INTERNATIONAL TRADE
Chapter 4: Resources and Trade:
The Heckscher Ohlin Model
Preview
1. A model of two-factor economy
• Two Factor Heckscher-Ohlin model
• Production possibilities
• Relationship between goods prices, factor prices,
factor levels and output levels.
• Trade in the Heckscher-Ohlin model
2. The effects of trade between two-factor economies
• Relative price and pattern of trade
• Gain from trade
• Income distribution and income inequality
3. Empirical evidence
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A MODEL OF TWO-FACTOR ECONOMY
Two Factor Heckscher-Ohlin Model
1. Only two countries are modeled: domestic and foreign
2. Labor (L) and Capital (K) are resources important for
production.
3. The amount of labor and capital varies across countries, and
this variation influences productivity.
4. The supply of labor and capital in each country is constant.
5. Only two goods are important for production and
consumption: cloth and food.
6. Competition allows factors of production to be paid a
“competitive” wage, a function of their productivities and the
price of the good that it produces, and allows factors to be used
in the industry that pays the highest wage/rate.
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Production Possibilities
• When there is more than one factor of production,
the PPF (opportunity cost in production) is no
longer a straight line
• PPF slope = opportunity cost of cloth in terms
of food
• The opportunity cost of producing cloth in terms of
food is not constant in this model
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Production Possibilities
Production Possibilities
• Let’s expand the previous chapter’s model to include
two factors of production, labor and capital
¨ aKC = unit of capital used for a unit of cloth
¨ aLC = unit of labor used for a unit of cloth
¨ aKF = unit of capital used for a unit of food
¨ aLF = a unit of of labor used for a unit of food
¨ L = total amount of labor available for production
¨ K = total amount of land (terrain) available for
production
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Production Possibilities
• Production possibilities are influenced by both
capital and labor (requirements):
a KFQ F + aKC QC ≤ K
aLFQF + aLCQC ≤ L
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Production Possibilities
• Let’s assume that cloth production is labor intensive
and food production is capital intensive if:
o Total resources used in each industry:
LC /KC > LF /KF.
o Each unit of cloth production uses labor intensively
and each unit of food production uses capital
intensively:
¨ aLC /aKC > aLF/aKF
¨ aLC /aLF > aKC /aKF
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Production and Prices
• The PPF describes what an economy can produce,
but to determine what the economy does produce,
we must determine the prices of goods.
• In general, the economy should produce at the point
that maximizes the value of production (V):
V = PC QC + PF QF
¨ where PC is the price of cloth and PF is the price of food.
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Production and Prices
• Given prices of output, one isovalue line represents
a constant value of production.
¨ V = PC QC + PF QF
¨ PF QF = V – PC QC
¨ QF = V/PF – (PC /PF) QC
¨ The slope of an isovalue line is – (PC /PF)
=> At that point, the opportunity cost of cloth in
terms of food equals the relative price of cloth
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Production and Prices
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Factor Prices, Goods Prices and Factor Levels
• Producers may choose different amounts of factors of
production used to make cloth or food.
• Their choice depends on the wage rate, w, and the
rental rate r of using capital.
• As the wage rate increases relative to the rental rate,
producers are willing to use more capital and less labor in
the production of food and cloth.
¨ Recall that food production is capital intensive and cloth
production is labor intensive.
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Factor Prices, Goods Prices and Factor Levels
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Factor Prices, Goods Prices and Factor
Levels
• Under competition, the price of a good equals the cost
of production, and the cost of production depends
on the wage rate and the rental rate.
• The effect of the rental rate of capital on the price
of cloth depends on the intensity of capital
usage in cloth production.
¨ An increase in the rental rate of capital will affect the price
of food more than the price of cloth.
• Under competition, changes in w/r are therefore
directly related to changes in PC /PW .
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Factor Prices, Goods Prices and Factor Levels
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Factor levels (resources) and Output
Levels
• The allocation of factors used in production
determine the level of output at the
economy’s PPF.
• How do output levels change when the
economy’s resources change?
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Factor Levels and Output Levels
• A economy with a high ratio of capital to labor
is predicted to have a high output of food
relative to cloth and a low price of food relative
to cloth.
¨ It will be relatively efficient at (have a comparative
advantage in) producing food.
¨ It will be relatively inefficient at producing cloth.
• An economy will be relatively efficient at producing
goods that are intensive in the factors of production in
which the country is relatively well endowed.
