INTERNATIONAL ECONOMICS

Hecksher-Ohlin
Preview
— Theory:

— Autarky

— Trade in the Heckscher-Ohlin model

— Empirical evidence

— Practice:

— Problem Set H-O

Introduction
— In addition to differences in labor productivity, trade occurs due to
differences in resources across countries.
— Ex. Canada exports forest products to the U.S. not only because:
— Its lumberjacks are more productive, but also …
— Forested land per capita is greater

— The Heckscher-Ohlin theory argues that trade occurs due to

differences in labor, labor skills, physical capital, capital, or other
factors of production across countries.
— Countries have different relative abundance of factors of production.
— Production processes use factors of production with different relative
intensity.
Two-Factor Heckscher-Ohlin Model
1. Two countries: home and foreign.

2. Two goods: computers and food.

3. Two factors of production: labor and capital.

4. The mix of labor and capital used varies across goods.

5. The supply of labor and capital in each country is constant and

varies across countries.

6. In the long run, both labor and capital can move across sectors,
equalizing their returns (wage and rental rate) across sectors.
The input markets…
Choosing mix of Capital and Labor

KF An isoquant represents the amount of

Isocost lines, capital and labor needed to produce a
slope w/r certain number of units of food
KF/LF (for example, the unit isoquant represents the
quantity of capital and labor needed to produce one
unit of food).

Unit isoquant
An isocost shows all combinations of capital
and labor which cost the same total amount.
C = rK + wL
K = C/r - (w/r)L
LA Thus, they are lines with slope -w/r

Given w and r, the firm minimizes the

cost subject to the constraint of The line which goes from the origin through
producing one unit. It corresponds to the the tangency point represents the KF/LF ratio
lowest isocost tangent to the unit isoquant. used to produce food, given factor prices
w/r.
Relationship between Prices and Use of Inputs

Start in the equilibrium point 1.

KF
KF1/LF1 Now increase the cost of capital, r.
The optimal amount of inputs shifts
1 to point 2: the firm uses more labor
and less capital.
That is, KF2/LF2 < KF1/LF1
-(w/r)1 KF2/LF2
2
-(w/r)2
The same comparative statics take
place if the cost of labor, w,
LF decreases.
Relationship between Prices and the Relative Use of Inputs

w/r For each good, food and computer,

Food there exists a relationship between the
relative price of inputs, w/r, and the
Computers
relative use of inputs, K/L

Assume that the computer curve is to

the right of the food curve: that is, given
a ratio w/r, computers use relatively
more capital.

In that case, the production of

computers is relatively intensive in
K/L capital and the production of food
As we have just seen, an increase in the is relatively intensive in labor.
relative cost of labor (w/r) increases the
relative use of capital (K/L).
Determination of the Relative Price of Inputs: the Lerner Diagram

Isovalue computers (1 €) Each isovalue corresponds to an isoquant. For

K example, if PF = 0.5 , the isovalue of 1 € corresponds
to isoquant 2.
KC/LC
When the price of any good changes, the position of
the isovalue curve shifts.

If the economy produces both goods and

Isovalue food (1 €) there is perfect competition, the cost of
producing each good will also be one euro.
(PF = 0 y PC = 0)
KF/LF
That is, the lowest possible cost that allows us
to produce one euro of each of the goods is
-(w/r) the same. Thus, producing 1 euro of each of
the goods must happen on the same isocost,
L
rKF + wLF = rKC + wLC
Isovalue curves: combination of inputs There is a UNIQUE isocost, tangent to the
needed to produce a given value of each two isovalue curves.
good, for example, one euro.
The slope of this isocost is the relative price of
inputs, -w/r.
Then, for each PF/PC we can find w/r (see
next slide).
 Relationship between Relative Prices and Inputs: the Lerner Diagram

Assume that PC = 1. This normalization is the

same as representing all units in terms of K
CC
units of computers. (1/r)2

(1/r)1
The initial situation is represented by the red
curves. The relative price of inputs is (w/r)1.
-(w/r)1
Note: since the isocost is wL+rK=1, the
vertical intercept has slope (1/r)1 and the
horizontal (1/w)1.

