The Heckscher-Ohlin Model

Udayan Roy http://myweb.liu.edu/~uroy/eco41

BASIC ASSUMPTIONS

The Heckscher-Ohlin Assumptions Basics

There are
two countries, Home and Foreign two goods, Cloth and Food, and two resources, Labor and Capital
these are used to produce Cloth and Food

The Heckscher-Ohlin Assumptions Preferences

The preferences of all consumers in the world are identical. The preferences of any individual are such that the Marginal Rate of Substitution is independent of the scale of consumption.
The MRS of Wine for Cheese is the additional amount of Wine that would keep the individual's level of happiness unchanged even after the consumption of Cheese is reduced by one unit. Under this assumption, if the amounts of Cheese and Wine being consumed are, say, doubled, then the MRS remains unchanged. In other words, the MRS does not change if the ratio of the amounts of Cheese and Wine consumed, Cheese/ Wine, does not change.

The Ricardian Assumptions Preferences

The preferences of all consumers in the world are identical. For any individual, the Marginal Rate of Substitution is independent of the scale of consumption.
An individuals MRS of wine for cheese is the maximum amount of wine that he/she would be willing to pay for one unit of cheese. Under this assumption, if the amounts of Cheese and Wine being consumed are, say, doubled, then the MRS remains unchanged. In other words, the MRS does not change if the ratio of the amounts of Cheese and Wine consumed, Cheese/ Wine, does not change.

Marginal Rate of Substitution

Cheese consumed (C) 10 600 10 Wine consumed (W) 20 1200 5 CheeseWine Ratio (C/W) 0.5 0.5 2 MRSWC

2 2 1.6

The Heckscher-Ohlin Assumptions Markets

All markets are perfectly competitive.
That is, no buyer or seller of a commodity has the power to affect the price of the commodity by himself. More specifically, the market for a commodity is said to be perfectly competitive if:
There are many sellers There are many buyers All sellers sell the exact same product

Individuals make decisions so as to maximize happiness, whereas Firms make decisions so as to maximize profits

The Heckscher-Ohlin Assumptions Governments

Governments do not interfere with the smooth functioning of markets
There are no taxes, subsidies, tariffs, quotas, etc.

However, although there is free trade in goods and services, there is no crossborder movement of resources, such as labor

The Heckscher-Ohlin Assumptions Technology

Technological knowledge is the same in both countries Goods are produced (with capital and labor) using technologies that satisfy Constant Returns to Scale.
That is, if the producer of a commodity, say, doubles the amounts used of all resources, then the amount produced will have to double also.

The Heckscher-Ohlin Assumptions Factor Abundance

Home has a higher ratio of labor to capital than Foreign does.
That is, if KH, KF, LH, and LF denote the amounts of K (capital) and L (labor) that Home and Foreign are endowed with, then LH / KH > LF/ KF. L/K may be informally interpreted as the number of workers per machine. Home is said to be the labor-abundant country and Foreign is the capital-abundant country.

The Heckscher-Ohlin Assumptions Factor Intensities

The production of food is capital-intensive and the production of cloth is laborintensive
That is, the number of workers per machine (L/K) is always higher in cloth production than in food production

Prices of Goods
Let PC and PF denote the nominal prices of cloth and food. Then, PC/PF is the relative price of cloth (in units of food) and PF/PC is the relative price of food (in units of cloth)
See earlier lecture

Prices of Factors
Let w be the nominal price (or, wage) of labor. Let r be the nominal price (or, rent) of capital Then w/r is the relative price of labor (in units of capital) and r/w is the relative price of capital (in units of labor)
Example: If w = $10 per hour for one worker and r = $100 per hour for one machine, then the relative wage for one worker is 1/10 machines and the relative rent on a machine is 10 hours of labor.

Nominal Prices
The nominal price of a commodity is simply the number of dollars (or any other relevant unit of account) that must be paid to buy one unit of the commodity For example, the nominal price of labor also called the nominal wagemay be $8 per hour

Real Prices
The real price of commodity X, in units of commodity Y, is the amount of Y that costs the same as one unit of X For example, if the nominal price of labor is $8 per hour and the nominal price of a cup of coffee is $2, then the real price of labor is 4 cups of coffee per hour Real prices are also called relative prices

Real and Nominal Prices

Real Price of X, in units of Y, is equal to Nominal Price of X / Nominal Price of Y So, if w is the nominal wage and P is the nominal price of a cup of coffee, then the real wage is w / P. For example, if w is $8 per hour and P is $2, then the real wage is w / P = 8/2 = 4 cups of coffee per hour, as in the previous slide.

