respective comparative advantages in international trade.

Since Heckscher-Ohlin theory opened up a new path and established a so-called reasonable theoretical approach of explaining and analyzing issues of international trade, the theory had been widely accepted in the academic circles in the western world and had taken the position of the orthodox trade theory (正统的贸易理论 ) or the main trend of trade theory (贸易理论的主流 ). Therefore, factor endowment theory could be appropriately evaluated as a theoretic milestone in development of trade theory. Consequently, factor endowment theory has become the important theoretical origin of the so-called new trade theories developed in the past several decades.

Ⅱ. How did Heckscher analyze the principle of theory of factor endowment?

Heckscher established his theory on two assumptions: First, changes induced by foreign trade in the nature of the factors of production (“dynamic” changes) are completely disregarded. Thus the quantity of factors of production within a country is given; Second, no attention is paid to the advantages one particular country may achieve by means of protection. That is to say he only discussed problem of international trade in the framework of free trade.

If one initially employs all of the above assumptions it follows from the nature of barter that trade will create the maximum satisfaction of wants or the maximum national income (按此两个假定，根据物物交换的性质，贸易可以使人们的需求满足以及国民收入最大化 ). Exchange will only be agreed upon or continue insofar as it offers the traders a higher gain than if it did not occur. There is still no reason for the country to alter its economic system unless the total satisfaction of wants is thereby increased. That implies no benefit no trade.

Heckscher concluded as the follows:

A difference in the relative scarcity of the factors of production between one country and another is thus a necessary condition for a difference in comparative costs and consequently for international trade. A further indispensable condition is that the proportions in which the factors of production are combined shall not be the same for one commodity as for another. In the absence of this second condition, the price of one commodity, compared with the price of another would remain the same in all countries regardless of differences in relative factor prices.

Ⅲ. How did Ohlin analyze the principle of theory of factor endowment?

Ohlin attached great importance to space （俄林十分强调空间的重要性） . From the very beginning of his book Interregional and International Trade he pointed out:“Space is important in economic life for two chief reasons: the factors of production are to some extent confined to certain localities and move only with difficulties; and costs of transport and other impediments prevent free movement of commodities.”

Ohlin analyzed the reasons of trade from the advantages of labor division and specialization of production and then he extended the basic principle to behavior of a nation.

What are the causes of division of labor in general? Why do individuals trade with each other, instead of each one producing his own requirements? Why does division of labor increase the total efficiency of production? The reasons may be grouped under two headings: “varying ability” and “advantages of specialization”.

First of all, some individuals have greater ability for certain tasks than others. Varying natural aptitudes make one fitter to be an engineer, another better suited for the work of physician or a lawyer. Some people take greater interest in gardening than in other occupations, and hence probably make better gardeners than others. Examples could be multiplied.

Second, even if all individuals had exactly the same natural abilities, it would still be advantageous to have specialization in a small number of occupations. In this way, much greater skill can be acquired than if everyone produced everything for himself. Furthermore, the workman who constantly attends to one task wastes no time changing over from one occupation to another. In short, there results an increase in skill and a saving of time when each individual is occupied in the production of a large number of one particular article instead of cooperating in the production of a small quantity of many different articles.

Turning from individuals to regions, one finds that the two regions might be quite differently endowed with facilities for the production of various articles. One reason is that they are differently supplied with productive factors. One region may have plenty of iron and coal but little land for wheat-growing, while another has plenty of wheat-growing land but a scanty supply of mineral resources; clearly the former is better adapt to iron production and less well adapt to wheat-growing than the latter.

It is the proportion of the factors in a region that determines its fitness for specific industry.

The nature of a country’s factor endowment determines the method of production and then the relative price of production factors and consequently the relative costs of products and at last the comparative advantages of a particular country.

Relatively abundant factor——extensive method of employment——relatively low price of this factor——price of the goods requiring relatively large proportions of the abundant factor would be relatively low.

Relatively scarce factor——intensive method of employment——relatively high price of this factor——price of the goods requiring relatively large proportions of the scarce factor would be relatively high.

“In brief, each region is best equipped to produce the goods that require large proportions of the factors relatively abundant there; it is least fit to produce goods that require large proportions of factors existing within its borders in small quantities or not at all. Clearly, this is the cause of interregional trade, just as varying individual abilities is cause of individual exchanges”.

Ⅳ.The assumptions of factor endowment theory

Basically speaking, there are four sections of theoretical assumptions when Heckscher and Ohlin analyzed their factor endowment theory:

1.Assumption Section One:

The extended trade model is employed. That is the so-called “two country-two factor-two goods model” ( 2×2×2 model ). The model could be used to illustrate trade between the two countries when they produce two commodities by using two sorts of productive factors.

If we define the two sorts of factors as capital and labor, in this model, it is assumed that one country endows relatively abundant labor but relatively scant capital while the other country has a relatively abundant stock of capital but labor is of relative scarcity. Further more, one commodity is assumed to be labor-intensive while the other commodity capital-intensive. At last, barter trade would be carried out. No money used in trade for simplifying the analysis.

2.Assumption Section Two:

Factor endowment of a country is constant. That means the variations in a country’s natural endowment of productive factors would be disregarded. In addition, factors of production are internationally completely immobile but intranationally freely mobile.

3.Assumption Section Three:

The two countries are as the same as each other in almost every respect except their factor endowment. It follows that the same production techniques would be applied to produce the two commodities, or equivalently speaking, the two countries have the same production functions of the two commodities.

Furthermore, propensity to consume in one country is as the same as that in the other country. The same propensity to consume implies that consumption proportion of the two goods does not differ in the two countries when prices of the two commodities are given.

4.Assumption Section Four:

Production techniques are constant and returns in scale do not change in line with variations in production scale. This assumption indicates that certain percentage of changes in input of productive factors will lead to the same percentage of changes in the output produced. No diminishing returns of scale.

From the above basic theoretical assumptions of factor endowment theory we can easily see that the essential difference between the theory and other trade theories is that it inserts a new element into its trade model. That is factor of production. The former “2×2 model” has been changed into the so-called “2×2×2 model”. By adding this element into trade model Heckscher and Ohlin successfully laid the basis of trade on different factor endowments of the exchanging countries.

In this 2×2×2 model, for instance the two countries, A and B, are producing and exchanging two goods, F and C, by using two sorts of productive factors, L and K, if we say country A has a relatively abundant supply of labor and a relatively scant endowment of capital. It is equivalently to say that country B is relatively rich in capital endowment and it is relatively scantly supplied with labor. Similarly, in this model if Good F is labor-intensive that implies Good C is capital-intensive.