Question: 1

Enlist and explain the distinguishing features of

Inter-regional trade and international trade.
Answer:
International Trade
The exchange of goods and services between countries is called International Trade.
Inter-Regional Trade
The exchange of goods and services with in a country is called Inter-regional Trade.
Distinguishing Features of Inter-Regional Trade & International Trade
Immobility of factors of production
According to classical writers, labor and capital were perfectly mobile within the country and
immobile between countries, the immobility is due to differences in language, social and
political life, religion and traditions, etc.
Different Political Circumstances:
Mostly countries differ in political circumstances. In inter-regional trade, trade takes place
among same people. But international trade takes place among people of different cultures,
habits and languages. These cultural distinctions between markets, important in the absence of
different national measures have led political scientists to take look at the nature of countries.
Difference in National Resources:
Different countries are endowed with different type of natural resources. They tend to
specialise, in the production of those commodities in which they are richly endowed and trade
them with others where such resources are scare.
Geographical and climatic differences:
Every country cannot produce and commodities due to geographical and climatic conditions,
except at possibly prohibitive costs. Countries having climatic and geographical advantage
specialize in the production of particular commodities and trade them with others
Differences in production conditions
Production conditions differs due to several causes. An advanced country in science and
technology uses better methods of production than that of an under developed country. Due to
this the costs and prices also vary. Because of these differences in production costs and prices,
the international trade takes place.
Problem of Balance of Payments
The problem of balance of payments is perpetual in international trade while regions with in a
country have no such problem.
Restrictions on Trade
Trade between different countries is not free. There are restrictions imposed by custom duties,
exchange restrictions, fixed quotas or other tarrif barriers.
Natural Resources
The countries differ in natural resources and geographical conditions. This leads to territorial
division of labor and localization in industries. Countries rich in iron and coal resources
specialize in the production of steel. And countries having plenty of land and favorable climate
produce agricultural commodities. These advantages cannot be transferred at all to other
countries. It is only possible to transfer, thereby the cost becomes extremely prohibitive.
Currency system differs
Different countries have different currency systems, and conversion of one country currency
into another currency is difficult. Sometimes scarcity of foreign exchange restricts the imports.
Besides, due to changes in the monetary policies, the price levels also vary, and this makes
international trade much more difficult.
Trade and Exchange controls
There are lot of restrictions like exchange controls, customs duties, tariff barriers and quotas
followed by countries which restrict the free flow of international trade.
Market knowledge
People possess a very good knowledge of the conditions of trade in their own country. But they
cannot be so conversant with the conditions obtained in other countries. This lack of
knowledge may hinder international trade.
Barter systems
In international trade, exchange of goods and services is done mostly on barter terms. In
external trade the exchange is often made for money of that country.
Difference in law
Internal trade is governed by the law of the land. But international trade is conditioned by the
law of the exporting countries and importing countries and the countries through which the
goods and services pass.
Objective differs
In internal trade, profit motive in terms of monetary unit of that country is the primary
objective. But in international trade, the main objective is balancing the payments position
between different countries.
Cultural distinctions
The various cultural practices between countries make international trade difficult. Example
Britain produces right hand driven cars while the France uses left hand driven cars. The trade in
cars between these two countries will not take place. Markets are also separated by language,
customs, trading, usage, habits, tastes and other factors which make trade between countries
difficult.

