International Trade

Lecture 12: Heckscher-Ohlin Model of Trade

International Trade 1 / 28
Today’s Plan

1 HO model: Main Assumptions

2 HO model: Production and Factor Prices in Equilibrium
3 Numerical Example
4 Two-Country Equilibrium

International Trade 2 / 28
Motivation

While world trade is partly explained by differences in labor

productivity, it also reflects differences in countries’ resources
Canada export forest products to the US not because lumberjacks are
relatively more productive but because Canada has more land per
capita
US exports orange juice to Canada not because its Orange farmers
are inherently more productive but because it is endowed with good
weather in Florida
The Heckscher-Ohlin theory emphasizes resource differences as the
only source of trade

International Trade 3 / 28
Main Assumptions

We now study a model of trade where all factors of production are

flexible in the long run
The technologies used to produce different goods will use different
factors relatively more intensively
This model emphasizes differences across countries in aggregate
factor abundance
For simplicity, we will mostly abstract from differences in technologies
across countries
With more than one factor and differences in production technologies
across sectors (different relative factor intensities), differences in
factor abundance are enough to generate differences in country PPFs
and relative supply curves — and hence a pattern of comparative
advantage

International Trade 4 / 28
The Heckscher-Ohlin Model

International Trade 5 / 28
Main Assumptions: Production

The technologies for producing C and F are represented by the

production functions QC = FC (KC , LC ) and QF = FF (KF , LF )
Production of C is labor intensive relative to F recap

Both labor and capital can move across sectors, and hence must be
paid same factor prices in both sectors
Subject to endowment constraints L = LC + LF , K = KC + KF
Like in the specific factor model, for fixed relative price pC /pF labor
allocation (LC , LF ) satisfies pC MPLC = pF MPLF .
HO model should also find an equilibrium allocation of capital
( KC , KF ) .
We need to determine jointly the equilibrium allocation of capital and
labor, as well as the factor prices that sustain that allocation.

International Trade 6 / 28
Unit Input Used

We assume that production functions have constant returns to scale

Recall that in this case firms use the same unit amount of labor and
capital independently of the level of production Input choice
aKC = capital used to produce 1 unit of cloth
aLC = labour used to produce 1 unit of cloth
aKF = capital used to produce 1 unit of food
aLF = labour used to produce 1 unit of food

International Trade 7 / 28
Input Use vs Requirement

We speak of the quantity of capital or labour used rather than

required, to produce a unit of cloth or food
The reason is that there is some room for choice in the use of inputs
For example, if you want to produce a car, you can use one machine
and you would only need one worker. But if you use only workers, you
need 10 of them.

International Trade 8 / 28
Aggregate Production and Factor Prices
Factor prices and unit input use determine goods prices
Marginal cost pricing implies (zero-profit assumption)
pC = waLC + raKC
pF = waLF + raKF
1-1 relationship between factor prices (w , r ) and goods prices
(pC , pF ), which can be inverted to determine (w , r ) as a function of
(pC , pF )
Unit input use determine factor allocations and production
LC + LF = L QC aLC + QF aLF = L
⇔
KC + KF = K QC aKC + QF aKF = K
Given (aLC , aLF , aKC , aKF ), this can be solved for (QC , QF ) and
hence (LC , LF , KC , KF )
This analysis assumes that both C and F are produced
International Trade 9 / 28
Factor Price Equalization Theorem

We just saw that there is a 1-1 relationship between goods prices and
factor prices
Changes in factor endowments have no effects on factor prices
— This is referred to as ‘factor price insensitivity’
If countries produce both goods with the same technologies and face
the same goods prices, then they will share the same factor prices
— This is referred to as ‘factor price equalization theorem’
In these cases, trade in goods is a (perfect) substitute for trade in
factors, which equalizes those returns across countries

International Trade 10 / 28
Relative Factor Prices and Relative Factor Demands
Recall that the relative factor price will determine relative
employment levels in both sectors:

The production of C is labor intensive relative to the production of F

On the other hand, the aggregate relative supply of factors
L/K = (LC + LF )/(KC + KF ) is fixed by the country’s factor
endowments
What happens if the economy is completely specialized in C or F ?
What can be said about the equilibrium range of w /r when both C
and F are produced?
International Trade 11 / 28
Relative Factor Prices and Relative Factor Demands

Just like the case of relative demand curves for goods, the aggregate
relative demand curve for factors is a weighted average of the relative
demand for factors in each sector:

One can write L/K as a weighted average of LC /KC and LF /KF

L L + LF L K L K
= C = C C + F F
K K KC K KF K

International Trade 12 / 28
Relative Factor Prices and Relative Factor Demands

The relative wage w /r is thus determined by the allocation of

production between C and F

What happens as economy produces relatively more C (and less F )?

