TRADE AND RESOURCES: THE HECKSCHER-OHLIN MODEL

TRADE AND RESOURCES: THE HECKSCHER-OHLIN MODEL
4 1 Heckscher-Ohlin Model 2 Effects of Trade on Factor Prices 3 Extending the Heckscher-Ohlin Model 4 Conclusions TRADE AND RESOURCES: THE HECKSCHER-OHLIN MODEL

International Economics
Bertil Ohlin International Economics

International Economics
Chapter Outline Introduction Heckscher-Ohlin Model Assumptions No-Trade Equilibrium Free Trade Equilibrium Testing the Heckscher-Ohlin theorem: Leontief’s Paradox Effects of Trade on Factor Prices Effect of Trade on the Wage and Rental of Home Determination of the Real Wage and Real Rental Changes in the Real Wage and Rental: A Numerical Example International Economics

Heckscher-Ohlin Model
The HO model is a long run model because all factors of production can move between the industries. There are two countries, Home and Foreign. Each country produces two goods, computers and shoes. Production uses two factors of production, labor (L) and capital (K). We can add up the resources used in each industry to get the total for the economy. Capital in each good for each country K = KC + KS and K* = K*C + K*S Labor in each good for each country L = LC + LS and L* = L*C + L*S International Economics

Assumptions of the Heckscher-Ohlin Model
Both factors can move freely between industries, but not between countries. Capital must earn the same rental rate, R, in both industries. All labor earns the same wage in both industries. If not, then capital or labor would move to the industry where it received the higher rate. International Economics

Shoe production is labor-intensive; it requires more labor per unit of capital to produce shoes than computers, so that LS/KS > LC/KC. Computer production is capital-intensive—more capital per worker is used to produce computers than to produce shoes. Shoes use more labor per unit of capital. International Economics

Figure 4.1 Figure 4.1 Labor Intensity of Each Industry The demand for labor relative to capital is assumed to be higher in shoes than in computers, LS/KS >LC/KC. These two curves slope down just like regular demand curves, but in this case, they are relative demand curves for labor (that is, demand for labor divided by demand for capital). International Economics

Foreign is labor abundant; the labor-capital ratio in Foreign exceeds that in Home. Equivalently, Home is capital abundant L*/K* > L/K and K/L > K*/L* Here, we do not consider why the amount of resources differs across countries, but accept the differences as important determinants of why countries engage in trade. We focus on a particular case where Foreign is labor abundant and Home is capital abundant. International Economics

The final outputs, shoes and computers, can be traded freely, without restrictions, between nations, but labor and capital do not move between countries. We do not allow labor or capital to move between countries. International Economics

The technologies used to produce the two goods are identical across the countries. This is opposite of the assumption in the Ricardian model. It is not a realistic assumption, but it allows us to focus on a single reason for trade—the different amounts of labor and capital. International Economics

Consumer tastes are the same across countries, and preferences for computers and shoes do not vary with a country's level of income. A poorer country will buy less of both shoes and computers, but in the same ratio as a wealthier country facing the same prices. Again, although not a very realistic assumption, it allows us to focus attention on the differences in resources as the sole reason for trade. International Economics

Heckscher-Ohlin Model No Trade Equilibrium
We are going to use the differences in resources to predict the pattern of trade. We begin by looking at the equilibrium that exists in each country without trade. Production Possibility Frontiers Home is capital abundant and computer production is capital intensive. Home is capable of producing more computers than shoes. Foreign is labor-abundant and shoe production is labor-intensive. Foreign is capable of producing more shoes. International Economics

Heckscher-Ohlin Model No Trade Equilibrium
Figure 4.2 No-Trade Equilibria in Home and Foreign Figure 4.2 No-Trade Equilibria in Home and Foreign The Home production possibilities frontier (PPF) is shown in panel (a), and the Foreign PPF is shown in panel (b). Because Home is capital abundant and computers are capital intensive, the Home PPF is skewed toward computers. Home preferences are summarized by the indifference curve, U, and the Home no-trade (or autarky) equilibrium is at point A, with a low relative price of computers, as indicated by the flat slope of (PC /PS)A. Foreign is labor abundant and shoes are labor intensive, so the Foreign PPF is skewed toward shoes. Foreign preferences are summarized by the indifference curve, U*, and the Foreign no-trade equilibrium is at point A*, with a higher relative price of computers, as indicated by the steeper slope of (P*C /P*S)A*. International Economics

Heckscher-Ohlin Model Free Trade Equilibrium
Figure 4.3 Figure 4.3 (a): International Free-Trade Equilibrium at Home At the free-trade world relative price of computers, (PC/PS)W, Home produces at point B in panel (a) and consumes at point C, exporting computers and importing shoes. (Point A is the no-trade equilibrium.) The “trade triangle” has a base equal to the Home exports of computers (the difference between the amount produced and the amount consumed with trade, QC2 − QC3). The height of this triangle is the Home imports of shoes (the difference between the amount consumed of shoes and the amount produced with trade, QS3 − QS2). International Economics

