1. Heckscher-Ohlin Model “Predicts trade across dissimilar countries and in dissimilar goods: it says that labour abundant developing countries will export labour-intensive products such as food and clothing, whereas capital abundant developed countries will export capital-intensive products such as machinery and computers”. (Debraj Ray)

2. 2 Heckscher-Ohlin Model Outline 1. Two goods model 1.1 Assumptions 1.2 Production Possibilities : Combination of Factors 1.3. Production possibilities : Combination of Goods 1.4. Efficient production and consumption in autarky 1.5. What happens to consumption when both countries open to trade? 1.6. Integrated economy equilibrium: division of production 1.7. Integrated equilibrium consumption and trade 1.8. Production and factor price equalization 1.9. Factor prices and redistribution of income inside a country 1.10. Endowment changes (at given factor prices) [Gains 18] [H-O trade 29] [FPE 38] [Stolper-S. 41] [Rybcynski 44] = 5 theorems [ Nice « General Equilibrium » model : goods and factor quantities and (relative) prices ]

3. 3 1.1 Assumptions 2 countries i : North (1) and South (2). 2 goods j = X and Y. 2 factors: capital (K) and labour (L). Factors mobility across industries but not across countries in the medium term. Perfect competition and price flexibility in goods and factors markets. Prices will be noted by:. Identical production and utility function in both countries. Both countries share the same knowledge. Constant returns to scale and decreasing returns of individual factors. 1.Two goods model

4. 4 1.2. Production Possibilities : Combination of factors Production function is given by: for each good j. As countries have identical knowledge, even when they do not produce the same goods, this production function will be the same for all countries. The constant returns to scale of the production function can be expressed by: And the decreasing returns of individual factors implies that: The marginal productivity of individual factors is decreasing.

5. 5 Isoquants: give the combinations of labour and capital needed to produce a certain amount Q of good j=X,Y, for a given production technology. L K QYQY QXQX The form of the isoquants shows that the factor intensity needed to produce each good is different. While the good X is capital intensive good, the good Y is labour intensive. K L QXQX QYQY A KAKA LAYLAY LAXLAX < At A, the same reduction of K, requires a lower increase of L to maintain the production of Y constant than to maintain the production of X constant. Labor is more efficient in Y than in X : Y is “labor intensive” (Y “prefers” L).

6. 6 Maximize profits. Under perfect competition For the given prices the producer will chose the quantity of labour and capital that minimize the costs : Then, the slope of the isocost is. Prices of X and Y are given. Factors prices, wages w and rental rate (interest rate) r, are given. Isocost How to determine the required labour and capital for 1 (monetary cost) unit of each good? Combination of factors:

7. 7 For a given output of X (isoquant Q X,A ), and a given relative factor price w/r, A is the cost-minimizing combination of factors K & L (with cost C X,A = wL A +rK A ). L K A Q X,A For a given and equal factor cost, i n the graph, A represents the optimum production level of good X, and B represent the optimum level of production of good Y. Cost minimization : tangency isoquant and isocost -w/r QYQY B

8. 8 How can we see the relative use of factors for each goods production? In the expansion line: formed by the tangency points between the isocost (for given w/r) and each isoquant. L K K X /L X K Y /L Y QXQX QYQY Good X is more capital intensive than good Y. Expansion of production: maintained proportions of factors for given w/r

9. 9 What happens to the capital intensive good if wages go down? As w goes down the isocost becomes less steep. On a new expansion line we can see that the production process uses labour in a more intensive way than before. however capital intensive good remains as such. L K K X /L X w/rw'/r (K X /L X )' Relative factor price changes (w/r  ) Note : The capital intensive good remains capital intensive relative to the other good which remains labor intensive. Factor space

10. 10 Efficiency curve: Using the isoquants in a factor endowment space (K,L) - efficient allocations of factors in the production of both goods in one country. - tangency points of the isoquants, - equal marginal rate of substitution of K and L for both goods OXOX OYOY L K QXQX QYQY M L K J For any point that is not a tangency point of the isoquants there is a way to increase production of one good without reducing production of the other good. 1.3. Production possibilities : Combination of Goods

