Topic 3

Two-Good Two-Factor Model (Two-by-two model)

There are two factor inputs- labor and capital and only two goods can be
produced with the production functions:
y i=f i ( Li , K i ) wherei=1,2
The resource constraints are:
L1 + L2 L
K1+ K2 K
For this two-by-two model there are two sets of equilibrium conditions. They
are:
I.

Profit equals zero.

p1=c 1 (w ,r )
p2=c 2 (w ,r )

II.

Full employment of both resources.

a1 L y 1+ a2 L y 2=L
or, L1+L2=L
a1 K y 1+ a2 K y 2=K

or, K1+K2=K

Factor Intensity Reversal

In this model we assume the cost functions c i (w, r) are non-decreasing and
concave in (w, r) as follows:
c i ( w , r )=w aiL +r aiK
pi=c i ( w , r )

According to the zero profit condition:

pi=w aiL +r aiK

Totally differentiating the above equation and holding prices fixed, we have:
1

0=aiL dw+ aiK dr (because d pi=0)

dr aiL Li
=
=
dw aiK
Ki
This is the slope of the iso-cost curve.

dr/dw= -a1L/ a1K= -L1/K1

dr/dw= -a2L/ a2K= -L2/K2

p2= c2(w, r)
p 1= c1(w, r)

Industry 1 is Labor Intensive.

Industry 2 is Capital Intensive.
In the above figure, the isocost lines only intersect once at point A. The slope
of a point on the isocost curve of industry 1 is greater than the slope of a
point on the isocost curve of industry 2. There is no factor intensity reversal.
In other words,

L1 L2
>
K 1 K 2 always.

The case where isocost lines intersect more than once corresponds to 'Factor
Intensity Reversals'.
r

B
p1= c1(w, r)
p2= c2(w, r)
0

w
wA

wB

In the above figure, industry 1 is labor-intensive at point A but capitalintensive at point B. This is an example of 'Factor Intensity Reversal'.
While FIRs might seem like a theoretical curiosum, they are actually quite
realistic.
E.g. while much of the footwear is produced in developing nations, the US
retains a small number of plants. Some of these plants operate computerized
equipment with up to 20 sewing machine heads running at once. Whereas,
plants in Asia use century-old, labor intensive techniques.
The technology used to make sneakers in Asia is like industry 1 at point A,
using labor-intensive technology and paying low wage w A, while industry 1 in
US is at point B, paying higher wage w B and using capital-intensive
technology.