Figure 4.3 Figure 4.3 (b): International Free-Trade Equilibrium at Home In panel (b), we show Home exports of computers equal to zero at the no-trade relative price, (PC/PS)A, and equal to (QC2 − QC3) at the free-trade relative price, (PC/PS)W. International Economics

Figure 4.4 Figure 4.4 (a): International Free-Trade Equilibrium in Foreign At the free-trade world relative price of computers, (PC/PS)W, Foreign produces at point B* in panel (a) and consumes at point C*, importing computers and exporting shoes. (Point A* is the no-trade equilibrium.) The “trade triangle” has a base equal to Foreign imports of computers (the difference between the consumption of computers and the amount produced with trade, Q*C 3 − Q*C2). The height of this triangle is Foreign exports of shoes (the difference between the production of shoes and the amount consumed with trade, Q*S2 − Q*S3). International Economics

Figure 4.4 Figure 4.4 (b): International Free-Trade Equilibrium in Foreign In panel (b), we show Foreign imports of computers equal to zero at the no-trade relative price, (P*C/P*S)A*, and equal to (Q*C3 − Q*C2) at the free-trade relative price, (PC/PS)W. International Economics

Figure 4.5: Determination of the Free-Trade World Equilibrium Price The world relative price of computers in the free-trade equilibrium is determined at the intersection of the Home export supply and Foreign import demand, at point D. At this relative price, the quantity of computers that Home wants to export, (QC2 − QC3), just equals the quantity of computers that Foreign wants to import, (Q*C3 − Q*C2). International Economics

Pattern of Trade Home exports computers—the good that uses their abundant factor of production intensively—capital. Foreign exports shoes—the good that uses their abundant factor of production intensively—labor. This is the Heckscher-Ohlin Theorem: With two goods and two factors, each country will export the good that uses intensively the factor of production it has in abundance, and will import the other good. International Economics

Wassilly Leontief (1906-1999) Nobel Prize 1973
Does the H-O model actually explain trade patterns ? Leontief assumed and tested The US is well endowed with capital The US should export capital intensive goods and import labour intensive goods The opposite appeared to be true – hence the Leontief paradox International Economics

Leontief’s Test Table 4.1 Leontief’s Test Leontief used the numbers in this table to test the Heckscher-Ohlin theorem. Each column shows the amount of capital or labor needed to produce $1 million worth of exports from, or imports into, the United States in As shown in the last row, the capital-labor ratio for exports was less than the capital labor ratio for imports, which is a paradoxical finding. Source: Wassily Leontief, 1953, “Domestic Production and Foreign Trade: The American Capital Position Re-examined,” Proceedings of the American Philosophical Society, 97, September, 332–349. Reprinted in Richard Caves and Harry G. Johnson, eds., 1968, Readings in International Economics, Homewood, IL: Irwin. International Economics

Why would this paradox exist? U.S. and foreign technologies are not the same as assumed. By focusing only on labor and capital, land abundance in the U.S. was ignored. No distinction between skilled and unskilled labor. The data for 1947 could be unusual due to the recent end of WWII. The U.S. was not engaged in completely free trade as is assumed by the HO model. International Economics

Several of the explanations depend on having more than two factors of production. The U.S. is land abundant, and much of what it was exporting might have been agricultural products which use land intensively. It might also be true that many of the exports used skilled labor intensively. More current research was aimed at redoing the Leontief test. The “extended” HO model works much better for the same year of data. International Economics

Effects of Trade on Factor Prices
How do the changes in pre-trade and post-trade relative prices affect the wage paid to labor in each country and the rental earned by capital? Remember the relative price of computers in Home increase, causing them to export computers. The relative price of computers in Foreign decreases, causing them to import computers. This change in production also changes demand for factors of production, and factor returns will change too. International Economics

Economy-Wide Relative Demand for Labor The quantities of labor and capital used in each industry add up to the total available labor and capital. K = KC + KS and L = LC + LS We can divide total labor by total capital to get the relative supply equal to the relative demand. Relative Demand Relative Supply International Economics

Figure 4.6 Determination of Home Wage/Rental The economy-wide relative demand for labor, RD, is an average of the LC /KC and LS/KS curves and lies between these curves. The relative supply is shown by a vertical line because the total amount of resources in Home is fixed. The equilibrium point A determines the wage relative to the rental, W/R. International Economics

Increases in the Relative Price of Computers PC/PS increases at Home. Production shifts away from shoes to computers. Shoe production decreases and computer production increases. Labor and capital both move from shoe production to computer production. Relative labor supply does not change. Since capital has shifted to the computer industry, the relative demand for labor changes. The terms used in the weighted average, KC/K and KS/K, change. International Economics

Initial equilibrium before change in relative price of computers The real wage falls which increases the amount of workers per unit of capital in both industries The increase in the relative price of computers causes the relative demand curve to shift left—toward computers Figure 4.8 Effect of a Higher Relative Price of Computers on Wage/Rental An increase in the relative price of computers shifts the economy-wide relative demand for labor, RD1, toward the relative demand for labor in the computer industry, LC /KC. The new relative demand curve RD2 intersects the relative supply curve for labor at a lower relative wage, (W/R)2. As a result, the wage relative to the rental falls from (W/R)1 to (W/R)2. The lower relative wage causes both industries to increase their labor capital ratios, as illustrated by the increase in both LC /KC and LS/KS at the new relative wage. International Economics