Question: 2
What is community Indifference curve? What are the
Criticisms on its use in international trade?
Answer:
The community indifference curves are derived by the aggregation of the
indifference curves of all the individuals in the society. Since all combinations on a
social indifference curve yield the same level of satisfaction, the increase in the
quantity of one commodity must correspond with some decrease in the quantity
of other commodity. Consequently the community or social indifference curve
slopes downwards from left to right as shown
In Figure, IC is the community indifference curve. The two combinations A and B
of commodities X and Y are supposed to give equal satisfaction to the community.
Combination A includes OQ of X + OP of Y and combination B includes OQ1 of X +
OP1 of Y. In combination B, as society increases the consumption of X by QQ1, it
reduces at the same time, the consumption of Y by PP1 so that compensating
variation in satisfaction takes place and both the combinations A and B are
equally preferred.
If a series of community indifference curves is shown such that higher the
indifference curve, higher is the level of satisfaction from combinations lying upon
it and vice-versa, that series of social indifference curves represents the
community indifference map, which is shown in Figure.
In this Figure, IC1, IC2 and IC3 represent a community indifference map. The
combinations A, B and C lie on IC1, IC2 and IC3 respectively. The combination B
includes more quantities of both the commodities than the combination A. The
quantities of the two commodities in combination C are more than in
combination B. Thus combination C gives more satisfaction than B and latter gives
more satisfaction than A. Hence higher the indifference curve, higher is the level
of satisfaction and vice- versa.
The slope of the indifference curve is measured by the marginal rate of
substitution of X for Y (MRSxy), MRSxy is the quantity of Y which the society gives
up in order to have some quantity of X commodity. It is measured by the ratio of a
change in quantity of Y commodity to a change in the quantity of X commodity.
MRSxy = – (δy/δx)
As the community increases the consumption of an additional unit of X, it may be
willing to give up less and less quantities of Y. Consequently, the MRSxy goes on
diminishing and the community indifference curve follows the path of a negatively
sloping convex curve to the origin.
Criticisms of Community Indifference Curves on international Trade
The device of community indifference curves has been employed in the analysis
of problems related to international trade by several prominent economists like
Ellsworth, Johnson, Leontief, Sodersten and Vanek. There are, at the same time,
several theorists who raised certain objections against their use.
These objections are as follow
Aggregation of Individual Tastes or Preferences:
The community indifference curve is derived through the aggregation of the
preferences of the individual consumers. In their construction, a highly over-
simplifying assumption is taken that taste patterns of consumers are identical.
This assumption ignores the inter-personal differences in tastes. There is also no
inconsistency between tastes of individuals and society from period to period.
The changes take place from time to time in the preferences of both individuals
and community. These differences not only create problems in the aggregation of
pattern of preferences but also necessitate changes in the indifference map of the
society. It becomes difficult to state whether a community was better off before
or after the change in tastes.
Cardinal Measurement of Utility:
The community indifference curve suffers from the defect of cardinal
measurement of utility. When it is said that combination C is better than B and B
is better than A Figure second, it involves transitivity. The extent by which C and B
are better than A, can be stated only on the basis of some explicit social welfare
function which converts the ordinal into quantifiable cardinal utility. Without an
international social welfare function, it is difficult to determine whether a gain of
one dollar to country X is equivalent to one dollar or more or less of gain to
another country.
Reliance on Compensation Principle:
The community indifference curves inherently involve the inter-personal
comparisons of utility. The problems created by such comparisons were sought to
be overcome by Scitovsky through the use of compensation principle. If the
increase in income due to price change is enough to compensate the loss of the
losers and makes at least one person better off, there is an improvement in social
welfare.
If the compensation principle is found meaningful, the community indifference
curves can have some relevance. But alike other welfare criteria, the
compensation principle has its theoretical and practical pitfalls. The compensation
principle involves a strict value judgment which is not universally applicable.
Changes in Distribution of Income:
Metzler pointed out that the real national income and its distribution among
individuals has much effect upon the community indifference curves. As the
international trade causes changes in the distribution of income, there may also
be shifts in these curves. It creates problems in the specific determination of
meaningful indifference curves for the country as a whole.
Changes in Factor Prices:
According to Johnson, the distribution of income can remain stable only if the
factor prices and preferences remain constant. However, if international trade or
domestic productive activity results in a change in factor prices, the income
distribution will change. This will cause a shift also in the weights assigned to
different people’s preferences in the aggregation of the preference system.
Difficulty in the Measurement of Price Change:
Kindelberger does not doubt the possibility of change in factor prices. He has
raised a fundamental objection that it is operationally difficult or almost
impossible to measure the pre- trade and post-trade change in prices. Unless the
extent of price variation is precisely determined, it is not only difficult to measure
exactly the income distribution but difficulty arises also in the determination of
trade equilibrium.
In view of its structural and practical deficiencies, Haberler dismissed this device
as unsatisfactory. Vanek recognized that the concept was used frequently but it
was weak and shaky. While making assessment of the community indifference
curve.
Stevens says that there is “a striking contrast between the quite vague and
tenuous nature of the concept of reliable commodity indifference curves on the
one hand, and the definite and forcefully stated conclusions which those who use
them claim to reach.” Despite its flaws, many economists still rely upon them for
analyzing trade equilibrium and several other fields of economic investigation.
Question 3
State and explain Ricardo’s theory of comparative
Differences in costs.
Answer:
David Ricardo agreed that absolute difference in cost gives a clear reason for trade to take
place. He, however, went further to argue that even that the country has absolute advantage in
the production of both commodities it is beneficial for that country to specialize in the
production of that commodity in which it has a greater comparative advantage. The other
country can be left to specialize in the production of that commodity in which it has less
comparative advantage. According to Ricardo the essence for international trade is not the
absolute difference in cost but comparative difference in cost.
The Ricardo comparative costs analysis

 There is no intervention by the government in economic system.

