The Heckscher-Ohlin-Samuelson Model Factor Proportions Theory

Problems with the Generic Neoclassical Model What is the source of a country’s comparative advantage? Generic neoclassical theory doesn’t really say Factors other than labor (especially capital) are not explicitly included

H-O-S In General Heckscher, and his student Ohlin, worked in the early part of the 20th century Samuelson refined their work after WWII Closer attention is paid in this model to each country’s resource endowment

H-O-S Assumptions 2 countries 2 commodities 2 factors (labor and capital) Perfect competition exists in all markets Each country’s endowment of factors is fixed Factors are mobile internally, but immobile internationally

H-O-S Assumptions (cont’d) Each producer has a wide range of options as to how to produce X or Y –if K is cheap relative to labor, a relatively capital-intensive method will be adopted –if K is expensive relative to labor, a relatively labor-intensive method will be adopted Each country has the same CRTS technology

H-O-S Assumptions (cont’d) Tastes and preferences are the same for both countries

Concepts and Terminology The capital-labor ratio for good X is simply K X /L X, and for Y is K Y /L Y If K X /L X > K Y /L Y, production of good X is capital intensive relative to production of good Y Also, production of Y must be relatively labor intensive (If K X /L X > K Y /L Y, then L Y /K Y > L X /K X )

Concepts and Terminology Country A is said to be capital abundant relative to Country B if (K/L) A > (K/L) B In such a case, Country B must be relatively labor abundant So: –goods are produced relatively K or L intensively –countries are relatively K or L abundant

Concepts and Terminology The factor price of labor (the wage) is denoted w The factor price of capital is denoted r If labor is relatively expensive, w/r will be a relatively big number If labor is relatively cheap, w/r will be a relatively small number

More on Factor Prices What makes labor relatively expensive? –If it is relatively scarce What makes labor relatively cheap –If it is relatively abundant So: If (K/L) A is a relatively big number (that is, capital is relatively abundant), w/r will be a relatively big number, reflecting the relative scarcity of L and abundance of K

A Review of Trade in the Neoclassical Model Suppose the U.S. is capital abundant relative to Mexico This, of course, means that Mexico is relatively labor abundant These differences affect the shape of each country’s PPF Suppose that cars are produced rel. K- intensively, and textiles labor intensively

Autarky in Mexico and the U.S. Mexico U.S. Cars Textiles (P T /P C ) Mex (P T /P C ) US X1X1 Y1Y1 X4X4 Y4Y4 E e

Autarky in Mexico and the U.S. The relative price of textiles in autarky is greater in the U.S. than in Mexico That is, the U.S.’s autarky price line is steeper than Mexico’s In symbols, (P T /P C ) U.S. > (P T /P C ) Mex. This means that Mexico has the comparative advantage in textiles

Autarky in Mexico and the U.S. This also means that the relative price of cars in autarky is lower in the U.S. than in Mexico That is, (P C /P T ) U.S. < (P C /P T ) Mex. This means that the U.S. has the comparative advantage in cars

Production in Trade Mexico U.S. Cars Textiles X1X1 Y1Y1 X4X4 Y4Y4 E e (P X /P Y ) T X2X2 Y2Y2 X5X5 Y5Y5 e' E'

Consumption in Trade Mexico U.S. Cars Textiles X1X1 Y1Y1 X4X4 Y4Y4 E e X2X2 Y2Y2 X5X5 Y5Y5 e' E' C' c' (P X /P Y ) T

The Result The relatively capital abundant country (U.S.) exports the relatively capital intensive good (cars) The relatively labor abundant country (Mexico) exports the relatively labor intensive good (textiles)

The Heckscher-Ohlin Theorem A country will export the commodity that uses relatively intensively the factor that country has in relative abundance A country will import the commodity that uses relatively intensively the factor that is relatively scarce in that country

The Source of Comparative Advantage If a country has a lot of labor relative to K, its wage rates will be relatively low, so the product that uses a lot of labor in its production (relatively speaking) will be produced at a relatively low cost, so the country should export the labor intensive good

The Source of Comparative Advantage If a country has a lot of capital relative to L, its capital price will be relatively low, so the product that uses a lot of K in its production (relatively speaking) will be produced at a relatively low cost, so the country should export the capital intensive good

The Source of Comparative Advantage So it is a country’s relative factor endowment that determines its comparative advantage This is why the H-O-S model is also called the factor proportions theory

Changes in Relative Commodity Prices As we learned before, –(P T /P C ) US falls as the U.S. moves to trade. That is, the international relative textile price is lower than the U.S.’s autarky price. –(P T /P C ) Mex rises as Mexico moves to trade. That is, the international relative textile price is higher than Mexico’s autarky price.