-(w/r)2 FF1
Keeping PC=1, an increase in PF/PC FF2
represents an increase in PF. To produce 1 € (1/w)2 (1/w)1 L
of food, we need less capital and labor, so
that the isovalue shifts from FF1 to FF2. Given the normalization, an increase in PF/PC
means that the wage buys more food and
The isocost also changes: (w/r)2 > (w/r)1. the rental rate buys less food.
Moreover, the change in the intercepts
implies that: w2 > w1 and r2 < r1.
 Stolper-Samuelson Theorem
§ In the above exercise, we saw that an increase in PF/PC implies that the wage buys more food and
the rental rate buys less food.

§ If we had chosen the other possible normalization (PF=1), we would have found that an
increase in PF/PC (which would be equivalent to a decrease in PC) implies that the wage
buys more computers and the rental rate buys less computers.

§ That is, an increase in PF/PC allows the workers to buy more of both goods and the capital
owners to buy less of both goods.

STOLPER SAMUELSON THEOREM

An increase in the relative price of a good will increase the real return to the factor used
intensively in the production of that good, and will decrease the real return to the other factor.

IMPORTANT: The Stolper-Samuelson Theorem relates changes in the relative price of goods
to changes in the REAL return of factors (and not simply to the absolute price and/or the
relative price of factors).
Alternative Analysis of Stolper-Samuelson
Food
w/r

Computers

(w/r)2

(w/r)1

(PF/PC)2 (PF/PC)1 (KF/LF)1 (KF/LF)2 (KC/LC)1 (KC/LC)2 K/L

PF/PC
The left-hand side panel represents the
relationship between the relative price of
goods and factors.
The right-hand side panel represents the
relationship between the relative price of
factors and their relative use.
An increase in the relative price of the good
intensive in labor (food) increases the relative
price of labor (i.e., w/r).
Moreover, the production of each good
becomes more intensive in capital: KF/LF and
KC/LC increase.
 Alternative Analysis of Stolper-Samuelson
§ In the last figure we saw that an increase in the relative price of food (PF/PC), raises the relative reward of labor
(w/r), which increases the optimal (K/L) ratio in both sectors.

§ In a competitive economy, nominal wages are equalized in both sectors:

w = PFMPLF = PCMPLC

§ We define the “real” wage in terms of food as

ωF= w / PF = MPLF

§ And the real wage in terms of computers as

ωC= w / PC = MPLC

— An increase in PF/PC , raises KF/LF and therefore increases both MPLF, and ωF. For the same
reason, ωS also rises. Thus, the real wage rises.

— Similarly, one can prove than an increase in PF/PC, reduces the real rental rate of capital.
Allocation of Factors of Production

LC
OC
KF + KC = K The width of the box represents the
amount of labor available in the
LF + LC = L economy and the height represents
the capital. Each point in the box
represents a possible allocation of
inputs between sectors.
F

KF KC
Given PF/PC, we know KF/LF and
KC/LC. From the origin OF we
draw a line with slope KF/LF and
from OC we draw a line with slope
C KC/LC.
OF LF The intersection between both
lines is the allocation of inputs in
We have seen how the relative price of factors and this economy.
the ratio K/L was determined for each good. Now
we investigate how they are allocated between
sectors.
Question: Can we end up outside the box?
 Introduction to the Rybczynski Theorem

L2C
O2C An increase in the endowment
of capital, raises the height of
L1C
the box. The origin of the
O1C production of computers is now
O2C.
Keeping PF/PC constant, the line
with slope KC/LC shifts up in a
parallel fashion.
F In the new equilibrium (point 2),
1 K1 more of both inputs are used in
K1 F C

2 the production of computers.

K2 F K2 C Thus, the production of
computers increases.
C2
C1 Less of both inputs are devoted
OF L2F L1F
to the production of food. So, its
production decreases.
In this exercise we see how an increase in the
endowment of capital changes the allocation of inputs
in each sector and the production of both goods.
 Alternative Analysis of Rybczynski

QC Another way of interpreting an increase in the

endowment of capital is through the
production possibility frontier.
2
Y2 C Slope -(PF/PC)
An increase in the endowment of capital
causes the production possibility frontier to
move outward, but more in the direction of
computers than in the direction of food. There
is a biased expansion of the production
Y1 C 1
possibility frontier.