 Perfect competition exists both in the commodity and factor markets.
 There are static conditions in the economy. It implies that factors supplies, techniques of
production and tastes and preferences are given and constant.
 Production function is homogeneous of the first degree. It implies that output changes
exactly in the same ratio in which the factor inputs are varied. In other words,
production is governed by constant returns to scale.
 Labour is the only factor of production and the cost of producing a commodity is
expressed in labour units.
 Labour is perfectly mobile within the country but perfectly immobile among different
countries.
 Transport costs are absent so that production cost, measured in terms of labour input
alone, determines the cost of producing a given commodity.
 There are only two commodities to be exchanged between the two countries.
 Money is non-existent and prices of different goods are measured by their real cost of
production.
 There is full employment of resources in both the countries.
 Trade between two countries takes place on the basis of barter.
The comparative differences in costs can be measured as

a1/a2 < a3/a4 < 1

The Table satisfies the condition specified for comparative difference in costs
a1/a2 < 1 < a3/a4 < 1
12/16 < 10/12 < 1
In case a1/a2 = a3/a4, there are equal differences in costs and there is no possibility of trade
between the two countries.

In Fig. 2.2, AA1 and BB1 are the production possibility curves pertaining to countries A and B.
Given the same amount of productive resources, A can produce larger quantities of both the
commodities than the country B. It means country A has absolute cost advantage over B in
respect of both the commodities.
If the curve BC1 is drawn parallel to AA1; the curve BC1 can represent the production possibility
curve of country A. If country A gives up OB quantity of Y and diverts resources to the
production of X, it can produce OC1 quantity of X, which is more than OB1. It means the
country A has comparative cost advantage in the production of X-commodity.
From the point of view of B, it can produce the same quantity OB of Y, if it gives up the
production of smaller quantity OB1 of X. If signifies that country B has less comparative
disadvantage in the production of Y commodity. Accordingly, country A will specialize in the
production and export of X commodity, while country B will specialize in the production and
export of Y-commodity.

Question 4
Critically examine Graham’s view of trade under
Decreasing costs.
Answer:
Grahams does not agree with the classical view that when production is subjected to the law of
decreasing cost, specialization along the comparative cost will increase the volume of
production.

 There are two countries England and America produced two good that is wheat and
watches
 England produced 40 unit of wheat and watches.
 America produced 40 unit of wheat and 37 unit of watches
 America has CA in wheat and England in watches
Invalid assumption of decreasing cost

 Cost decreasing production expand.

 Cost increasing production contract.
Decreasing cost with perfect competition
This assumption is highly precarious because industry is operating under law of decreasing cost
Beneficial for monopolist
Due to decreasing cost industry is already monopoly and the monopoly is full control over his
supply
Average and marginal relationship
Another weakness is this is fail of marginal and average relationship
Incomplete analysis
Trade relation between the two countries when the two goods are producing under same law
of production in England as in America
Cost difference
Trade is difference in comparative cost and decreasing cost in one of the cause that explain why
comparative cost differ.