Changes in Factor Prices In autarky, the K-intensive product (cars) is less expensive to produce in the U.S. as compared to Mexico –this is because K is relatively abundant in the U.S., which makes the price of capital relatively low As trade commences, r will rise since demand for capital will rise

Changes in the Price of Capital in the U.S. r QKQK SKSK D1KD1K r1r1 In autarky, the price of capital (r 1 ) is determined by supply of and demand for capital in the U.S

Changes in the Price of Capital in the U.S. r QKQK SKSK D1KD1K r1r1 When trade starts, the U.S. increases its production of the capital intensive product, and therefore demand for capital increases in the U.S. D2KD2K r2r2

Changes in Factor Prices In autarky, the L-intensive product (textiles) is more expensive to produce in the U.S. as compared to Mexico –this is because L is relatively scarce in the U.S., which makes the price of labor relatively high. As trade commences, w will fall since demand for labor will fall

Changes in the Price of Labor in the U.S. w QLQL SLSL D1LD1L

w QLQL SLSL D1LD1L In autarky, the price of labor (w 1 ) is determined by supply of and demand for labor in the U.S w1w1

Changes in the Price of Labor in the U.S. w QLQL SLSL D1LD1L When trade starts, the U.S. decreases its production of the labor intensive product, and therefore demand for labor decreases in the U.S. w1w1 w2w2

Commodity and Factor Prices In Trade: A Summary When trade begins, the relative price of the good intensive in the abundant factor rises (e.g., (P C /P T ) US rises) The relative price of the good intensive in the scarce factor falls (e.g., (P T /P C ) US falls) Also, the price of the abundant factor rises, and the price of the scarce factor falls (i.e., w falls, r rises in the U.S.)

Commodity and Factor Prices In Trade: A Summary In our example, (P T /P C ) US falls as trade commences (w/r) US also falls In Mexico, the opposite is happening: –(P T /P C ) Mex rises –(w/r) Mex also rises Therefore relative commodity and factor prices move together as trade commences

The Relative Cost Curve Since relative factor and commodity prices move together as countries move from autarky to trade, we can look at a picture of these two sorts of prices We also know that in autarky (P T /P C ) Mex is lower than (P T /P C ) US (w/r) Mex is also lower in autarky than (w/r) US since Mexico is relatively labor abundant

The Relative Cost Curve P T /P C w/r (w/r) Mex (P T /P C ) Mex (w/r) US (P T /P C ) US As trade commences, (P T /P C ) US falls, and (P T /P C ) Mex rises

The Relative Cost Curve P T /P C w/r (w/r) Mex (P T /P C ) Mex (w/r) US (P T /P C ) US In addition, as trade commences (w/r) US falls, and (w/r) Mex rises

Factor Price Equalization In fact, each country moves along the relative cost curve to a common point We know this because there is only one international price If the countries wind up with a common international price, they must also wind up with a common set of relative factor prices

The Relative Cost Curve P T /P C w/r (w/r) Mex (P T /P C ) Mex (w/r) US (P T /P C ) US Both relative commodity and factor prices equalize in trade (P T /P C ) Int (w/r) Int

The Factor Price Equalization Theorem In equilibrium, with both countries facing the same relative (and absolute) product prices, both having the same technology, and with constant returns to scale, relative (and absolute) costs will be equalized. This can only happen if factor prices are equalized between countries.

H-O-S and the Distribution of Income The H-O theorem, together with the FPE theorem also tell us about how the incomes of different groups within a country change as trade starts This provides insight into the politics of free trade

The Stolper-Samuelson Theorem The increase in the price of the relatively abundant factor and the fall in the price of the relatively scarce factor because of trade implies that the owners of the abundant factor will find their real incomes rising; the owners of the scarce factor will find their real incomes falling.

H-O-S and the Distribution of Income According to the S-S theorem, if the U.S. is a relatively K-abundant country, who in America should favor free trade? Who in America should favor protectionism?

Theoretical Qualifications to H-O-S Suppose we relax some of the many assumptions. Will the implications of the H-O-S model still be the same?

