Factor Endowments Theory and Heckscher-Ohlin Model ECON 331 Chapter 4 Salvatore: International Economics, 8th Edition © 2004 John Wiley & Sons, Inc. Factor Endowments Theory and Heckscher-Ohlin Model

Factor-Proportions Theory Explained by Eli Heckscher and Bertil Ohlin Also called the Heckscher-Ohlin (H-O) Theory A country’s comparative advantage is based on its endowment of the factors of production Salvatore: International Economics, 8th Edition © 2004 John Wiley & Sons, Inc.

Assumptions of H-O Theory Two countries – (U.S. and UK) Two goods – (wheat and cloth) Production and consumption conducted under perfect competition Firms are price takers Prices of factors determined by supply and demand in each market Salvatore: International Economics, 8th Edition © 2004 John Wiley & Sons, Inc.

Assumptions (Cont.) No constraints to trade (free trade) International trade will not lead to complete specialization Consumers in both countries have equal tastes and preferences Both countries endowed with homogeneous factors of production and both used in production: Capital (K) and Labor (L) Salvatore: International Economics, 8th Edition © 2004 John Wiley & Sons, Inc.

Assumptions (Cont.) Technology for production same in both countries and produced under constant returns to scale. Capital and Labor can flow freely from one industry to the other domestically Labor and Capital cannot move freely between countries Salvatore: International Economics, 8th Edition © 2004 John Wiley & Sons, Inc.

A new concept - Factor Intensity The input used in the production of a product intensively makes it «that» input intensive. If Labor is used intensively in the production of a product (ie wheat) it is said labor intensive product If capital is used intensively in its production, then it is capital intensive product (ie. Clothing) Cloth industry use more of capital relative to labor – high K/L ratio Wheat production uses more of labor relative to capital – low K/L ratio Salvatore: International Economics, 8th Edition © 2004 John Wiley & Sons, Inc.

Factor Intensity Kw/Lw < KC/ LC In a world of two goods (cloth and wheat) and two factors (labor and capital), cloth production is capital-intensive, if at any given wage-rental ratio the capital-labor ratio used in the production of cloth is greater than that used in the production of wheat: Kw/Lw < KC/ LC Example: If wheat production uses 80 workers and 20 units of Capital, while cloth production uses 20 workers and 20 units of Capital, then cloth production is Capital-intensive and wheat production is labor-intensive. Salvatore: International Economics, 8th Edition © 2004 John Wiley & Sons, Inc.

Factor Abundance The U.S. is relatively labor abundant and UK is relatively capital abundant The K/L ratio is higher in U.K. than in US Important: It is the relative quantity of capital to labor that is key. Salvatore: International Economics, 8th Edition © 2004 John Wiley & Sons, Inc.

Factor Abundance (K/L)UK > (K*/L*)US A country is capital-abundant compared to other country (US and UK) if and only if the ratio of the total amount of capital to labor is greater than that: (K/L)UK > (K*/L*)US Country with lower Capital- Labor ratio is said to be labor-abundant compared to other Salvatore: International Economics, 8th Edition © 2004 John Wiley & Sons, Inc.

b. What can you say for the factor abundance of each country? Following table shows the labor and capital requirements for the production of two goods Beer and Chips in Mexico and USA, where US exports Beer and Mexico chips. Answer the following questions according to the table. Capital Labor Beer 10 2 Chips 4 8 a. Which product is labor intensive and which product is capital intensive? Show your calculations. b. What can you say for the factor abundance of each country? Salvatore: International Economics, 8th Edition © 2004 John Wiley & Sons, Inc.

The Factor-Proportions Theorem Assumed similar demand conditions in each country, supply of resources determines factor prices So Before trade Capital is less expensive in capital abundant country – i.e.U.K. Labor is less expensive in labor abundant country – i.e. US Salvatore: International Economics, 8th Edition © 2004 John Wiley & Sons, Inc.

Figure 1 General Equilibrium Framework of the Heckscher-Ohlin Theory. Salvatore: International Economics, 8th Edition © 2004 John Wiley & Sons, Inc.

Empirical tests of the H-O theory The Leontief Paradox A 1951 test of the H-O theory Showed that that pattern of trade did not fit the conclusions of the H-O theorem. Imports in the U.S. were capital intensive when they should have been labor intensive.

Empirical tests of the H-O theory The Leontief Paradox Is the paradox real? The test assumed a two factor world which required assumptions about what is capital and what is labor. The test assumed consistent technology between nations. However, technology varies so this assumption may have biased the test.

Empirical tests of the H-O theory The Leontief Paradox Is the paradox real? The test assumed a two factor world which required assumptions about what is capital and what is labor. The test assumed consistent technology between nations. The test assumes perfect mobility between factors of production. In practice, some factors of production are specific to sectors of the economy. Sector specific factors alter the predictions of the H-O theory and require a different testing procedure.