11. 11 Production possibility frontier: is an curve in the goods space X,Y, that shows all the possible combinations of goods X and Y which use an efficient distribution of factors. It represents the maximal production of one good for a given quantity of the other. And it is formed by the points on the efficiency curve in the factor space K,L (Edgeworth box). A QXQX J K L M QYQY The slope of the tangent curve in A represents the quantity of Y that must be given up (“paid”) in order to obtain an additional unit of X. Goods Space

12. 12 A QYQY QXQX If you free some capital and labor from Y’s production, the production of X will increase substantially using intensively the large amounts of capital freed by labor intensive Y. However the rate of increase in X will decrease as you free more capital from Y (because labor-intensive Y doesn’t have large quantities of K anymore to free up). Why does the production possibilities frontier have this shape? Because it is more costly to do only one good. As soon as goods have different intensity in the use of factors, there will be a factor that will not be used in all it’s potential when we produce only one good.

13. 13 1.4 Which is the efficient production and consumption in autarky? Consumption of goods: It will depend on consumers preferences. The optimal production choice in autarky is given by the tangency point between the indifference curve of consumers and the production possibilities frontier for a given relative price level. Consumers indifference curve. -p X /p Y C QXQX QYQY XCXC YCYC Goods Space

14. 14 In autarky point C represents production and consumption quantities of goods X and Y. This point given by the tangency between production possibility frontier and indifference curve respects the budget constraint given by: where: is the price of good X. is the price of good Y. The slope of the budget constraint is given by the relative prices:

15. 15 Where can we see the factor consumption? Factor space K,L and isoquants X,Yof goods The production and consumption decisions in the goods space correspond to tangent isoquants in the factor space (Edgeworth box). For the chosen isoquants, the use of factors for the production of each good X and Y appears reading from each one’s origin, O X and O Y. At the tangent isoquants, the relative price (-w/r) of factors (rate of substitution for autarky) appears. C XCXC YCYC L KYKY LYLY LXLX KXKX OXOX OYOY K -w/r Consumption of factors Factor Space

16. 16 We can see the change in consumption in both spaces and the effect on prices of goods and factors The production and consumption decisions in the goods space correspond to tangent isoquants in the factor space (Edgeworth box). For the chosen isoquants, the use of factors for the production of each good X and Y appears reading from each one’s origin, O X and O Y, Labour intensity of both goods increases from C to D, labour becomes cheaper. At the tangent isoquants, the relative price (-w/r) of factors (rate of substitution for autarky) appears. C XCXC YCYC L KYKY LYLY LXLX KXKX OXOX OYOY K -w C /r Consumption of factors in the Consumption of goods Factor Space Consumers indifference Curve at C. -p XD /p Y C QXQX QYQY XCXC YCYC -p XC /p Y D XDXD YDYD Goods Space D -w D /r

17. 17 1.5 What happens to consumption when both countries open to trade? Countries are not longer bounded by their autarkic production possibilities but by their budget. The budget constraint will be now given by the international prices of goods that are being traded. It takes the form: The slope of the new budget constraint is: The new consumption point is given by the tangency between the new budget constraint and consumers indifference curve. While production takes place in the tangency of the new budget constraint and the production possibilities frontier. Under trade production takes place in P’ and consumption in C’, this is possible because the country imports the quantity X’ P - X’ C and exports Y’ P -Y’ C.

18. 18 New budget constraint with slope: Indifference curve P' Production of XConsumption of X Production of Y Consumption of Y -p X /p Y QXQX QYQY XCXC YCYC X' P X' C Y' C Y' P Indifference curve C' Y’s exports X’s imports C P Labor-intensive country (East) : Establishing Gains from Trade in the Goods space

19. 19 Where are the gains from trade? According to the new relative prices, consumption will take place on a different indifference curve, that belongs to the same family than the initial one, but corresponds to a higher utility level of consumers. The world relative price will be in between the relative prices existing in autarky: 1 is West, 2 is East : see graph

20. 20 PPF-East PPF-West QXQX QYQY Production possibility frontiers in the East and in the West. How do endowment differences between countries appear ? -Shape of the production possibility frontier p X /p Y East p X /p Y West < p X /p Y East Identical preferences -Size of the factor space (Edgeworth box) (see sub 6) and relative prices Establishing Comparative Advantage in the Goods Space

21. 21 Conclusion of graphs: Heckscher & Ohlin Theorem: “A country exports the good which uses intensively its abundant factor, and it imports the good which uses intensively the other factor” N.B. Specialisation in “trade” not in “production” Proof: world prices “between” domestic prices, which were determined by endowments : see previous 2 graphs.

