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Lecture 6

ECO230Y1 Lecture Notes - Lecture 6: Marginal Product, Shortage, Production Function

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Masoud Anjomshoa

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Resources, Comparative Advantage, and Income
Heckscher-Ohlin Model of Trade
Assumptions: 2x2x2 model
- Two countries, two goods, X and Y, and two production factors, capital – K,
and labour – L (X – labour intensive, Y – capital intensive)
- Technology is the same in two countries
- Production functions for both goods exhibit constant return to returns scale
- Each commodity uses a different factor intensity, which are not affected by
relative factor prices (no factor intensity reversal)  intensity remains the
- Tastes and preferences are identical in both countries.
- Perfect competition in both industries and both countries
- Country have different factor abundance levels
- Factors are perfectly mobile within countries but perfectly immobile across
the border  cannot go from home country to foreign country back and forth
- No transportation costs or tariffs or other barriers to trade
MRTS and Isoquants:
Isoquant: all possible combinations of capital and labour that could be used to
produce a particular quantity of output  Q = Q(K,L)
The Law of Diminishing Returns: Diminishing productivities of capital and labour
Slope of isoquant: marginal rate of technical substitution (MRTS) (slope of
isoquant), is decreasing
Production Optimization:
Isocost: All possible combinations of inputs, capital and labour, that cost the same
amount, say, C0
Slope of Isocost represents the Factor Price Ratio
Tangent  price optimization  optimal point
- Isocost and Isoquant have the same slope
Producer Optimization
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Resources, Comparative Advantage, and Income
Production Technology: Constant
Factor Endowments and Intensities:
Some countries have more capital and some countries have more labour
Suppose Home has relatively more Labour and foreign has relatively more capital
Home  low capital/labour ratio
Foreign  high capital/labour ratio
- X is “labour-intensive” in both nations
- Y is “capital intensive” in both nations
-At any w/r: (K/L) Y > (K/L) X
Factor Intensities:
w/r = f(k/L)
- Relative factor price ratio and relative factor ratio are positively related
- Production of Y is more capital intensive compared to production of X, in
both countries
-At any w/r: (K/L) Y > (K/L) X
- We assume NO factor intensity reversal
Production Possibility Frontier
Production Possibility Frontier: All combinations of X and Y that the economy can
produce, give fixed K and L.
- If production function is Constant Return To Scale, the PPF would be concave
Slope of PPF shows the Marginal Rate of Transformation (MRT 
negative slope) between two goods, X and Y
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