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Two Factor Heckscher-Ohlin Model
1. Only two countries are modeled: domestic and foreign
2. Labor (L) and capital (K) are resources important for
production.
3. The amount of labor and capital varies across countries,
and this variation influences productivity.
4. The supply of labor and capital in each country is
constant.
5. Only two goods are important for production and
consumption: cloth and food.
6. Competition allows factors of production to be paid a
“competitive” wage, a function of their productivities and
the price of the good that it produces, and allows factors
to be used in the industry that pays the highest
wage/rate. 4-19
Trade in the Heckscher-Ohlin Model
• Suppose that the domestic country has an
abundant amount of labor relative to the amount of
capital.
¨ The domestic country is abundant in labor and the
foreign country is abundant in capital: L/K> L*/ K*
¨ Likewise, the domestic country is scarce in capital
and the foreign country is scarce in labor.
¨ However, the countries are assumed to have the
same technology and same consumer tastes.
• Because the domestic country is abundant in
labor, it will be relatively efficient at producing cloth
because cloth is labor intensive.
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Trade in the Heckscher-Ohlin Model
• Note: “Abundance” is always defined in
relative terms, by comparing the ratio of
labor to capital in the two countries
Ø Thus, no country is abundant in everything.
Trade in the Heckscher-Ohlin Model
• The Heckscher-Ohlin theory: An economy will export
goods that are intensive in its abundant factors of
production and import goods that are intensive in its
scarce factors of production.
• Abundant factors: Resources of which a country has
a relatively large supply (labor in Home, capital in
Foreign)
• Scarce factors: Resources of which it has a relatively
small supply (capital in Home, labor in Foreign)
Trade in the Heckscher-Ohlin Model
• An economy will be relatively efficient at producing goods
that are intensive in its abundant factors of production.
Ø That is, this country has a comparative advantage in
producing these goods
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EFFECTS OF INTERNATIONAL TRADE
IN TWO-FACTOR ECONOMY
Relative price and Pattern of trade
• Since cloth is a labor intensive good, the
domestic country’s PPF will allow a higher ratio
of cloth to food relative to the foreign county’s
PPF.
• At each relative price, the domestic country
will produce a higher ratio of cloth to food than
the foreign country.
Ø The domestic country will have a higher
relative supply of cloth than the foreign
country.
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Relative price and Pattern of trade
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Relative price and Pattern of trade
• The relative supply schedules of Home (RS) and
Foreign (RS*).
• The relative demand curve, which we have assumed
to be the same for both countries, is shown as RD.
• If there were no trade, the equilibrium for Home
would be at point 1, while the equilibrium for Foreign
would be at point 3.
q That is, relative price of cloth would be lower in
Home than in Foreign without trade.
Relative price and Pattern of trade
• The Heckscher-Ohlin model predicts a convergence
of relative prices with trade.
• The relative price of cloth will rise in the domestic
country and fall in the foreign country.
¨ In the domestic country, the rise in the relative price of
cloth leads to a rise in the relative production of cloth
and a fall in relative consumption of cloth; the
domestic country becomes an exporter of cloth
and an importer of food.
¨ The decline in the relative price of cloth in the foreign
country leads it to become an importer of cloth and
an exporter of food.
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Gain from trade
• Over time, the value of goods consumed is
constrained to equal the value of goods produced for
each country.
PCDC + PFDF = PCQC + PFQF
where DC represents domestic consumption demand forcloth
and DF represents domestic consumption demand forfood
(DF – QF) = (PC /PF)(QC – DC)
Quantity Price of exports Quantity
of imports relative to imports of exports
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Gain from trade
(DF – QF) = (PC /PF)(QC –DC)
• This equation is the budget constraint for an
economy, and it has a slope of – (PC /PF)
(DF – QF) – (PC /PF)(QC – DC) = 0
• Note: The budget constraint shows the
various combinations of the two goods that
the consumer can afford.
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Gain from trade
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Gain from trade
• Note that the budget constraint touches the
PPF: a country can always afford to consume
what it produces.
• However, a country need not consume
only the goods and services that it produces
with trade.
¨ Exports and imports can be greater than zero.
• Furthermore, a country can afford to consume
more of both goods with trade.
=> This is gain from trade
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Trade and the distribution of income
• Because an economy can afford to consume more
with trade, the country as a whole is made better off.
• But some do not gain from trade, unless the model
accounts for a redistribution of income.
• Trade changes relative prices of goods, which have
effects on the relative earnings of labor and capital.