22. 22 1.6. Integrated economy equilibrium and division of production When studying the integrated economy it is necessary to consider the world factor endowment as a starting point to determine where production is going to take place and which consumption level of each good is going to be chosen by each country. To see the world factor endowment we can build an Edgeworth box where both countries factor endowments are represented starting from O 1 and O 2 for the North and the South respectively. At equilibrium point E, the endowments of the North are represented by O 1 -L 1 and O 1 -K 1 for labour and capital respectively. For the South the endowments are given by O 2 -L 2 and O 2 -K 2.

23. 23 E O1O1 O2O2 L1L1 L2L2 K1K1 K2K2 K L West = “capital abundant” ; East = “labour abundant”. World factor endowment = Sum of countries’ endowments WEST EAST How do endowment differences between countries appear ? -Shape of the production possibility frontier (as seen above 1.5.) -Size of the factor space (Edgeworth box)

24. 24 The efficiency curves and expansion lines of both countries can also be represented in the world endowment box: A and B are the expansion lines of goods Y and X, respectively, in the East. C and D are the expansion lines of goods Y and X, respectively, in the West. O1XO1X O1YO1Y L1L1 L2L2 K1K1 K2K2 O2YO2Y O2XO2X A B C D From an integrated world consumption view, the countries efficiency curves are inefficient in terms of consumption …

25. 25 The worldwide economy: if the world was a single country and all people had the same preferences, the consumption would not longer be constrained by each countries endowment (E) but by global factor endowment and it could reach Q’: However, a point like Q’ can not be reached by separated endowments. The best option is to choose a production division between two countries under which all factors are fully used, i.e. at point E, but consumers are satisfied better (i.e. obtain quantities Q’). OXOX L1L1 L2L2 K1K1 K2K2 OYOY E Q’

26. 26 The quantity of factor used ensures the full employment of factors. The division of production replicates the integrated economy: -thanks to constant returns to scale -thanks to an endowment point E within the integrated expansion paths L K O2O2 O1O1 E L1L1 K1K1 L2L2 K2K2 Y1Y1 X1X1 L1XL1X L1YL1Y K1XK1X K1YK1Y Q’

27. 27 1.7. Consumption by country at integrated equilibrium and trade Assumptions: Identical and homothetic preferences. Goods prices are equal between countries as trade takes place. Consumption will take place according to preferences and budget. Both countries consume both goods in the same proportion (identical preferences), then consumption will take place over the diagonal of the Edgeworth box. The budget constraint is given by the factors income: wL i +rK i of each country i. Under factor equalization prices the budget constraint has equal slope for both countries. Consumption takes place at the intersection of the budget constraint and the Edgeworth box diagonal.

28. 28 Identical preferences : Consumption on the diagonal (same proportion of K and L) Budget : Factor income : w/r sloped constraint through endowment point Optimum possible consumption : intersection : point C. E Y1Y1 X1X1 C Q’ Gains from Trade in the Factor Space : Consumption C outside of Endowment borders Consumption

29. 29 Decomposition by goods and countries along : translation of expansion paths (quantities) of each good : The West produces O 1 -X 1 and O 1 -Y 1 of good X and Y respectively; while it consumes O 1 -C X 1 and O 1 -C Y 1 of the same goods. This implies that it is a net importer of good Y and a net exporter of good X. E Y1Y1 X1X1 C Export Import Q’ Gains from Trade in the Factor Space : Consumption outside of Endowment Comparative advantage in the Factor Space : relative factor endowment Consumption

30. 30 Consumption point C will be outside the endowment possibilities of each country: = gain from trade ! Preferences are satisfied better ! Comparative advantage Theorem (Hecksher-Ohlin): (Export according to factor endowment) “A country exports the good which uses intensively its abundant factor, and it imports the good which uses intensively the other factor” Proof : See graph. Note: Production level can be measured along the expansion lines. Then, production of good X in the North is O 1 -X 1 and production of Y is O 1 -Y 1. The use of factors can be read in the projection along the axes: O 1 -K 1 X and O 1 -L 1 X of capital and labour for the production of good X in the West. O 1 -K 1 Y and O 1 -L 1 Y of capital and labour for the production of good Y in the West.