Figure 5-6: Factor Prices and Goods Prices

Relative price of cloth, PC/PF
FPGP

17

As labor becomes more expensive relative to capital, cloth, which is labor-intensive in production, finds itself at a disadvantage and becomes relatively more expensive compared to food

Wage-rent ratio, w/r

As both Home and Foreign use the same technologies, the same FPGP curve is applicable in both countries

Figure 5-6: Factor Prices and Goods Prices

Relative price of cloth, PC/PF
FPGP

Under free trade, the relative price of cloth will be the same in both countries Therefore, the wagerent ratio will also be the same in the two countries

17

Wage-rent ratio, w/r

Figure 5-5: Factor Prices and Input Choices

Wage-rent ratio, w/r Cloth production Food production

As labor becomes relatively more expensive, relatively more capitalis used in production

of both food and cloth

5

12

Machines per worker, K/L

But the number of machines per worker is always higher in food production, reflecting the assumption that food production is capital intensive

Figure 5-5: Factor Prices and Input Choices

Wage-rent ratio, w/r Cloth production Food production

As both Home and Foreign use the same technologies, these two curves must be true in both countries.

As free trade equalizes the wage-rent ratio worldwide, machines per worker in cloth production must be the same worldwide.
Same must be true for food production.
4 12 Machines per worker, K/L

Therefore, Foreign, which has more machines per worker than Home, must produce relatively more food

Figure 5-9: Relative Supplies

Relative price of cloth, PC/PF 17 RSFOREIGN RSHOME In Figure 5-5, we saw that at w/r = 5, Foreign must produce relatively more food and Home must produce relatively more cloth. In Figure 5-6 we saw that w/r =5 corresponds to PC/PF = 17. Therefore, Home must produce relatively more cloth at PC/PF = 17, or indeed at any other relative price.

As cloth becomes more expensive relative to food, the output of cloth will increase relative to food. Therefore, the relative supply curves slope upward.

Yards of cloth produced per calorie of food produced, QC/QF

Figure 5-9: Relative Demand

Relative price of cloth, PC/PF 17

The H-O assumptions about preferences imply that that consumer behavior can be summarized by this Relative Demand curve and that the same curve is true in both Home and Foreign

3
In this figure, when the price of a yard of cloth is 17 times the price of a calorie of food, the number of yards of cloth consumed is 3 times the number of calories of food consumed, for every individual worldwide. Why isnt the latter ratio different for different people?

Yards of cloth consumed per calorie of food consumed, QC/QF

Relative Demands
Lets say that Alex consumes 3 times as many yards of cloth as calories of food (relative demand is QC/QF = 3) when a yard of cloth is 17 times as expensive as a calorie of food (relative price PC/PF = 17) If Alexs income changes, his relative demand should not change because MRS is independent of the scale of consumption

Relative Demands
Since identical preferences have been assumed, if the relative price of cloth is PC/PF = 17, then Bettys relative demand must also be QC/QF = 3 irrespective of Bettys income Therefore, the same relative demand curve represents everybody Therefore, the same relative demand curve represents both Home and Foreign

Figure 5-9: Relative Supplies and Demands

Relative price of cloth, PC/PF RSFOREIGN RSHOME

Foreign

Home

The relative supplies and demands can be combined to find the autarky relative prices in Home and Foreign Clearly, they are different Therefore, trade will occur if it is allowed Since Home and Foreign differ only in their relative factor endowments, that difference must be the reason why trade occurs

RD Yards of cloth produced per calorie of food produced, QC/QF

Who will export what?

In autarky, the laborintensive good is relatively cheaper in the laborabundant country Therefore, under free trade, the labor-intensive good is exported by the labor-abundant country and the capital-intensive good is exported by the capital-abundant country
PC/PF

Foreign
autarky

Free Trade Home

Foreign : capital abundant, labor scarce Home: capital scarce, labor abundant Cloth: labor intensive production Food: capital intensive production

The Heckscher-Ohlin Theorem

To repeat, when trade occurs, the labor-abundant country (Home) exports the labor-intensive good (cloth) and The capital-abundant country (Foreign) exports the capital-intensive good (food) In general, each country exports the good that makes intensive use of the resource that is abundant in that country This is called the Heckscher-Ohlin Theorem
See the section Relative Prices and the Pattern of Trade in Chapter 5 of the textbook

Goods Prices: from autarky to free trade

In autarky, the laborintensive good is relatively cheaper in the laborabundant country Free trade makes relative prices equal everywhere Therefore, the laborintensive good becomes more expensive in the labor-abundant country, and less expensive in the labor-scarce country.
PC/PF

Foreign
autarky

Free Trade Home

Foreign : capital abundant, labor scarce Home: capital scarce, labor abundant Cloth: labor intensive production Food: capital intensive production

Figure 5-6: Factor Prices and Goods Prices

Relative price of cloth, PC/PF
FPGP

Fig. 5-9 showed that, in autarky, the relative price of cloth is higher in Foreign Therefore, in autarky, the wage-rent ratio must also be higher in Foreign Free trade makes the wage-rent ratio the same in the two countries

Foreign Free Trade Home

Home

Foreign Free Trade

Wage-rent ratio, w/r

Factor Prices: from autarky to free trade

In autarky, the wage-rent ratio is higher in the laborscarce country and lower in Foreign autarky the labor-abundant country Free Trade When autarky ends and free trade begins, the wage-rent Home ratio falls in the labor-scarce country and rises in the labor abundant country Foreign : capital abundant, labor scarce
Home: capital scarce, labor abundant Cloth: labor intensive production Food: capital intensive production

PC/PF

w/r

WHO GAINS AND WHO LOSES FROM GLOBALIZATION?