Question 5
Explain the criticism on the mill’s theory of reciprocal
Demand?
The theoretical structure of J.S. Mill’s theory of reciprocal demand rests upon the foundation of
Ricardian principle of comparative costs.Consequently, the theoretical assumptions in Mill’s
theory are almost the same as in the Ricardian theory. That makes Mill’s theory of reciprocal
demand susceptible to similar weaknesses as are found in the Ricardian analysis.
In addition to structural deficiencies, Mill’s approach has been attacked by F.D. Graham and
Jacob Viner on the following main grounds
Neglect of Supply
According to Graham, the reciprocal demand theory concentrates too much on demand for
determining the international values and the supply aspect has been grossly neglected. Such an
approach can be accepted, if the theory of international trade is built in terms of fixed
quantities of product. In practice, trade involves such commodities the supply of which
undergoes significant variations. Therefore, the supply conditions are bound to have decisive
effect on the international exchange ratio.
Unnecessary
Graham dismissed the whole idea of reciprocal demand as unnecessary in the theory of
international values. If the production takes place under constant cost conditions, as assumed
both by Ricardo and Mill, the supply conditions alone are sufficient to settle the final
equilibrium rate of exchange.
Neglect of Domestic Demand
In this theory, the international exchange is supposed to be influenced by the demand in one
country for the product of the other or the reciprocal demand. The domestic demand in each
country for her exportable product can also exert an important influence because each country
is likely to export the product, which is left after satisfying the domestic demand. The
determination of exchange ratio, by overlooking the domestic demand, was clearly faulty.
Not Relevant in Multi-Country, Multi- Commodity Trade
The entire analysis in the Ricardian-Mill comparative costs theory is in terms of a two-country
and two-commodity model. In the real world multi-country, multi-commodity trade situation,
there is strong possibility that the international terms of trade are determined by the cost ratios
rather than the reciprocal demand.
Size of Trading Countries
The reciprocal demand theory can possibly influence the terms of trade between the two
trading countries, provided the two countries are of equal size and the values of their
respective products are also equal. However, if one of the two countries is large and the other
is small, the gain from trade goes largely to the smaller country rather than the larger country.
Since the produce of smaller country is not sufficient to meet the needs of the larger country
and at the same time, the former cannot absorb fully the produce of the latter, there will be
incomplete specialisation in the larger country but a complete specialisation in the smaller
country. The smaller country will have to take whatever is offered by the larger country and
export what is required by latter.
In the trade between the countries of unequal size, therefore reciprocal demand has little
relevance. A small country is usually a price-taker rather than a price- maker. Since the terms of
trade are likely to be close to the domestic exchange ratio of larger country, the major
beneficiary from trade would be the smaller country rather than the larger country.
Variations in Income
Mill’s theory of reciprocal demand maintains that income levels in two countries remain the
same. Such an assumption is unrealistic. In addition the variations in income may have effect
upon the terms of trade between the trading countries. This theory tends to overlook the
impact of income variations on the terms and pattern of trade.
Over-Simplification
The theory of reciprocal demand is an over-simplification of reality. In the determination of
international terms of trade, it fails to take into account such significant factors as wage-price
rigidities, price movements and balance of payments conditions.
There is no doubt that some of the arguments advanced by Graham do carry some weight. The
neglect of supply factor was certainly a serious lapse on the part of J.S.Mill but it is not realistic
to suppose that the reciprocal demand has absolutely no significance. In the words of Findlay,
“The fact that the terms of trade will usually be equal to the cost ratio of some intermediate or
‘marginal’ country does not mean that demand can be dispensed with, for it is precisely the
demand condition that determines which is the marginal country whose cost ratio is equal to
the terms of trade.”
In fact, much of Graham’s criticism of reciprocal demand theory was unwarranted and
misguided. In the conditions of increasing costs, when the countries are likely to have
incomplete specialization, both cost ratio and reciprocal demand must determine the terms of
trade. It is clearly fallacious to dismiss the reciprocal demand as an irrelevant factor in the trade
relations among the countries.