We can use our earlier equation for relative supply and demand to show the response to the increase in the relative price of computers, PC/PS. Relative Supply No change Relative Demand No change in total International Economics

Determination of the Real Wage and Real Rental. Who gains and who loses from the change in the relative price of computers? We need to determine the change in the real wage and real rental. The change in the quantity of shoes and computers that each factor of production can purchase. International Economics

Change in the Real Rental Because the labor/capital ratio increases in both industries, the marginal product of capital increases. There are more people to work with each unit of capital. The rental rate of capital is determined by its marginal product. R = PC*MPKC R = PS*MPKS Capital can move freely between industries in the long run. The rental rate will be equalized across industries. International Economics

Change in the Real Rental Both marginal products of capital increase. Rearranging the previous equation we get: MPKC = R/PC and MPKS = R/PS R/PC measures the quantity of computers that can be purchased with the rental. R/PS measures the quantity of shoes that can be bought with the rental. Since the MPKC and MPKS both increase, R/PS and R/PC must increase as well. Therefore, capital owners are clearly better off when the relative price of capital increases. International Economics

Change in the Real Rental Therefore, capital owners are clearly better off when the relative price of capital increases. Computers are the capital intensive industry and the relative price of capital has increased. An increase in the relative price of a good will benefit the factor of production used intensively in producing that good. International Economics

Change in the Real Wage Again we make use of the fact that the labor/capital ratio increases in both industries. The law of diminishing returns tells us the marginal product of labor must decrease in both industries. As before the wage is determined by the marginal product of labor and the price of goods. W = PC*MPLC and W = PS*MPLS Rearranging MPLC = W/PC and MPLS = W/PS International Economics

Change in the Real Wage W/PC is the quantity of computers that can be purchased with the wage. W/PS is the quantity of shoes that can be purchased with the wage. MPLC and MPLS decrease, so W/PC and W/PS decrease. Labor is clearly worse off due to the increase in the price of computers. International Economics

The Stolper-Samuelson Theorem: In the long run when all factors are mobile, an increase in the relative price of a good will increase the real earnings of the factor used intensively in the production of that good and decrease the real earnings of the other factor. Therefore, in the Heckscher-Ohlin model: The abundant factor gains from trade, and the scarce factor loses from trade. International Economics

Changes in the Real Wage and Rental: A Numerical Example Suppose we have the following data: Computers Sales Revenue = PCQC = 100 Earnings of labor = WLC = 50 Earnings of capital = RKC = 50 Shoes Sales Revenue = PSQS = 100 Earnings of labor = WLS = 60 Earnings of capital = RKS = 40 International Economics

Shoes are more labor-intensive than computers. The share of total revenue paid to labor in shoes (60%) is more than the share in computers (50%). When trade opens, the relative price of computers, PC, increases while the price of shoes, PS, does not change. Computers: % increase in price = ΔPC/PC = 10% Shoes: % increase in price = ΔPS/PS = 0% International Economics

Our goal is to see how the increase in the relative price of computers translates into long run changes in the wage and rental. Rental on capital is calculated by taking total sales revenue in each industry, subtracting the payments to labor, and dividing by the amount of capital: International Economics

Since the price of computers has risen, ΔPC > 0 and ΔPS = 0. Using this in the last equations: International Economics

We can rewrite the last equation in percentage changes: International Economics

Plugging in data from before Our goal is to find out by how much rental and wage change given changes in the relative price of the final goods Solve for 2 unknowns with 2 equations International Economics

After solving we get: (ΔW/W) = -(20%/0.5) = -40% When the price of computers increases by 10%, the wage falls by 40% Labor can no longer afford to buy as many computers or shoes. The real wage, measured in terms of either good, has fallen, so labor is worse off. International Economics

We can also see: (ΔR/R) = -(ΔW/W)(60/40) = 60% Rental on capital increases by 60% when the price of computers rises by 10% Owners of capital can afford to buy more of both computers and shoes. The real rental measured in terms of either good has gone up, and capital owners are clearly better off. International Economics

General Equation for the Long-Run Change in Factor Prices In the long run we can summarize as follows: For an increase in PC ΔW/W < 0 < ΔPC/PC < ΔR/R Real wage falls, real rental increases For a decrease in PC ΔR/R < ΔPC/PC < 0 < ΔW/W Real rental rate falls, real wage increases For an increase in PS ΔR/R < 0 < ΔPC/PC < ΔW/W Real rental falls, real wage increases International Economics

These equations relating the changes in product prices to change in factor prices are sometimes called the “magnification effect.” They show how changes in the prices of goods have magnified effects on the earnings of factors. Even modest fluctuations in the relative prices of goods on world markets can lead to exaggerated changes in the long-run earnings of both factors. This shows why some are opposed to trade and some support it. International Economics

TRADE AND RESOURCES: THE HECKSCHER-OHLIN MODEL

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