Econ 141 / F.B.

Natividad-Carlos AY 2009-10 (2) The H-O-S Model Name _____________________________

Instruction: Do 1.2.1, 1.2.2, 1.2.4, 1.2.6, 1.2.7, 2.1, and 2.2 below.

0. Notations. Define:

1. Review of Econ 102/Econ 106

[2 factors (K, L), 2 goods (= X,Y), …]

1.1 Consumer Theory

1.1.1 Budget Line. Given: Px .Cx + Py.Cy = V0 .

(1) It can be shown that the equation for the budget line is Cy = V0 / Py + (−(Px / Py )) Cx . Illustrate graphically.



v .int ercept slope

(2) |dCy / dC x |BL , equal to Px/Py, measures … .

(3) What happens to the budget line as Px increases (decreases), Py decreases (increases), and thus Px/Py increases (decreases)?
Illustrate graphically.

1.1.2 Utility function. Given: U = U(C x , Cy ) , which exhibits positive but diminishing marginal utilities :
MUCx ≡ ∂U / ∂C x > 0, ∂(∂U / ∂C x ) / ∂C x < 0, MUCy ≡ ∂U / ∂Cy > 0, ∂(∂U / ∂Cy ) / ∂Cy .
xy called MRS
 
(1) Use the concept of total differential to show that |dCy / dC x |IC = MUCx / MUCy .
 
∂U / ∂C x ∂U / ∂Cy
MRSxy



(2) |dC y / dC x |IC , equal to MUCx / MUCy , measures … .
 
∂U / ∂C x ∂U / ∂C y

1.1.3 Optimal consumption choice

xy MRS

(1) To obtain the condition for optimal (utility-maximizing) consumption choice, MUCx (C x , Cy ) / MUCy (C x , Cy ) = Px / Py :

 
  

∂U / ∂C x ∂U / ∂Cy |dCy / dCx|BL


|dCy / dCx|IC
MRSxy
  
(1a) Equate the slopes: |dCy / dC x |IC =|dC y / dC x |BL ⇒ MU Cx / MUCy = Px / Py .
 

∂U / ∂C x ∂U / ∂C y |dCy / dCx|BL

  
|dCy / dCx|IC
(1b) Maximize utility U(…) s.t. a given level of expenditure V0.
MRSxy
  
max U = U(C x , Cy ) s.t. Px .Cx + Py.Cy = V0 MU
⇒  Cx / MU Cy = Px

 /Py .

∂U / ∂C x ∂U / ∂C y |dCy / dCx|BL

  
|dCy / dCx|IC

(1c) Minimize expenditure V(…) s.t. a given level of utility U0.

xy MRS
  
min V = Px.Cx + Py.Cy s.t. U(Cx , Cy ) = U0 ⇒ MU
 Cx / MU Cy = Px

 /Py .

∂U / ∂C x ∂U / ∂C y |dCy / dCx|BL

  
|dCy / dCx|IC
(2) What does the condition MRSxy = Px/Py mean? What if MRSxy > (<) Px/Py? Illustrate graphically.
Econ 141 / F.B. Natividad-Carlos AY 2009-10 (2) The H-O-S Model Name _____________________________

1.2 Production Theory

1.2.1 Isocost Line. Given: C 0 j = wL j + rK j .

(1) It can be shown that that the equation for the isocost line is K j = V0 / r + (−(w / r )) Lj . Illustrate graphically.




v .int ercept slope

(2) |dK j / dLj |Iso costLine , equal to w/r, measures … .

(3) What happens to the isocost line as w increases (decreases), r decreases (increases), and thus w/r increases (decreases)?
Illustrate graphically.

