1. 1 HO Model – Factor Proportions INTERNATIONAL ECONOMICS, ECO 486 Bertil Ohlin 1899-1979 Eli F. Heckscher, 1879-1952.

2. 2 Learning Objectives Examine the need to build a new model Understand five more assumptions Prove Rybczynski Theorem Prove HO Theorem Prove Factor-Price Equalization Theorem Prove Stolper-Samuelson Theorem.

3. 3 Learning Objectives Examine the need to build a new model Understand five more assumptions Prove Rybczynski Theorem Prove HO Theorem Prove Factor-Price Equalization Theorem Prove Stolper-Samuelson Theorem.

4. 4 Classical Model Strengths –Trade is mutually beneficial –High & low wage countries may trade –Explains some of the trade patterns we observe Weaknesses –Why does so much trade occur among developed countries? –Why does technology differ across countries?

5. 5 Heckscher-Ohlin (HO) Model Built upon observed differences among –Factors that countries possess –Factors required to produce various goods Insights –Causes of trade –Effects of trade on factor prices –Effect of economic growth on trade patterns –Political behavior

6. 6 Learning Objectives Examine the need to build a new model Understand five more assumptions Prove Rybczynski Theorem Prove HO Theorem Prove Factor-Price Equalization Theorem Prove Stolper-Samuelson Theorem.

7. 7 Assumptions for HO Model Keep assumptions 1 through 10 Drop assumptions 11 & 12 Add assumptions 13 through 17

8. 8 Assumption #13 There are two factors of production, labor (L), and capital (K). Owners of capital are paid a rental payment (R) for the services of their assets, and labor receives a wage payment (W).

9. 9 Assumption #14 The technologies available to each country are identical. –Any technology is available to any country –Factor prices determine the technology chosen –Assumes away the Ricardian explanation of the source of comparative advantage.

10. 10 // Input combinations that produce one bushel of Soybeans Unit Capital input a TS, in machines per bushel Unit Labor input a LF, in hours per bushel A Model of a Two-Factor Economy Input Possibilities in Soybean Production

11. 11 Assumption #15 The production of T is labor intensive relative to the production of S –That is, T requires more labor per machine Implies that production of S is capital intensive (relative to the production of T). –That is, S requires more machines per worker

12. 12 K per Worker for US Industries Thousands of 1972 dollars. P. 89, 6 th edition, Husted & Melvin, International Economics

13. 13 PW Relative price of Textiles, P T /P S Wage-rental ratio, w/r The Magnification Effect A change in the relative price of a good (say, T) results in a proportionately larger change in the price of its intensive factor (Labor).

14. 14 1 2 Wage-rental ratio, w/r Capital-labor ratio, K/L The relative price of a resource affects the intensity of its use. Which line represents the Capital-intensive industry, 1 or 2?

15. 15 Textiles Soybeans Wage-rental ratio, w/r Capital-labor ratio, K/L Soybean production is capital-intensive at any given wage/rental ratio The relative price of a resource affects the intensity of its use.

16. 16 Textiles (K T /L T ) 1 Soybeans Mag. Effect Capital- labor Ratio, K/L Relative price of T, P T /P S Wage-rental ratio, w/r (P T /P S ) 1 (K T /L T ) 2 (K S /L S ) 2 (K S /L S ) 1 (w/r) 2 (w/r) 1 Increasing Changes in relative prices affect the distribution of income (P T /P S ) 2

17. 17 Assumption #16 Country A is relatively capital abundant, while B is labor abundant.

18. 18 K per Worker: Selected Countries 1985 international prices. Item 4.2, page 91, 6 th edition Husted & Melvin

19. 19 Quantity definition of factor abundance Country A is relatively capital abundant, if the ratio of its capital stock to its labor force (K/L) is greater than that of the other country:

20. 20 Price definition of factor abundance Country A is relatively capital abundant, if its wage-rental ratio (W/R) is higher than the other country’s wage-rental ratio:

21. 21 Strong factor abundance assumption If country A is relatively capital abundant, by the quantity definition, its wage-rental ratio (W/R) will be higher than the other country’s wage-rental ratio. That is, the price definition holds, too.