Empirical tests of the H-O theory The Leontief Paradox Is the paradox real? More current test of the H-O theory are built on multiple factor (including sector specific factors) models that extend the basic H-O framework. These show good predictive ability.

Need for extending the h-o model In the H-O model of trade, the pattern of trade is driven by relative factor abundance. Labor abundant countries export goods that are labor intensive in their production. Capital abundant countries export goods that are capital intensive in their production.

EXTENSIONS OF H-O MODEL-Factor Price Equalization In the H-O model of trade, the pattern of trade is driven by relative factor abundance. Exported commodities experience an increase in their price relative to the autarky situation.

EXTENSIONS OF H-O MODEL-Factor Price Equalization International trade leads to complete equalization in the relative and absolute returns to homogeneous factors across countries. In the absence of trade, labor would earn less in labor abundant economy than in capital abundant economy, and capital would earn more in labor abundant economy and less in capital abundant economy Salvatore: International Economics, 8th Edition © 2004 John Wiley & Sons, Inc.

Factor price equalization Exported commodities experience an increase in their price relative to the autarky situation. The Stolper-Samuelson theorem demonstrates that an increase in the relative price of a commodity raises the return of the factor used intensively in its production. Thus, the labor abundant country will see an increase in wages, but a fall in the return to capital while the capital abundant country will experience the opposite pattern of change.

Implications of FPE Developed nations are expected to be capital abundant. Therefore, following the opening of trade the return to capital in the developed countries is expected to increase and wages are expected to fall. This pattern of change should worsen inequality in the developed countries.

Implications of FPE Developed nations are expected to be capital abundant. The change in inequality should be the opposite for the developing (and labor abundant) countries.

Implications of FPE Developed nations are expected to be capital abundant. The change in inequality should be the opposite for the developing (and labor abundant) countries. The conclusion of worsened inequality in the developed world holds only if: The assumptions of the H-O theory holds. As will be seen, this may not be the case. The Stolper-Samuelson theorem is the only force driving changes in inequality.

When US exports L-intensive wheat it exports labor embodied in the product as well where UK exports K-intensive cloth with capital embodied in it. Salvatore: International Economics, 8th Edition © 2004 John Wiley & Sons, Inc.

FIGURE 2 Relative Factor–Price Equalization. Salvatore: International Economics, 8th Edition © 2004 John Wiley & Sons, Inc.

Mechanism of Factor Price Equalisation An increase in the price of wheat relative to that of cloth, Pw/Pc ,will: Raise the income of workers relative to that of capital owners, w/r. Raise the ratio of capital to labor, K/L, in both wheat and cloth production and thus raise the marginal product of labor in terms of both goods. Raise the purchasing power of workers and lower the purchasing power of capital owners, by raising real wages and lowering real interest in terms of both goods. Salvatore: International Economics, 8th Edition © 2004 John Wiley & Sons, Inc.

Convergence of Prices When Home and Foreign trade with each other, their relative prices converge. The relative price of wheat rises in US and declines in UK. In US, the rise in the relative price of wheat leads to a rise in the production of wheat and a decline in its relative consumption, so US becomes an exporter of wheat and an importer of cloth. Conversely, the decline in the relative price of wheat in UK leads it to become an importer of wheat and an exporter of cloth. Salvatore: International Economics, 8th Edition © 2004 John Wiley & Sons, Inc.

Factor Price Equalization (cont.) Three assumptions crucial to the prediction of factor price equalization are not true in reality: Both countries produce both goods Both countries have the same technologies in production Both countries have the same prices of goods due to trade One thing the factor-price equalization theorem does not say is that international trade will eliminate or reduce international differences in per capita incomes. Salvatore: International Economics, 8th Edition © 2004 John Wiley & Sons, Inc.

Factor Price Equalization Has international trade equalized the returns to homogeneous factors in different countries in the real world? Even casual observation clearly indicates that it has not. Example: Wages are much higher for doctors, engineers, technicians, mechanics and laborers in the United States and Germany than in Korea and Mexico. Under these circumstances, it is more realistic to say that international trade has reduced, rather than completely eliminated, the international difference in the returns to homogeneous factors. Salvatore: International Economics, 8th Edition © 2004 John Wiley & Sons, Inc.

Rybczynski Theorem (effect): How do the outputs of the two goods change when the economy’s resources change? If a factor of production (K or L) increases, then the supply of the good that uses this factor intensively increases and the supply of the other good decreases for any given commodity prices (The reverse is also true). Salvatore: International Economics, 8th Edition © 2004 John Wiley & Sons, Inc.

Stolper-Samuelson Theorem (effect): Factor Prices and Goods Prices If the relative price of a good increases, holding factor supplies constant, then the nominal and real return (in terms of both goods) to the factor used intensively in the production of that good increases, while the nominal and real return (in terms of both goods) to the other factor decreases (The reverse is also true). If (Pw/Pc ) increases, (w/r) will increase as well Salvatore: International Economics, 8th Edition © 2004 John Wiley & Sons, Inc.