α 1−α j
1.2.2 Given: production function Q j = A j K j j Lj which exhibits positive but diminishing marginal products:
MPLj (K j , Lj ) ≡ ∂Qj / ∂Lj > 0, ∂(∂Qj / ∂Lj ) / ∂Lj < 0, MPKj (K j , Lj ) ≡ ∂Qj / ∂K j > 0, ∂(∂Qj / ∂K j ) / ∂K j < 0

(0) Show that the MPLj is a positive function of Kj/Lj. MPLj (K j , Lj ) ≡ ∂Qj / ∂Lj = __________________________
Show that the MPKj is a negative function of Kj/Lj. MPLj (K j , Lj ) ≡ ∂Qj / ∂Lj = __________________________
LK , j called MRTS
 
(1) Use the concept of total differential to show that |dK j / dL |
j isoquant = MPL j (K ,
j jL ) / MPK j (K j Lj ) .
,

 

∂Qj / ∂Lj ∂Qj / ∂K j
MRTSLK , j

(2) |dK j / dLj |Isoquant , equal to MPL j (K j , Lj ) / MPK j (K j , Lj ) , measures … .



∂Q j / ∂Lj ∂Q j / ∂K j

1.2.3 Optimal input choice

LK , j MRTS
 
(1) To obtain the condition for optimal (cost-minimizing) input choice, MPL j (K j j, L ) / MPK j (K j Lj ) =
, w
 /r :

 
 |dK j /dLj|Iso cos t line
∂Qj / ∂Lj ∂Qj / ∂K j

  
|dK j / dLj|Isoquant

LK , j MRTS
 
(1a) Equate the slopes: |dK j / dLj |isoquant =|dK j / dLj |Iso cost Line ⇒ MPLj (K j , Lj ) / MPK j (K j , Lj ) = w/r .


 |dK / dLj|Iso cos t line
∂Qj / ∂Lj ∂Qj / ∂K j j

  
|dK j / dLj|Isoquant

(1b) Minimize cost Cj (…) s.t. given level of output Q0j.

LK , j MRTS
 
α 1−α
min C j = wL j + rK j s.t. Aj K j Lj = Q0 j ⇒ MPLj (K j , Lj ) / MPK j (K j , Lj ) = w /r


 |dK / dLj|Iso cos t line
∂Qj / ∂Lj ∂Qj / ∂K j j

  
|dK j / dLj|Isoquant

(1c) Maximize Q s.t. a given level of Cost.

LK , j MRTS
 
α j 1−α j
max Q j = A j K j Lj s.t. wL j + rK j = C 0 j ⇒ MPLj (K j , Lj ) / MPK j (K j , Lj ) = w/r


 |dK /
∂Qj / ∂Lj ∂Qj / ∂K j j dLj|Iso cos t line

  
|dK j / dLj|Isoquant

(2) What does the condition MRTS LK,j = w/r mean? What if MRTS LK,j > (<) w/r? Illustrate graphically.
Econ 141 / F.B. Natividad-Carlos AY 2009-10 (2) The H-O-S Model Name _____________________________

1.2.4 Relationship between optimal K j / Lj and w / r .

(1) Substitute the MPL j (K j , Lj ) function and the MPK j (K j , L j ) function into the MRTSLK , j = w / r condition to show that the
optimal K j / Lj is positively related to w / r .
(2) Thus, K j / Lj increases (decreases) as (w / r ) increases (decreases). Assuming that X is relatively L-intensive and Y is relatively K-
intensive, use the equation showing the relationship between optimal K j / Lj and w / r to draw the XX and the YY curve on a
Kj/Lj –w/r graph.

1.2.5 Factor demand functions and overall factor demands

(1) Factor demands. The two equations – the condition for optimal input choice MRTSLK , j = w / r and the constraint
C 0 j = (wLj + rK j ) – yields the two unknowns : the factor demand for capital Kj (…) and the factor demand for labor Lj (…).

(i) Factor demand for capital. Use the equation for the expansion path to substitute for Lj in the FOC wrt λ j ( C 0 j = (wL j + rK j ) ) to
show that the factor demand for capital is given by
1−α j
K j = [(α j / (1 − α j ))(w / r )] (Q0 j / Aj )

(ii) Factor demand for labor. To get the factor demand for labor, substitute the factor demand for capital into the expansion path
(or, alternatively, use the equation for the expansion path to substitute for Kj in the FOC wrt λ j ):
−α j
Lj = [(α j / (1 − α j ))(w / r )] (Q0 j / Aj )

(iii) Note that the ratio of the Kj function to the Lj function is the same as the equation for the expansion path, the equation showing
the relationship between the optimal Kj/Lj and w/r.