31. 31 1.8. Production and factor price equalization If factor’s prices are equal in both countries, for given price of goods, the intensity in the use of factors are equal in both countries, and equal to the integrated economy use of factors. We can see this in the Edgeworth box: Through trade, countries produce more of what they do best, i.e. of the goods which use their abundant factor more intensively. This raises the price of this relatively cheap factor and brings it closer to the price of this factor in the country where it is scarce. This trade effect can be strong enough to equalize factor prices. If not, then one country will be unable to produce one of the goods and pressures for factor mobility will remain to try to equalize factor prices and replicate the integrated economy. O1O1 O2O2 K L Factor price equalization across countries depend upon their endowments. We consider 2 cases: A – E is within the expansion paths at w/r B – E is outside these expansion paths

32. 32 Reminder: graphical presentation of expansion paths for goods (X,Y) at given factor prices (w/r) and factor abundance of countries (1,2) for endowments E1 and E2: K L K Y /L Y K X /L X K 1 /L 1 K 2 /L 2 E1E1 E2E2 K1K1 K2K2 L1L1 L2L2 -w/r Countries GOODS A. Endowment point E is inside the diversification cone (expansion paths): The division of production can be organized between the countries at identical factor prices, so that both countries keep producing both goods (cfr slide 25, box with division of production).

33. 33 The West is relatively abundant in capital. If it uses all the endowment for the production of good X (capital intensive good) at given w/r, there will be some labour that will be underemployed (see graph). The country needs to keep producing both goods to ensure the full employment of factors. As the same can be shown for the East at the same relative factors prices (w/r, see previous graph), then there is factor price equalization: East and West can work at the same prices and fully use all their factors. Production of both goods (rather than full specialization): Labour underemployment when country 1 produces X only at given w/r.

34. 34 B) Endowment point is outside the diversification cone If the North is too rich in capital the real constraint will be given by the amount of labour available. It is only going to produce good X, which consumes all the endowment of labour, and leaves K 1 X -K 1 underemployed. L K O2O2 O1O1 E L1L1 K1K1 L2L2 K2K2 K1XK1X Unemployed capital in West (North) at FPE

35. 35 The North is over-endowed in capital as to produce under the price of the integrated economy. The price of capital will have to decrease in order for this economy to use all its endowment. r goes down w/r increases As a consequence the North will keep producing good X, which now becomes more capital intensive than before, but still not as much as if FPE could occur (w/r will stay higher in the capital rich country than in an integrated economy and than in the other country).

36. 36 Capital over-endowment in the North Production of X at w/r’ instead of w/r<w/r’ and at K’/L’ > K/L No production of Y, given at w’/r’ : less output at w’/r’ than at w/r. Equal cost (K,L) point : wL+rK = w’L+r’K

37. 37 The same situation can be reproduced for the South if it’s endowment point is outside the diversification point. If the South is over-endowed in labour, it can’t produce at the price of the integrated economy. Then, the price of labour will have to decrease in order for this economy to use all it’s endowment. w goes down w/r decreases As a consequence the South will keep producing good Y, which now becomes more labour intensive than before.

38. 38 Labour over-endowment in the South

39. 39 The situations discussed in point B will lead to countries specializing in the production of one good only. The North will specialize in the production of capital intensive good, X; and the South will specialize in the production of labour intensive good, Y. When full specialization in production takes place there is no reason for factor prices to equalize across nations. Full specialization happens in 1 country, but need not to happen in both when FPE is not reached (see next slide). Factor Price equalization theorem : If both countries produce both goods, factor price equalization will take place when there is international trade on a perfect competitive market and countries have access to the same production functions. This requires factor endowments that are similar enough Note : Unequal factor prices indicate an inefficiency (See chap. 3). Specialization is then inefficient from a world consumption point of view.