22. 22 SOYBEANS, S (millions of bushels per year) 6 18 40812 2 14 20 S is K-intensive A is K-abundant TEXTILES, T (millions of yards per year) America’s PPF Increasing Opportunity Cost in A 1016

23. 23 20 50 40 10 TEXTILES, T (millions of yards per year) SOYBEANS, S (millions of bushels per year) Britain’s PPF Increasing Opportunity Cost in B T is L-intensive B is L-abundant

24. 24 20 50 40 10 TEXTILES, T (millions of yards per year) SOYBEANS, S (millions of bushels per year) Britain’s PPF Increasing Opportunity Cost in B T is L-intensive B is L-abundant

25. 25 Assumption #17 Tastes in the two countries are identical. –Given same GDP & prices, same choice Implies that supply conditions alone determine the direction of comparative advantage (CA). –Different tastes would imply different demand –Could reverse the direction of CA.

26. 26 The importance of assuming identical tastes.

27. 27 Relative quantity of S, Q S Q* S Q S + Q* S Q T Q* T, Q T + Q* T Relative price of S, P S /P T RD B RS A RS B 1 2 Tastes differ markedly, reversing the direction of Comparative Adv. RS WORLD RD A (P S /P T ) A (P S /P T ) B

28. 28 Learning Objectives Examine the need to build a new model Understand five more assumptions Prove HO Theorem Prove Rybczynski Theorem Prove Factor-Price Equalization Theorem Prove Stolper-Samuelson Theorem.

29. 29 Rybczynski Theorem At constant world prices, if a country experiences an increase in the supply of one factor, it will produce more of the product intensive in that factor and less of the other. –See Figure 4.7, page 103 –Read Item 10.1 “The Dutch Disease,” page 289, 7 th edition of Husted & Melvin

30. 30 L __ K_K_ L_L_ K_K_ Labor used in ________________ production O_O_ Increasing Capital used in ________ production Capital used in _____ production 1 __ O_O_ Which is the K-intensive industry?

31. 31 LSLS KSKS LTLT KTKT Labor used in Soybean production Labor used in Textile production OSOS Increasing Capital used in Textile production Capital used in S production 1 S T OTOT S is K intensive, T is L intensive

32. 32 How do the outputs of the two goods change when the economy’s resources change? Increase the amount of one factor, say K, and observe the results Rybczynski Theorem

33. 33 K2SK2S K2TK2T T L2SL2S L2TL2T K1SK1S K1TK1T S1S1 L1SL1S L1TL1T 1 L used in S production L used in T production Increasing K used in T production K used in S production S2S2 O1SO1S O2SO2S 2 OTOT K increases. S (K int.) expands. S needs more labor. T must contract

34. 34 2 1 PPF 1 PPF 2 Output of T, Q T Output of S, Q S Slope = -P S /P T Q2TQ2T Q2SQ2S Q1TQ1T Q1SQ1S An increase in K in Country A.

35. 35 PPF 1 PPF 2 Output of T, Q T Output of S, Q S Slope = -P S /P T 2 Q2TQ2T Q2SQ2S 1 Q1TQ1T Q1SQ1S An increase in L in country B.

36. 36 Also helps us to understand that an economy will tend to be more productive in industries that use its abundant factor intensively. Rybczynski Theorem

37. 37 Learning Objectives Examine the need to build a new model Understand five more assumptions Prove Rybczynski Theorem Prove HO Theorem Prove Factor-Price Equalization Theorem Prove Stolper-Samuelson Theorem.

38. 38 Heckscher-Ohlin Theorem A country will export the goods whose production is intensive in the factor with which that country is abundantly endowed.

39. 39 General equilibrium for a closed economy; increasing opportunity costs

40. 40 Proof of the HO theorem

41. 41 With free trade, there will be one world relative price for S (P S /P T ) and T (P T /P S ). As P S /P T rises in Country A, their S industry expands while their T industry contracts. As P S /P T falls in Country B, their S industry contracts while their T industry expands. Tricky to draw the general equilibrium solution, so let’s try it together.