Given PF/PC, an increase in the endowment of

capital increases the production of computers
Y2 F Y1 F
QF and decreases the production of food.
Rybczynski Theorem

RYBCZYNSKI THEOREM

Given relative prices, an increase in a factor endowment will increase output in the
sector that uses that factor intensively, and will decrease output in the other sector.

Given relative prices, an increase in the relative endowment of a factor, will

relatively increase output in the sector that uses that factor intensively.
 Production Possibility Frontiers

YC
Remember that we have two countries Production
(Spain and Poland). possibility frontier
in Spain
The only difference is that Spain is relatively
capital abundant: K/L > K*/L*.

The production possibility frontiers are such

that, given prices, Spain (Poland) produces
relatively more computers (food). YF
Y*C
Production
This is an illustration of the Rybczynski possibility froniter
Theorem. in Poland

Y*F
Relative Prices under Autarky

Relative supply: the relative shapes of the PF /PC RS

production possibility frontiers of both
countries imply that the relative supply of RS*
food in Poland is higher than in Spain.
PF /PC

Relative demand: if preferences are P*F /P*C

identical and homothetic, then the relative RD=RD*
demand is the same in both countries.
YF /YC

Prices under autarky: the relative price of Y*F /Y*C

food is lower in Poland:
(PF /PC)A > (P*F /P*C)A
Road Map
— Theory:

— Autarky

— Trade in the Heckscher-Ohlin model

— Empirical evidence

— Practice:

— Problem Set H-O

Relative Prices under Free Trade

Relative supply: will be between RS and PF /PC RS

RS* (depending on the relative size of both RSFT
countries) RS*

PF /PC
Relative demand: the same
(PF/PC)FT
P*F /P*C

Relative prices: relative prices will converge RD=RD*=RDFT

(PF /PC)A ≥ (P*F /P*C)FT ≥ (P*F /P*C)A

YF /YC

Y*F /Y*C
Pattern of trade: given that (PF /PC)A > (P*F /P*C)A, Spain exports computers and
Poland exports food.

HECKSCHER-OHLIN THEOREM
Each country exports that good which intensively uses the factor the country is
relatively abundant with.

Gains from trade: the terms of trade of each country improves, thus, both countries
gain from trade.
Gains from Trade

Autarky: Production (YA) equals

SPAIN consumption (CA)
QC

Free Trade: The relative price PF/PC

YFT
falls.
CFT
- (PF/PC)FT
YA=CA Spain produces more computers than
before (the production point, YFT, moves
up).
CA The new consumption point is on a
- (PF/PC)A higher indifference curve. Spain
consumes more food (substitution and
wealth effect go in the same direction).
QF The change in the consumption of
computers is indeterminate (substitution
and wealth effects go in opposite
directions).
 Income Distribution

§ After trade liberalization, the relative price of food falls (rises) in Spain (Poland).

§ The Stolper-Samuelson Theorem implies that:

§ Spain: real wage falls and rental rate rises.

§ Poland: real wage rises and rental rate falls

§ Workers in Spain will be against trade. In Poland capital owners will be against.
Factor Price Equalization (FPE)
Food
w/r

Computers
(w/r)

(w/r)L
C

(w*/r*)

(K*F/L*F) (K* /L* ) (KC/LC)

PF/PC (PF/PC) (P*F/P*C) (KF/LF) C C K/L
(PF/PC)FT (KF/LF)FT (KC/LC)FT

Convergence in price of goods, due to free trade, implies convergence in relative factor
returns (w/r) and relative use of factors in each sector (KF/LF and KC/LC).
 FPE
§ In the last figure we saw that free trade brings about equalization of relative factor prices (w/r) and
relative use of factors (KA/LA y KS/LS).