Real Wage and Real Rent

w w/PC w/PF r r/PC r/PF Nominal wage: currency earned per hour of a workers labor Real wage: yards of cloth purchasable with the nominal wage Real wage: calories of food purchasable with the nominal wage Nominal rent: currency earned per hour per unit of capital Real rent: yards of cloth purchasable with the nominal rent Real rent: calories of food purchasable with the nominal rent

Marginal Product of a Resource

The Marginal Product (MP) of labor in cloth production is the additional amount of cloth that would be produced if an additional unit of labor is employed
We can similarly define
Marginal Product of labor in food production, Marginal Product of capital in cloth production, and Marginal Product of capital in food production

Marginal Product of a Resource

See the Appendix to Chapter 4 of the textbook for more on the Marginal Product.

Example: Level of Resource Use

Suppose an additional worker produces an additional 5 yards of cloth in one hours work. Then MP = 5. Therefore, to make one additional yard of cloth, you need only 1/5 of a worker. In general, the labor needed to make one unit of cloth can be calculated as 1/MP Marginal Cost is the additional cost of an additional unit of output Therefore, MC = w (1/MP) = w/MP

Price = Marginal Cost

If P > MC at the current level of production, additional production would increase profit If P < MC at the current level of production, reduced production would increase profit Therefore, profit is maximized only if P = MC Therefore, if a good is being produced, P = MC must be true

Real Wage and Real Rent

Therefore, P = MC = w / MP Therefore, w/P = MP This implies that the real wage in units of, say, cloth is the Marginal Product of labor in the production of cloth Similarly, the real rent in units of food is the Marginal Product of capital in food production

w C MPL PC
r F MPT PF

Real Factor Rewards and Productivity

In general, the real payment to a resource is equal to its productivity (or, marginal product)
This is the main conclusion of the Marginal Productivity Theory of Income Distribution

Factor Use and Factor Productivity Labor-Abundant Country

Wage-rent ratio, w/r

Cloth production

We saw earlier that when autarky ends and free trade begins w/r rises in the labor- Foreign abundant country (Home). Therefore, Free trade More capital is used per worker
in cloth production and in food production
Home

Food production

This makes labor more productive and capital less productive Therefore,

Abundant resource benefits from globalization Scarce resource loses

w/PC and w/PF both increase, and r/PC and r/PF both decrease.

Machines per worker, Foreign : capital abundant, labor scarce K/L

Home: capital scarce, labor abundant Cloth: labor intensive production Food: capital intensive production

Factor Use and Factor Productivity Capital-Abundant Country

Wage-rent ratio, w/r

Cloth production

When autarky ends and free trade begins w/r falls in the capital-abundant country Foreign (Foreign). Therefore, Free trade Less capital is used per worker
in cloth production and in food production
Home

Food production

This makes labor less productive and land more productive Therefore,

Abundant resource benefits from globalization Scarce resource loses

w/PC and w/PF both decrease, and r/PC and r/PF both increase.

Machines per worker, Foreign : capital abundant, labor scarce K/L

Home: capital scarce, labor abundant Cloth: labor intensive production Food: capital intensive production

Trade: Who Gains and Who Loses?

In short, each countrys abundant resource benefits from trade and Each countrys scarce resource loses from trade

Factor Price Equalization

Free trade equalizes Wage-rent production Food the wage-rent ratio ratio, w/r production Therefore, the capital-per-worker ratio in cloth Foreign, autarky production is also equalized Free trade This equalizes the productivity of labor Home, autarky in cloth production in the two countries This equalizes w/PC in the two countries In a similar way, Machines w/PF, r/PC, and r/PF per worker, each become Foreign : capital abundant, labor scarce K/L equalized worldwide Home: capital scarce, labor abundant
Cloth: labor intensive production Food: capital intensive production
Cloth

Factor Price Equalization

PC/PF
Australia
autarky

w/r

(K/L)F (K/L)C w/PF

high high high

w/PC
high

r/PF

r/PC

high

high

low

low

Free Trade Belgium

autarky low

low

low

low

low

low

high

high

Australia: capital abundant, labor scarce Belgium: capital scarce, labor abundant Cloth: labor intensive production Food: capital intensive production

Factor Price Equalization Theorem

The Factor Price Equalization Theorem: When there is free trade in goods, the real reward for any resource (in units of either good) becomes the same in both countries!
An implication of this result is that if there is free trade in goods, resources will have no incentive to move from one country to another

Factor Price Equalization Theorem

Heckscher-Ohlin theory implies FPE. But does FPE imply that free trade will make everybody equally rich? Certainly not!
Not every individual is endowed with the same amount of resources

How accurate is the Heckscher-Ohlin theory?

Sadly, its not very accurate by itself
It explains North-South trade quite well But not trade within the North

But, if modified to take cross-country differences in technology into account, it fits the data well So, a theory that combines the insights of Ricardo and Heckscher-Ohlin might be best

The contribution of Heckscher-Ohlin theory

The theorys main contribution is to point out that cross-country differences in relative resource availability can explain trade It does not claim that differences in relative resource availability are the only reason why trade occurs

Were Done!
Any questions or comments?