40. 40 Same total production of X, Different factor intensities, same total cost at w/r and w’/r Qx -w’/r -w/r K L Qy Q’y Not same production of Y at same total cost of X and different w/r and w’/r [QED] (Y can only be sold by low w/r country) To produce and trade both goods at same price (and cost) than other country, same factor prices required in both countries. Otherwise only one good can be produced at same cost by both. Demonstration of FPE and specialization distribution using isoquants and isocosts Equal cost (K,L) point : wL+rK = w’L+r’K

41. 41 1.9. Factor prices and redistribution of income inside a country What happens to production and to factor prices when goods price change ? (due to trade opportunities or to change in worldwide preferences) How does production react to the output price shock? Try to increase the production of the good whose price goes up. E.g. when opening up to trade, countries will increase the production of goods that can be exported and reduce the production of those that will be imported. How are resources freed for this production? By freeing capital and labor from the other sector. Suppose, the price of the labor-intensive good goes up. The capital intensive good will free factors, but it will tend to free more capital than labor (because it has more) in such a way that the labor- intensive good will use capital in a more intensive way.

42. 42 Illustration: the giants and the dwarfs Imagine people ranked by their height, and divided in two groups at some cut-off point : the tall ones (the giants) and the lower ones (the dwarfs). Now assume the cut-off point is changed, so that the tallest of the dwarfs moves to the group of the giants. The effect is that the average height in both groups has fallen ! Similarly, the shifting “the most labor one can” from a “capital- intensive” sector to a labor intensive one, leads to a reduction in the labor-intensity of both sectors! What happens to the relative price of the factors? The rising price of labor whose demand has increased (to produce more of a labor-intensive good by assumption) will lead to factor mobility and to economizing on this (now relatively scarce) factor in both sectors.

43. 43 Effect on the purchasing power of each factor ? Use perfect competition P=Cost, Assume P Y + 10%, P X unchanged, We know W up: How much ? At least 10% allowed by P Y + 10%, Must R go down? Yes if W up and P X unchanged, Then W up by more than all prices, R down compared to all prices. Stolper-Samuelson theorem: (relative price theorem) : a relative increase in a good’s price leads to an increase of the income and purchasing power of the factor that is used intensively in it’s production and to a fall in the income of the other factor. This applies, whatever the source of the price change. In North-South trade opening, the scarce factor loses in each country, the abundant one gains (they are the opposite ones in each country).

44. 44 Graphical illustration : Goods factor intensity after reduction of capital intensive good price

45. 45 OXOX OYOY K L X’ Y X Y’ Decrease of capital intensive good price in the endowment box. General Equilibrium view : All change in price (factor and goods) and quantity (factor and goods) are visible and explained in 1 graph !

46. 46 What happens if factor endowments change? In the case of small open economies it is common that the availability of capital increases. If the goods and factors relative prices remains equal, an increase in the capital endowment leads to an increase in the production of the capital intensive good and reduction of the labour intensive good. Factor quantity theorem (Rybczynski): for given factor prices, an increase in the available quantities of one factor leads to an increase in the production of good that use it on an intensive way. The production of the other good is reduced. 1.10. Endowment changes (at given factor prices) Note : Capital is a factor that can be accumulated through savings !

47. 47 Initial production levels: O X -A of good X and O Y -A of good Y. Final production levels: O’x-B of good X and O Y -B of good Y. A B

48. 48 5 key results of 2x2x2 model Gains from trade Comparative advantage in good that uses intensively the locally abundant factor (general effect of indirectly exporting the abundant factor through the goods exported) (Heckscher-Ohlin-Vanek) Factor price equalization if both countries produce both goods (Heckscher-Ohlin) Price change in goods benefits to factor intensively used in higher priced goods, and hurts other factor but gains > losses (Stolper-Samuelson) Increase in one factor increases production of good using it intensively and decreases production of other good (Rybczynski) ! Model is static, reality is dynamic : capital and technical progress accumulation…

