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The author wishes to acknowledge helpful comments received from John Karlik, Mohsin Khan, Jonathan Ostry, and Assaf Razin on an earlier version of the paper. The author, however, bears sole responsibility for any errors or omissions.
The factor content of trade refers to the embodiment of the services of different primary factors of production in goods traded between countries. Thus, for instance, the factor content of a country’s exports might be predominantly comprised of labor services, in which case the country would typically exchange these services for those of other factors—in relatively limited supply in the country—embodied in its imports.
The analysis is developed without extensive mathematics, relying instead upon diagramatic demonstration of basic concepts and, as necessary, appeal to the fundamental theorems of international trade theory. In addition to the seminal contributions of Heckscher, Ohlin and Samuelson discussed in standard economic textbooks on international trade, see Dixit and Norman (1980), Helpman and Krugman (1985), and Ethier (1984).
Regarding the relevance of this “3x2” model versus other “even” and “uneven” HOS-based models, see Ethier (1984). Closely related variants of the model employed here should be expected to yield similar analytical results. Among these variants, a particularly important one is the so-called specific factor model developed by Jones (1971) and applied extensively by Krueger (1977) and others. The specific factor model is sometimes viewed as providing a more apt description of the economic circumstances of commodity-exporting countries because, in specifying a wide range of factors by country, it is viewed as providing analytical assurance that countries can produce an equally wide variety of goods. As discussed in Dixit and Norman (1980) and Ethier (1984), however, concern for the ability of countries to produce a wide range of goods using a limited number of primary factors is often founded on some confusion between the partial versus general equilibrium determination of efficient possibilities for producing different goods in uneven HOS-based models. In the 3x2 version of the HOS model specified here, the integrated world equilibrium does not preclude efficient production of any good by any trading country, including relatively resource-abundant countries.
In addition, it is assumed that the two primary factors of production are inelastic in supply, production occurs under conditions of (quasi-concave) constant returns to scale, preferences are well-behaved and homothetic, and perfect competition prevails.
The boundary is determined by application of the so-called theorem of corresponding points to separate Edgeworth box diagrams for the two countries, given their actual endowments and the existence of similar preferences in both countries. See, Lancaster (1957), Travis (1964) and Melvin (1968).
Note that the upper boundary of the shaded area is the reflection of the lower boundary, thus enabling the measurement of factor requirements and intensities to produce each good from either country origin, OA or OB.
This assumption is given an explicit algebraic representation further below in the text. In Figure 1, the assumption is represented by the fact that the slope of a line segment drawn from OA to Q is less than the slope of either OAH’ or GH, and greater than the slope of OAG. Notably, this assumption also implies that the location of the endowment distribution point Q is not so “skewed” as to lie outside of the FPE set.
Along the efficient diversification frontier, fiscal incentives may be viewed as “momentary” measures, financed by nondiscriminatory lump-sum taxes on all firms. These taxes are used to promote different patterns of final goods production in the economy. As discussed further below, however, “neutral” fiscal measures to promote output of particular goods beyond the efficient diversification frontier are less benign. In particular, because they must be maintained indefinitely, these measures will cause relative factor rewards (and prices) in the home country to differ from those in the integrated world economy, and thereby will cause the welfare of the home country to fall.
Analogous results are obtained if output is initially expanded in sector 2 rather than sector 3. Thus, along the efficient diversification frontier, expansion of production of either of the two more capital-intensive goods will require an accompanying expansion of good 1, the most resource-intensive good.
This result contrasts sharply with that resulting from the familiar alternative development strategy of seeking through time to expand the relative stock of both physical and human capital, either through domestic saving or net foreign borrowing and investment. For a given ratio of factor rewards (and a given level of output of one of the three goods), an expansion of the stock of capital in country A will result in a greater than proportional expansion of output of the more capital-intensive good (good 2 or good 3) and a decline in output of the more resource-intensive good (good 1 or good 2). This “magnification” effect, first derived by Rybczynski (1955), occurs because expansion of the relatively scarce factor, capital, enables the country to diversify its output with reference to the requisite change in its net factor content of trade. More specifically, the requisite factor content of the country’s trade changes with the evolution of the country’s effective ratio of factor endowments, and hence it becomes efficient for the country to expand its output of the more capital-intensive good.
In the absense of international capital flows, a country can export at most only two goods in the simple 3-good HOS model considered here.
At the same time, production of good 3 would not be expanded to OAY, because at OAY the country’s entire stock of capital would be devoted to producing good 3. Also at OAY, an excess supply of natural resources would emerge at the equilibrium ratio of factor rewards, rR/rK.
Broadly speaking, the distance C’C measures the efficiency loss in aggregate output owing to the “nondistortionary” fiscal measures used to implement the export diversification policy.
Throughout this paper, a maintained assumption is that, from a global perpective, greater uncertainty surrounds the production of primary commodities than other traded goods.
The discussion that follows is based on the extension of the Stopler-Samuelson theorem to the case of uncertainty presented by Dumas (1980). Notably, Dumas uses a 2-good, rather than 3-good, model of international trade. However, his results are applicable, without modification, to 2-factor models of higher orders of (goods) dimensionality. On this point, see Ethier (1984).
See, for instance, International Monetary Fund (1991). These developments support the contention of Satterthwaite (1981), as discussed in Pomery (1984), that where unexploited gains from trade in risks exist, missing financial markets will be created by market-making arbitrage. In a related vein, it should be noted that some theoretical studies, e.g., Newbery and Stiglitz (1981) and Eaton and Grossman (1985), find that incomplete financial markets can result in equilibria in which unrestricted trade in goods reduces economic welfare. While these studies have spawned arguments in favor of limiting the integration of world goods markets, namely, as a form of social insurance, they do not consider the longer-run implications for international trade and economic welfare of expanding domestic and international financial markets in response to the market-making incentives referred to by Satterthwaite.