(2) Overall factor demands

(i) Overall capital demand

1−α
Kd = [(α x / (1 − α x ))(w / r )]1−αx (Q0 x / Ax )] + [(αy / (1 − αy ))(w / r )] y (Q0 y / Ay )]


 
Kx Ky

(ii) Overall labor demand

−α
Ld = [(α x / (1 − α x ))(w / r )]−αx (Q0 x / Ax )] + [(αy / (1 − αy ))(w / r )] y (Q0 y / Ay )]

 
 
Lx Ly

1.2.6 Cost function

(1) Total cost function. Substituting the Kj function for Kj and the Lj function for Lj into the cost equation Cj = wLj + rKj yields the
total cost function Cj:

(2) Unit cost

Cj ∂C j
AC j ≡ = ____________________ MC j ≡ = __________________
Qj ∂Q j
1−α j −α j
 α   αj   
where c0 j = 
j
 +   1  , a constant. Notice that for the CRTS Cobb-Douglas production function, …

 1 − α j  1−αj   A j
     
(3) Ratio of unit costs. Let the unit cost function ( ≡ AC j (w , r ) = MC j (w , r ) ) be denoted by c j (w , r ) . Show that

c x  c0 x   w αy −α x
=   
cy  c0 y  r 
where, assuming that …, α y − α x > 0.
Econ 141 / F.B. Natividad-Carlos AY 2009-10 (2) The H-O-S Model Name _____________________________

1.2.7 Relationship between Px/Py and w/r

Using the Pj = cj condition and the unit cost cj function, the equation showing one-to-one correspondence between Px/Py and w/r is
α −α
Px  c0 x   w  y x
given by: =   which is the equation for the SS curve on a w/r – Px/Py graph, where c0x/c0y > 0 and α y − α x > 0. If
Py  c0 y   r 
Px/Py increases (decreases) as w/r increases (decreases).

1.3 General Equilibrium

1.3.0 Note: It is assumed that the results for the relevant representative consumer (1.1) also apply to the economy as a whole and
that the results for the representative firm producing good j (1.2) also apply to the industry producing good j. Now, Qj
denotes industry j’s output, Kj denotes industry j’s labor demand, Lj denotes industry j’s capital demand, Kx + Ky denotes the
overall demand for K; Lx + Ly denotes the overall demand for L; … .

1.3.1 The Edgeworth production box, the production efficiency locus, and the PPF

…. See lecture notes/a good Microeconomics textbook/… .

… Also, factor-ratio paradox:

1.3.2 The PPF

(1) The PPF is downward-sloping because …

(2) The PPF is bowed-out because …
(3) A point on (inside) the PPF means that … (…).
called MRT
xy
  
(4) |dQy / dQx |PPF , equal to MC x (w , r ) / MC j (w j , rj ) , measures … .

 

∂C x / ∂Qx ∂C y / ∂Qy

(5) Assuming that Y is K-intensive and X is L-intensive, how will the Edgeworth production box, the efficiency locus, and the PPF
shift/change when:
(i) L increases?
(ii) K increases?
(iii) L decreases and K increases? The PPF will shift out if …

1.3.3 Isovalue line Px .Qx + Py.Qy = V0 .

(1) It can be shown that that the equation for the isovalue line is Qy = V0 / Py + (−(Px / Py )) Qx , where V0 is value of



v .int ercept slope

output or real income or real GNP.

(2) |dQy / dQx |Isovalueline , equal to Px/Py, measures … .

(3) What happens to the isovalue line as Px increases (decreases), Py decreases (increases), and thus Px/Py increases (decreases)?
Illustrate graphically.
(4) If Px remains the same, Py remains the same, and thus Px/Py remains the same, how can V (the value of
output or real income or real GNP) increase? How will the isovalue line shift?. Illustrate graphically.