49. Further readings and applications http://www.nber.org/digest/aug13/w18938.html Trade, Technology, and the Labor Market A $1,000 rise in import exposure per worker lowers the employment rate of non-college workers by an estimated 1.21 percentage points. Trade and technology have quite different effects on U.S. businesses, according to new research by David Autor, David Dorn, and Gordon Hanson. In Untangling Trade and Technology: Evidence from Local Labor Markets (NBER Working Paper No. 18938), they find that local labor markets exposed to rising Chinese import competition see significant declines in jobs, whereas those susceptible to computerization see a polarization of occupations, but no net job loss.David AutorDavid DornGordon Hanson18938 The authors also observe that job loss accelerated during the 2000s in labor markets hit by foreign competition, while the impact of computerization decelerated, at least in manufacturing. "Our analysis reveals a surprising degree of divergence between the labor market consequences of these two phenomena – both across industrial, occupational, geographic and demographic groups, and over time as the trajectory of these forces has evolved," they conclude. "Trade competition leads to sharp declines in local manufacturing employment, with corresponding growth in local unemployment and non-employment, particularly among workers without college education. In contrast, exposure to technological change has largely neutral effects on overall employment, yet leads to substantial polarization of occupational composition within sectors." To approximate local labor markets, the authors examine 722 commuting zones (CZs), covering the entire mainland United States, from 1990 to 2007. They determine how susceptible each of these CZs was to technological change, based on Census data on occupational patterns, and to Chinese competition, measured by the local market's industry mix in 1980. The impact of technology – or what the authors call "task-replacing technical change" through computerization – is spread throughout the United States. In contrast, those CZs affected by trade competition from China are geographically concentrated, leading to quite a bit of geographical disparity. 49

50. Trade, Technology and labor (cont’d) For example, the Providence, Rhode Island CZ -- a manufacturing hub -- experienced an increase of imported Chinese goods of $2,330 per worker between 1991 and 2000. Between 2000 and 2007, the value of Chinese goods that might otherwise have been made locally rose to $3,490 per worker. By contrast, the New Orleans CZ had few industries directly competing with China and saw only small increases in import exposure: $170 and $490 per worker respectively in those two time periods. Because the CZs are so disparate in terms of industry specialization, this regional approach makes it easier to identify the labor-market effects of trade shocks, which hit young and old, male and female, with roughly equal force. But the least educated are hit the hardest. A $1,000 rise in import exposure per worker lowers the employment rate of non-college workers by an estimated 1.21 percentage points; the impact on college workers is less than half that, 0.53 percentage points. These effects don't show up as much as a rise in the unemployment rate as they do in a decline in labor-force participation. By contrast, computerization hits women harder than men. A CZ at the 75th percentile of exposure to computerization typically sees a decline of 1.8 percentage points in the female employment-to-population ratio over a decade relative to a CZ at the 25th. "The effects of exposure to routinization also appear larger for older versus younger workers, though this difference is less precisely estimated," the authors write. This study also looks at what kind of workers are affected by these changes. For trade shocks, the impact is largest for routine-task intensive occupations, such as repetitive production and office clerical jobs. It is also significant for manual-task-intensive jobs, like vehicle driving, cleaning, and security. The effect is evident, but not significant, for abstract-task-intensive occupations, such as managerial and technical workers. For computerization, the only significant negative impact is on routine task-intensive occupations; it is as large as the impact of trade shocks for this group. "But these losses are largely offset by employment growth in abstract and manual-task-intensive occupations," the authors write. How can computerization have had such small, insignificant effects on manufacturing employment with all the labor-saving improvements of computer-aided manufacturing? Extending their study back to the 1980s, the authors find that computerization did have substantial impacts on job task composition in the 1980s and 1990s but not since then. In contrast, the effect of computerization in non-manufacturing industries has accelerated in that period, almost quadrupling from the 1980s to the 2000s. "Concurrent with the rapid growth of U.S. imports from China, the effect of trade competition on the manufacturing sector has become stronger over time, while the effect of technological change on employment composition in the manufacturing sector has subsided," the authors conclude. "Conversely, the impact of technology on the non- manufacturing sector is growing as technological change seems to be shifting from automation of production in manufacturing to computerization of information processing in knowledge-intensive industries." --Laurent Belsie The Digest is not copyrighted and may be reproduced freely with appropriate attribution of source. Replicate for European Countries ? What about wage adjustments ? 50