Question 6
On what basis Heckscher-Ohlin theory is criticized?
Explain.
Answer:
Criticism of Heckscher-Ohlin Theory
No doubt, the Heckscher-Ohlin theory has been found to be more exact, precise, scientific and
analytically superior to the earlier approaches to the theory of international trade, still it has
certain deficiencies for which it has been criticized by many a writer.
Partial Equilibrium Analysis
Haberler although recognized Ohlin’s theory as less abstract, yet it has failed to develop a
general equilibrium concept. It remains, by and large, a part of the partial equilibrium analysis.
This theory seeks to explain the pattern of trade only on the basis of factor proportions and
factor intensities, while ignoring several other influences such as transport costs, economies of
scale, external economies etc., which too exert influence on the cost of production.
In such a situation, Ellsworth states that “with several causes operating simultaneously upon
costs, it becomes a matter of adding up the influence of all cost-reducing and increasing forces
to arrive at a net result.”
Oversimplifying Assumptions
This theory is based upon highly over-simplifying assumptions of perfect competition, full
employment of resources, identical production function, constant returns to scale, absence of
transport costs and absence of product differentiation. Given this set of assumptions, the whole
model becomes quite unrealistic.
Static Analysis
The Heckscher-Ohlin model assumes fixed quantities of factors of production, given production
functions, incomes and costs. It means the theory investigates the pattern of international
trade in a static setting. The conclusions drawn from such an analysis are simply not relevant to
a dynamic economic system.
Identical Factors
This theory maintains that there are no qualitative differences in factors and that these factors
are capable of exact measurement so that factor endowment ratios can be calculated. In the
real world, however, qualitative factor differences exist. Moreover, there are more than one
variety of each factor. This creates serious complications in the measurement and comparison
of costs and the determinations of trade pattern.
Neglect of Product Differentiation
The theory overlooks the role played by product differentiation in international trade. Even
when the production agents are identical in two countries, the international trade may still take
place due to product differentiation. For instance, the Japanese machines are sold out in the
U.S.A. and the American machines are sold in Japan. In this context, Wijanholds opines that
factor prices do not determine cost. It is rather the commodity prices that determine factor
prices.
Prices of goods are determined by their utility to the buyers (the force of demand) and prices of
factors like raw materials, labour etc., are ultimately dependent on the demand and prices of
final goods because the demand for them is the derived demand. So Wijanholds states that
“prices are the only things we may accept as data. Everything else to be derived therefrom.” He
regards both Ricardian theory and Heckscher-Ohlin theory as faulty as they related cost to
factor prices and neglected the influence of product differentiation on international trade.
Factor Proportions and Specialization
The H-O theory suggests that the relative factor proportions or factor endowments determine
the specialization in exports of different countries. The capital-abundant countries export
capital-intensive goods and labor-abundant countries export the labor-intensive goods. It
implies that trade will not take place between such countries or regions as have similar relative
factor proportions. But this is not true.
A large part of world trade is between the U.S.A. and the countries of Western Europe despite
the fact that all of them have a relative greater capital- abundance and scarcity of labour. The
H-O theory cannot provide a complete and satisfactory explanation of trade in such cases. In
fact, the specialization is governed not only by factor proportions but also by several other
factors like cost and price differences, transport costs, economies of scale, external economies
etc. The H-O theory was clearly wrong in overlooking these factors.
Neglect of Factor Demand
The H-O theory assumes that the factor prices are determined by the relative factor
endowments of a country. It means the rate of interest should be relatively low and wage rates
relatively high in a capital-abundant but a labor-scarce country. On this basis, the United States
should have a lower structure of interest rate but it is in fact higher because even in that
capital-surplus country, the demand for capital too is very strong. In fact, the relative factor
prices are influenced not only by their supply but also by the demand for them. The H-O theory
failed to take into account the influence of demand for factors on their prices.
Factor Mobility
This theory assumes that there is absence of international mobility of factors. This assumption
is not valid. The writers like Williams and Levin have pointed out that the international mobility
of factors is actually even more than the inter-regional mobility within the same countries. This
is evident from international capital flows from advanced countries to such export sectors in
the LDC’s as petroleum, minerals, plantations etc.
Similarly the large-scale movement of labor from the Third World countries to the advanced
countries has assisted the latter in enlarging their production and export. It is, therefore, clear
that H-O theory takes an unrealistic assumption of international immobility of factors.
Neglect of Technological Change
The H-O model assumes identical production function. It implies that the technological
conditions in a given country remain unchanged. This assumption again is invalid. There has
been continuous improvement in techniques of production both in the advanced and the less
developed countries. The neglect of technological change in H-O theory makes this model quite
inconsistent with actual reality.
Factor-Intensity
This theory gives much prominence to the concept of factor intensity. It is assumed in this
model that one good is capital- intensive and the other is labor-intensive. The capital-intensive
good remains capital-intensive in both the counties and the labor-intensive good remains labor-
intensive in both the countries. It means there can be no reversal of factor-intensity i.e., the
same good is capital-intensive in one country while labor-intensive in the other. The empirical
evidence on this issue is conflicting. However, if there is reversal of factor-intensity, the whole
structure of H-O theory will collapse.
Neglect of By-Products
Sometimes byproducts are even more important than the main final product. The Heckscher-
Ohlin theorem, however, provides no explanation how the terms of trade are determined in the
case of by-products.
Possibility of Trade Even under Identical Proportions
The factor proportions theory implies that there can be no possibility of international trade
when factor proportions between two countries are identical. In fact the identical factor
proportions may not close the possibility of trade if consumer preferences are not identical due
to differences in income distribution in two countries. This can be explained through Figure