¨ A rise in the price of cloth raises the purchasing power of
domestic laborers, but lowers the purchasing power of
domestic capital owners.
• The model predicts that with trade owners of
abundant factors gain, but owners of scarce
factors lose.
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Trade and the distribution of income
• Unlike the Ricardian model, the Heckscher-Ohlin
model predicts that factor prices will be equalized
among countries that trade.
• Because relative prices are equalized and because of
the direct relationship between relative prices and
factor prices, factor prices are also equalized.
• Trade increases the demand for goods produced by
abundant factors, indirectly increasing the demand
for the abundant factors themselves, raising the
factor prices of the abundant factors across
countries.
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Trade and the distribution of income
• But factor prices are not really equal across countries.
• The model predicts that trading countries produce the
same goods, so that prices for those goods can
equalize
o But countries may produce different goods.
• The model assumes that trading countries have the
same technology
o But different technologies could affect the
productivities of factors and therefore the
wages/rates paid to these factors.
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Trade and the distribution of income
• Trade barriers and transportation costs may
prevent goods prices and factor prices from
equalizing.
• After an economy liberalizes trade, factors of
production may not quickly move to the industries that
intensively use abundant factors.
• In the short run, the productivity of factors will be
determined by their use in their current industry, so that
their wage/rate may vary across countries.
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Case study: Does Trade Increase Income
Inequality?
• Over the last 40 years, countries like South
Korea, Mexico and China have exported to
the US goods intensive in unskilled labor
(e.g., clothing, shoes, toys, assembled
goods).
• At the same time, income inequality has
increased in the US, as wages of unskilled
workers have grown slowly compared to those
of skilled workers.
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Case study: Does Trade Increase
Income Inequality?
• The Heckscher-Ohlin model predicts that owners
of abundant factors will gain from trade and
owners of scarce factors will lose from trade.
• But little evidence supporting this prediction exists.
1. According to the model, a change in income
distribution occurs through changes in goods prices,
but there is no evidence of a change in the prices of
skill-intensive goods relative to prices of
unskilled- intensive goods.
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Case study: Does Trade Increase
Income Inequality?
2. According to the model, wages of unskilled workers
should increase in unskilled labor abundant
countries relative to wages of skilled labor, but in
some cases the reverse has occurred:
¨ Wages of skilled labor have increased more rapidly in
Mexico than wages of unskilled labor.
3. Even if the model were exactly correct, trade is a
small fraction of the US economy, so its effects on
US prices and wages prices should be small.
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Trade and Income Distribution
• Changes in income distribution occur with every
economic change, not only international trade.
¨ Changes in technology, changes in consumer preferences,
exhaustion of resources and discovery of new ones all affect
income distribution.
¨ Economists put most of the blame on technological change
and the resulting premium paid on education as the major
cause of increasing income inequality in the US.
• It would be better to compensate the losers from trade
(or any economic change) than prohibit trade.
¨ The economy as a whole does benefit from trade.
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Empirical Evidence of the H-O Model
• Tests on US data
¨ Leontief found that US exports were less capital-intensive
than US imports, even though the US is the most capital-
abundant country in the world: Leontief paradox.
• Tests on global data
¨ Bowen, Leamer, and Sveikauskas tested the Heckscher-
Ohlin model on data from 27 countries and confirmed the
Leontief paradox on an international level.
• Tests on manufacturing data between low/middle
income countries and high income countries.
¨ This data lends more support to the theory.
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Summary
1. Substitution of factors in the production process
generates a curved PPF.
¨ When an economy produces a low level of a good, the
opportunity cost of producing that good is high
¨ When an economy produces a high level of a good, the
opportunity cost of producing that good is low
2. When an economy produces on its PPF, the
opportunity cost of producing a good equals the
relative price of that good.
3. If the relative price of a good increases, then the
real wage or rate of return of the factor used
intensively in the production of that good increases,
while the real wage or rate of return of the other
factor decreases.
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Summary
4. If we hold output prices constant as a factor of
production increases, then the supply of the good that
uses this factor intensively increases, and the supply
of the other good decreases.
5. An economy will export goods that are intensive
in its abundant factors of production and import
goods that are intensive in its scarce factors of
production.
6. The Heckscher-Ohlin model predicts that relative
good prices and factor prices will equalize, neither of
which occurs in the real world.
7. The model predicts that owners of abundant factors
gain, but owners of scarce factors lose with trade. 4-43