International Trade Theory and Policy
by Steven M. Suranovic

Trade 60-9

Depicting a Free Trade Equilibrium in the H-O Model

In the adjoining diagram we depict a free trade equilibrium in a Heckscher-Ohlin model. The US is assumed to be capital-abundant which skews its PPFUS(in green) in the direction of steel production, the capital-intensive good. France is labor-abundant which skews its PPFFR (in red) in the direction of clothing production, the labor-intensive good. In free trade each country faces the same price ratio.

The US produces at point P. The tangent line at P represents the national income line for the US economy. The equation for the income line is PCQC + PSQS = NI where NI is national income in dollar terms. The slope of the income line is the free trade price ratio (PC/PS)FT. Consumption in the US occurs where the aggregate indifference curve IFT, representing preferences, is tangent to the national income line at C. To reach the consumption point the US exports EXS and imports IMC.

France produces at point P*. The tangent line at P* represents the national income line for the French economy. The slope of the income line is also the free trade price ratio (PC/PS)FT. Consumption in France occurs where the aggregate indifference curve IFT*, representing preferences, is tangent to the national income line at C*. Note that since the US and France are assumed to have the same aggregate homothetic preferences and since they face the same price ratio in free trade, consumption for both countries must lie along the same ray from the origin, 0C. For France to reach its consumption point it exports EXC* and imports IMS*. In order for this to be a free trade equilibrium in a two-country model US exports of steel must equal French imports of steel (EXS = IMS*) and French exports of clothing must equal US imports of clothing (EXC* = IMC). In other words the US trade triangle formed by EXS, IMC, and the US national income line must be equivalent to France's trade triangle formed by EXC*, IMS*, and the French national income line.

International Trade Theory and Policy - Chapter 60-9: Last Updated on 7/31/06

PREVIOUSNEXT