Given the identical factor proportions in two countries A and B, there is the same production
possibility curve PQ for both the countries. A1 and A2 are the community indifference curves of
A. B1 and B2 are the indifference curves of B. In the absence of international trade,
consumption points of the two countries are respectively R1 and S1. It shows that country A has
a stronger consumer preference for machines and country B has a greater preference for cloth.
As international trade takes place, TT1 is the international exchange ratio line. Now both the
countries get superior alternatives at R2 and S2 respectively. At R2, country A consumes R2M of
machines and OM of cloth. On the other hand, country B consumes S2N quantity of cloth and
ON quantity of machines at S2. The consumption in excess of production is met through mutual
imports. Thus even when the factor proportions are identical, the international trade may still
occur and that vitiates the Heckscher-Ohlin theory.
Vague Theory
No doubt H-O theorem attempted to explain the basis reason for comparative advantage of the
trading countries, yet the theory is vague and conditional. It depends upon several restrictive
and unrealistic assumptions. In the words of Haberler, with many factors of production, some
of which are qualitatively incommensurable as between different countries, and with dissimilar
production functions in different countries, no sweeping a priori generalizations concerning the
composition of trade are possible.
Undoubtedly, this theory is based upon some unrealistic assumptions, yet Lancaster regards it
as of central importance in the theory of international trade because of its objectively and
simplicity. According to him, model occupies the very center of international trade theory, for
reasons unconnected with its realism, and indeed strengthened by the very properties which
have been subject to so much criticism. He goes on further to comment, it is in fact, the simple
model of international trade just as two-commodity indifference curve is the simple model of
consumer’s behavior.

Question 7
Define and mathematically, explain the factor price
Equalization theorem?
Answer:
The fourth major theorem that arises out of the Heckscher-Ohlin (H-O) model is called the
factor-price equalization theorem. Simply stated, the theorem says that when the prices of the
output goods are equalized between countries as they move to free trade, then the prices of
the factors capital and labor will also be equalized between countries. This implies that free
trade will equalize the wages of workers and the rents earned on capital throughout the world.
The theorem derives from the assumptions of the model, the most critical of which is the
assumption that the two countries share the same production technology and that markets are
perfectly competitive.
In a perfectly competitive market, the return to a factor of production depends on the value of
its marginal productivity. The marginal productivity of a factor, like labor, in turn depends on
the amount of labor being used as well as the amount of capital. As the amount of labor rises in
an industry, labor’s marginal productivity falls. As the amount of capital rises, labor’s marginal
productivity rises. Finally, the value of productivity depends on the output price commanded by
the good in the market.
In autarky, the two countries face different prices for the output goods. The difference in prices
alone is sufficient to cause a deviation in wages and rents between countries because it affects
the marginal productivity. However, in addition, in a variable proportions model the difference
in wages and rents also affects the capital-labor ratios in each industry, which in turn affects the
marginal products. All of this means that for various reasons the wage and rental rates will
differ between countries in autarky.
Once free trade is allowed in outputs, output prices will become equal in the two countries.
Since the two countries share the same marginal productivity relationships, it follows that only
one set of wage and rental rates can satisfy these relationships for a given set of output prices.
Thus free trade will equalize goods’ prices and wage and rental rates.
Since the two countries face the same wage and rental rates, they will also produce each good
using the same capital-labor ratio. However, because the countries continue to have different
quantities of factor endowments, they will produce different quantities of the two goods.
This result contrasts with the Ricardian model. In that model, production technologies are
assumed to be different in the two countries. As a result, when countries move to free trade,
real wages remain different from each other; the country with higher productivities will have
higher real wages.
In the real world, it is difficult to know whether production technologies are different, similar,
or identical. Supporting identical production technology, one could argue that state-of-the-art
capital can be moved anywhere in the world. On the other hand, one might counter by saying
that just because the equipment is the same doesn’t mean the workforces will operate the
equipment similarly. There will likely always remain differences in organizational abilities,
workforce habits, and motivations.
One way to apply these model results to the real world might be to say that to the extent that
countries share identical production capabilities, there will be a tendency for factor prices to
converge as freer trade is realized.

 The factor-price equalization theorem says that when the product prices are equalized
between countries as they move to free trade in the H-O model, then the prices of the
factors capital and labor will also be equalized between countries.
 Factor-price equalization arises largely because of the assumption that the two
countries have the same technology in production.
  Factor-price equalization in the H-O model contrasts with the Ricardian model result in
which countries could have different factor prices after opening to free trade.