Qualification #1: Demand Reversal Normally, the relative price of the commodity that uses intensively the abundant factor will be lower In our example, (P C /P T ) US < (P C /P T ) Mex Or, (P T /P C ) US > (P T /P C ) Mex What causes this difference in autarky prices? Differences in supply conditions

Qualification #1: Demand Reversal Suppose we let demand conditions differ Suppose domestic demand for the good that uses relatively intensively the relatively abundant factor is very strong in each country That is, demand for cars is very strong in the U.S., and demand for textiles is very strong in Mexico

Qualification #1: Demand Reversal Such strong demand makes the autarky car price in the U.S. higher, and the textile price in Mexico higher In the extreme, demand reversal could occur: (P C /P T ) US > (P C /P T ) Mex, and (P T /P C ) US < (P T /P C ) Mex So what?

Qualification #1: Demand Reversal When trade begins, as usual the int’l price will lie between the two countries’ APRs Therefore (P C /P T ) for Mexico will rise as it moves to trade Mexico, then, would export cars Meanwhile, (P T /P C ) for the U.S. will rise as it moves to trade The U.S., then, would export textiles

Bottom Line on Demand Reversals If demand reversals occur, the H-O theorem no longer holds: the K-abundant country is exporting the L-intensive good, and the L- abundant country is exporting the K- intensive good If demand reversals are common in the real world, we’d better find a new theory

Qualification #2: Factor Intensity Reversal Implicitly, we’ve assumed that if good X is K-intensive relative to good Y at one factor price ratio, it will be K-intensive at all factor prices A FIR is when a good is relatively K- intensive at one set of factor prices, but relatively labor intensive at another

Qualification #2: Factor Intensity Reversal FIRs occur when capital and labor can be substituted more easily in the production of one good than another Example: –Suppose butane production is very inflexible: 1K + 1L = 1 butane, and if you want more butane you must add more of both K and L –Suppose apple production is much more flexible

Qualification #2: Factor Intensity Reversal If w/r is very high, apple producers will choose a relatively K-intensive method (as compared with butane makers) If w/r starts to fall, apple producers will start substituting L for K Eventually, it’s possible that apples might be produced in a relatively L-intensive manner (as compared with butane)

Factor Intensity Reversal: Implications for Trade Suppose France is K-abundant relative to Germany (that is (K/L) F > (K/L) G ) This means that (w/r) F > (w/r) G Suppose further that there is a FIR: in France, at (w/r) F apples are produced relatively K-intensively but in Germany at (w/r) G apples are produced in a relatively L- intensive way

Factor Intensity Reversal: Implications for Trade If trade begins, according to the H-O theorem the relatively K-abundant country (France) will export the rel. K-intensive good (apples) and the rel. L-abundant country will export the rel. L-intensive good (also apples) This can’t work

Factor Intensity Reversal: The Bottom Line If FIRs are present, the H-O theorem breaks down If FIRs are common, we’d better find a new theory

Qualification #3: Transportation Costs In the real world, it is costly to transport goods internationally How do the implications of our model change if we allow for transportation costs? Consider the supply and demand curves for textiles in Mexico and the U.S.:

Basic Set-Up U.S. Mexico S Text D Text PTPT QTQT P A US S Text D Text PTPT QTQT P A Mex P Intl q1q1 q2q2 q1q1 q2q2 Imp. Exp.

Adding Transportation Costs Suppose Mexico tries to pass along 100% of the transportation costs to the U.S. consumers In this case, the U.S. textile price will rise, and the quantity of imports demanded will fall Mexico will have a surplus, and will eventually lower their domestic price

Adding Transportation Costs Therefore, unless Mexico is the only seller in the world, transportation costs will be borne by both the consumer (the U.S.) and the seller (Mexico). How does this look on the graph?

Adding Transportation Costs U.S. Mexico S Text D Text PTPT QTQT S Text D Text PTPT QTQT P Intl q1q1 q2q2 q1q1 q2q2 Imp. Exp. t-costs

Adding Transportation Costs Notice: there is no longer a single international textile price, but rather two different ones That is, transportation costs drive a wedge between the two countries’ prices

Adding Transportation Costs: the Bottom Line In general, the H-O theorem will still hold The FPE theorem breaks down, since factor prices only equalize if the commodity prices do Therefore, in the presence of transportation costs, factor prices have a tendency to move towards each other, but we should expect equalization

Relaxing Other Assumptions One can relax many other assumptions and examine how the implications of the model change: –perfect competition –CRTS –identical production technologies –lack of policy obstacles –factors being perfectly transferable

Relaxing Other Assumptions These issues have involved many researchers for many years You can read a bit about this research in your text, but we have other fish to fry Suffice it to say that relaxing these assumptions can modify the basic H-O-S model, but doesn’t lead us to scrap the model