42. 42 A’s PPF B’s PPF HO Model: Trade Equilibrium in a special case (easier to draw) Soybeans, Q S Textiles, Q T A Q D and D* Q* A*

43. 43 SOYBEANS, S (millions of bushels per year) 18 013 12 15 a TEXTILES, T (millions of yards per year) CIC 0 Autarky in A 1016

44. 44 SOYBEANS, S (millions of bushels per year) 18 013 12 15 6 million bushels S 6 million yards of T a (P S /P T ) A = |slope| = 1 yd./bu. TEXTILES, T (millions of yards per year) CIC 0 Autarky in A 1016

45. 45 10 30 406.5 20 40 9 a TEXTILES, T (millions of yards per year) SOYBEANS, S (millions of bushels per year) Britain’s PPF Autarky in B CIC 0

46. 46 5 million bushels of S 10 30 406.5 20 40 9 20 mil. yards of T a TEXTILES, T (millions of yards per year) SOYBEANS, S (millions of bushels per year) Britain’s PPF Autarky in B (P S /P T ) B = |slope| = 4 yd./bu. A has comp. adv. in S B has comp. adv. in T CIC 0

47. 47 RD RS A RS B 1 2 3 Trade Leads to a Convergence of Relative Prices Relative price of S, ______ Relative quality of S,

48. 48 Relative quantity of S, Q S Q* S Q S + Q* S Q T Q* T, Q T + Q* T 2 Relative price of S, P S /P T RD RS A RS B 1 3 Trade Leads to a Convergence of Relative Prices RS WORLD 54

49. 49 With free trade, there will be one world relative price for S (P S /P T ) and T (P T /P S ). As P S /P T rises in Country A, their S industry expands while their T industry contracts. As P S /P T falls in Country B, their S industry contracts while their T industry expands. Tricky to draw the general equilibrium solution, so let’s try it together.

50. 50 International Trade Equilibrium Incomplete specialization in Comparative Advantage good. Community Indifference Curve (CIC) & Terms of Trade line (ToT) tangent at consumption point Congruent trade triangles imply balanced trade.

51. 51 HO Trade Equilibrium – general case A produces more S, less T. Complete specialization in their comparative advantage good is unlikely. A exports S, imports T B produces more T, less S B exports T, imports S Their trade triangles are congruent.

52. 52 Derivation of national supply and demand curves; increasing opp. cost

53. 53 National supply and national demand in the classical and HO models.

54. 54 National supply and national demand in the classical and HO models.

55. 55 National supply and national demand in the HO model

56. 56 Learning Objectives Examine the need to build a new model Understand five more assumptions Prove HO Theorem Prove Rybczynski Theorem Prove Factor-Price Equalization Theorem Prove Stolper-Samuelson Theorem.

57. 57 Stolper-Samuelson Theorem Free international trade benefits the abundant factor and harms the scarce factor.

58. 58 As P S /P T rises in Country A, P T /P S and w/r fall. –Look back at Slide 16. –A is K abundant (L scarce) As P S /P T falls in Country B, P T /P S and w/r rise. –B is L abundant (K scarce)

59. 59 Learning Objectives Examine the need to build a new model Understand five more assumptions Prove Rybczynski Theorem Prove HO Theorem Prove Factor-Price Equalization Theorem Prove Stolper-Samuelson Theorem.

60. 60 Factor-Price Equalization (FPE) Theorem Given all the assumptions of the HO model, free trade will lead to the international equalization of individual factor prices. –Look again at Slide 16. One relative price for T, P T /P S One wage-rental ratio, w/r

61. 61 Factor-Price Equalization? “There isn’t any.” Why not? 1.Some goods are not produced in some countries. 2.Productivity (technology) does differ between countries. 3.Goods’ prices differ due to natural and artificial barriers to trade.

62. 62 The End of Chapter 4 See “Isocosts, Isoquants, and Proofs”in eco486 main folder See Specific-Factors Model: 03specific_factors_jde.ppt in Krugman folder