Question 8
Explain the Rybczynski theorem with the help of a
Graph?
Answer:
This theorem states that the increase in the supply of one of the factor of production, other
factors remaining the same, causes the output of the good using the accumulating factor
intensively to increase and the output of the other good to decrease in absolute amount,
provided that commodity and factor prices remain unchanged. Suppose in a labor- surplus
country, the supply of labor gets increased. It will lead to an increased output of the labor-
intensive commodity, say cloth, and reduced output of the capital- intensive commodity.
Output prices are held constraint. Accordingly, factor prices are fixed. This deals with growth of
a small open economy.
Input-output coefficients remain constant.
An increase in labor endowment increases the output of the labor-intensive industry and
decreases the output of the other industry (L and the L-intensive industry are friends.
Resource constraints
The relationship between input and output
aL1 y1 + aL2 y2 = L, (i.e., L1 + L2 = L)
aK1 y1 + aK2 y2 = K. (i.e., K1 + K2 = K.)
The aij's depend on w and r, not fixed as in Ricardian model.
The above equations show that the sum of the inputs used in the two industries must add up to
the nation's input supplies.
(L1,K1) + (L2,K2) = (L,K).
This relationship between inputs and outputs are shown below. An increase in the endowment
of labor increases the production of labor intensive good and decreases the production of the
other good capital intensive good. The cone of diversification can be used to illustrate
Rybczynski Theorem in the output space. An increase in the endowment of one factor results in
either an ultra-export or import biased growth.
Growth in a recession
During a recession, resources are not fully utilized. Proper economic policies may be adopted to
stimulate economic growth. US and Germany before WWII German unemployment rose to
about 30% at the height of the Great Depression 1932.
Similarly, when resources are not mobile within an economy, infrastructure investment may
increase mobility and stimulate economic growth China, Roman Empire, US after WWII
These changes cause a movement toward the PPF. PPF can also expand through labor or capital
growth.
Neutral growth
The supply of a factor grows over time. Capital and labor skills grow more rapidly in LDCs than
in the US. How does factor growth affect international trade and welfare of trading countries?
Production: Labor and capital growth may increase the output of both the exportable and the
importable by the same rate. This kind of growth is called neutral growth. For example, if K and
L grow by 5% (^K = ^L = 5%), then neutral growth occurs because both the outputs of the
exportable and the importable grow by the same rate.
Ultra-export biased growth
If the production of the exportable grows faster than that of the importable (^y1 > ^y2 > 0) it is
called export-biased growth. If the output of the exportable increases and that of the
importable decreases ^y1 > 0 > ^y2 the growth is ultra-export biased. Ultra-import biased
growth is similarly defined. The following figure shows neutral, import biased, export biased,
ultra-export biased and ultra-import biased growth.
War
Instead of shifting outward, sometimes the PPF contracts inwards. For instance, during World
War II, significant amounts of resources were diverted away from civilian consumption goods to
produce defense goods. North Korea is an example.
Consumption bias
The growth of a factor endowment does not necessarily increase the output of every good. The
growth of a factor does not necessarily increase exports. Figure below shows that export may
decline, if a consumption bias exists.
Small country
Factor growth in a small country always increases national income and welfare (because growth
does not affect prices)
Immiserizing Growth
If the terms of trade deteriorate sufficiently, growth can be immiserizing, lowering income and
welfare.
miserari = to pity in Latin.
immiserize = to become poorer, pitiful.
The trade takes place between two countries. The case of only one of the two countries will be
discussed here.

 The given country is labor-abundant and capital-scarce.

 This country produces two commodities cloth and steel.
 The production of these commodities requires two factors labor and capital.
 Capital and labor are perfectly mobile, perfectly divisible and substitutable in some
degree.
 Cloth is labor-intensive good and steel is a capital-intensive good.
 There are the conditions of perfect competition in the product and factor markets.
 The production functions related to both the commodities are homogenous of the first
degree. That implies constant returns to scale in production.
 The factor and commodity prices are constant.
 The supply of the factor labor expands while that of capital remains the same.
It is now clear that Rybczynki makes departure from H-O theorem and factor-price equalization
theorem in respect of his abandoning the assumption of fixed factor supplies. He discusses the
effect of an increased supply of the factor in which the country is abundant upon production,
factor and commodity prices and the terms of trade.