1.3.4 Value of output maximization

xy MRT
 
(1) Equate the slopes: |dQ / dQ | =|dQ / dQ MC
x IsovalueLine ⇒

| x ( w , r ) / MC ( w , r ) = Px / Py .
y x PPF y  
y 

∂C x / ∂Qx ∂C y / ∂Qy |dQy /dQx|Isovalueline

 
|dQy /dQx|PPF

(2) What does the condition MRTxy = Px/Py mean? What if MRTxy > (<) Px/Py? Illustrate graphically.
Econ 141 / F.B. Natividad-Carlos AY 2009-10 (2) The H-O-S Model Name _____________________________

1.3.5 Efficiency Conditions

(1) Efficiency in exchange: MRSxy indiv 1= MRSxy indiv 2. Utility maximization under perfect competition achieves efficiency in
exchange (MRSxy indiv 1 = MRSxy indiv 2) because each consumer chooses Cx and Cy such that his/her MRSxy = Px/Py and under
perfect competition consumers face the same goods prices, Px and Py, and thus MRSxy indiv 1 = Px/Py = MRSxy indiv 2 .

(2) Condition for efficient allocation of inputs (or efficiency in input use): MRTSLK, x = MRTSLK, y. Profit maximization under perfect
competition achieves efficiency in input use (MRTSLK, x = MRTSLK, y) because each firm chooses K and L such that MRTSLK, j = w/r and
under perfect competition firms face the same input prices, w and r, and thus, MRTSLK, x = w/r = MRTSLK, y.

(3) Condition for efficient output mix: MRTxy = MRSxy. Profit maximization under perfect competition (Pj = MCj and thus Px/Py =
MCx/MCy or MRTxy) and utility maximization (MRSxy = Px/Py) imply MRSxy = Px/Py = MRTxy and thus MRSxy = MRTxy.

2. The H-O-S Model:

2 factors (= K, L), 2 goods (= X, Y), 2 countries (Home (or A, or I) and Foreign (or B, or II).
Note: H-O-S is a LR model where Kj and Lj can be varied.

2.0 Assumptions:

(1) 2 factors (K, L), 2 goods (X, Y), 2 countries (Home (or A, or I), Foreign (or B, or II).
(2) The two countries have identical CRTS production function (identical production technology) for good X and
identical CRTS production function (identical production technology) for good Y.
(3) Good X (Y) is relatively L (K) – intensive everywhere: (K x / Lx ) < (K y / Ly ) in H; (K x / Lx ) < (K y / Ly ) in F.
H H F F

(4) Country H (F) is relatively L (K) – abundant: physical definition, (K / L ) < (K / L ) ; or price definition, (w / r ) < (w / r ) .
H H F F H H F F

(4) Full employment conditions: K H = K xH + K yH and LH = LHx + LHy in H; K F = K xF + K yF and LF = LFx + LFy in F.
(6) Zero profit condition
(7) In each country: fixed K supply and fixed L supply (except in the Rybczynski theorem)
(8) Free factor mobility between industries within a country (which together with perfect competition implies wx =wy = w and
rx = ry = r in each country); factor immobility across countries
(9) U max, profit max/cost min
(10) Perfect competition
(11) free trade
(12) balanced trade
(13) The two countries have identical tastes (identical indifference map).

2.1 From Autarky to Free Trade, Story ???

2.1.0 Diagrams
(1) PPFs, ICs, price lines
(2) Edgeworth production boxes
(3) SS on a Px/Py – w/r graph, XX and YY on a Kj/Lj – w/r graph
2.1.1 The Heckscher-Ohlin (H-O) theorem
2.1.2 The Stolper-Samuelson theorem. … and recall the magnification effect.
2.1.3 The factor price equalization (FPE) theorem.
2.2 Growth and Trade
2.2.1 Changes in Factor Endowments: The Rybczynski Theorem.
(0) Assumptions, PPFs and isovalue lines, Edgeworth production boxes, magnification Effect
(1) Effects on … of
(i) increase in L?
(ii) increase in K?
(iii) balanced increases in K and L?
(iv) increase in K and decrease in L?
2.2.2 Technological Progress
(0) Assumptions, PPFs and isovalue lines,
(1) Effects on … of