§ It is straighforward to see that absolute factor prices also converge. Remember that
nominal wages can be written as
w = PFMPLF = PCMPLC
w* = P*FMPL*F = P*CMPL*C

§ With free trade, PF=P*F and PC=P*C, and since KF/LF=K*F/L*F and KC/LC=K*C/L*C, it follows
that PFMPLF = P*FMPL*F and PCMPLC,= P*CMPL*C , so that
w = w*

§ Obviously, given that prices and nominal wages converge, real wages also converge:
ω= ω*

§ Following the same steps, it is easy to see that the rental rate of capital also converges,
both in real and nominal terms.
 FPE Theorem

FPE THEOREM

When there are no barriers to trade, technologies are identical and both countries
produce both goods, we have factor price equalization.
 Factor Mobility and Goods Mobility

Compare the following cases

§ Case 1: We allow factor mobility across countries but not trade in goods.

§ We know that in autarky ω > ω* (real wage) and ρ < ρ* (real return to capital).
§ With factor mobility, workers move to Spain and capital moves to Poland.
§ In equilibrium, ω = ω* and ρ = ρ* (this happens when K/L = K*/L*).

§ Case 2: We allow trade in goods but factors cannot move across countries.

§ We have seen that trade in goods brings about FPE, ω = ω* y ρ = ρ*, WITHOUT THE
NEED OF FACTOR MOBILITY.
Road Map
— Theory:

— Autarky

— Trade in the Heckscher-Ohlin model

— Empirical evidence

— Practice:

— Problem Set H-O

Empirical Evidence of the Heckscher-Ohlin Model

— Because the Heckscher-Ohlin model predicts that factor prices

will be equalized across trading countries, it also predicts that
factors of production will produce and export a certain quantity
goods until factor prices are equalized.
— In other words, a predicted value of services from factors of production will
be embodied in a predicted volume of trade between countries.
Empirical Evidence of the Heckscher-Ohlin Model (cont.)

— But because factor prices are not equalized across countries, the
predicted volume of trade is much larger than actually occurs.
— A result of missing trade discovered by Daniel Trefler.

— The reason for this missing trade appears to be the assumption

of identical technology among countries.
— Technology affects the productivity of workers and therefore the value of
labor services.
— A country with high technology and a high value of labor services would not
necessarily import a lot from a country with low technology and a low value
of labor services.
Empirical Evidence of the
Heckscher-Ohlin Model (cont.)
— Contrast the exports of labor-abundant, skill-scarce nations
in the developing world with the exports of skill-abundant,
labor-scarce (rich) nations.
— The exports of the three developing countries to the United
States are concentrated in sectors with the lowest skill-intensity.
— The exports of the three skill abundant countries to the United
States are concentrated in sectors with higher skill intensity.
Export Patterns for a Few Developed and Developing Countries, 2008–2012
Road Map
— Theory:

— Autarky

— Trade in the Heckscher-Ohlin model

— Empirical evidence

— Practice:

— Problem Set H-O

North-South Trade and Income Inequality
— Over the last 40 years, countries like South Korea, Mexico, and
China have exported to the U.S. goods intensive in unskilled labor
(ex., clothing, shoes, toys, assembled goods).
— At the same time, income inequality has increased in the U.S., as
wages of unskilled workers have grown slowly compared to those
of skilled workers.
— Did the former trend cause the latter trend?
North-South Trade and Income Inequality (cont.)
— The Heckscher-Ohlin model predicts that owners of relatively
abundant factors will gain from trade and owners of relatively
scarce factors will lose from trade.
— Little evidence supporting this prediction exists.

1. According to the model, a change in the distribution of income

occurs through changes in output prices, but there is no
evidence of a change in the prices of skill-intensive goods
relative to prices of unskilled-intensive goods.
North-South Trade and Income Inequality (cont.)
2. According to the model, wages of unskilled workers should
increase in unskilled labor abundant countries relative to wages
of skilled labor, but in some cases the reverse has occurred:
— Wages of skilled labor have increased more rapidly in
Mexico than wages of unskilled labor.
— But compared to the U.S. and Canada, Mexico is supposed
to be abundant in unskilled workers.