The aggregate relative demand for L rises and w /r increases
w /r increase induces firms to substitute L with K : LC /KC & and
LF /KF &
How can aggregate L/K remain constant?
International Trade 13 / 28
Relative Factor Prices and Relative Production

One can graphically show the relationship between relative production

QC /QF and the relative wage w /r :

International Trade 14 / 28
Relative Good Prices and Relative Production

International Trade 15 / 28
Relative Factor Prices and Relative Good Prices

What happens as pC /pF increases between p 1 and p 2 ?

What happens when pC /pF < p 1 or pC /pF > p 2 ?

International Trade 16 / 28
Numerical Example

International Trade 17 / 28
Production

Food and Cloth are produced with Labor (L) and Capital (K )
A unit of Cloth is produced with 2 parts Labor for 2 parts Capital
A unit of Food is produced with 1 part Labor for 3 parts Capital
The prices of Food (pF ) and Cloth (pC ) are fixed
You have a given supply of both Labor (L = 2000) and Capital
(K = 3000)
Important questions:
What are the prices of Capital and Labor?
What is the output of Food and Cloth?

International Trade 18 / 28
Factor Prices
Start with the opposite problem: you can purchase Labor and Capital
at prices w and r — What is the competitive price for the goods?

pC = 2w + 2r

pF = w + 3r

International Trade 19 / 28
Factor Prices
Start with the opposite problem: you can purchase Labor and Capital
at prices w and r — What is the competitive price for the goods?

pC = 2w + 2r

pF = w + 3r

This can be inverted to obtain the value of Labor and Capital

3 1
w= pC − pF
4 2
1 1
r=pF − pC
2 4
So when pC % then w % and r &
Which good production is relatively Labor-intensive?
International Trade 19 / 28
What to Produce?

How should you split your Capital and Labor supply between the
production of Food and Cloth?
Recall factor allocation and production determination from unit input
requirements:

2QC + 3QF = K Q = 43 L − 14 K
⇒ C if QC > 0 and QF > 0
2QC + QF = L QF = 12 K − 12 L

In our example, K = 3000 and L = 2000, so QC = 750 and

QF = 500
Why don’t production levels depend on good prices?
Would it ever make sense not to produce/sell Food or Cloth?

International Trade 20 / 28
Production Possibility Frontier

Why don’t production levels depend on good prices?

Would it ever make sense not to produce/sell Food or Cloth?
What does Relative Supply curve look like?

International Trade 21 / 28
Two Country Trade Equilibrium

We now introduce a second country and study the free trade

equilibrium
Both countries share the same technologies for producing
Consumers in both countries share the same homothetic preferences:
same world and country relative demand curves
The two countries differ in their relative factor abundance: we assume
that
Note that this does not imply anything about absolute levels of
factors!

International Trade 22 / 28
Relative Factor Abundance and Factor RD Curves

Differences in factor abundance induce differences in the range of

possible equilibrium factor prices
There is a range of free trade relative goods prices that is consistent
with incomplete specialization in both countries
Recall that when both goods are produced in both countries, then free
trade leads to factor price equalization across countries
International Trade 23 / 28
Relative Factor Abundance and Factor RD Curves

Whenever both goods are produced, differences in factor abundance

then lead to differences in aggregate relative factor demand

At same w /r , the higher (relative) foreign supply of labor is employed

by shifting production towards C (which is more labor intensive)

International Trade 24 / 28
Relative Factor Abundance and Relative Goods Supply

Differences in aggregate labor demand across countries are also linked to

differences in the countries’ relative goods supply:

International Trade 25 / 28
Relative Factor Abundance and Comparative Advantage

These differences in relative supply (generated by differences in factor

abundance) then generate a pattern of comparative advantage

In autarky, Cloth – Labor-intensive good – is relatively more expensive

in Home – relatively Labor-scarce country

International Trade 26 / 28
Heckscher-Ohlin Theorem

The relatively labor abundant country will export the good that uses
labor relatively more intensively (and vice-versa for the capital abundant
country)

International Trade 27 / 28
Complete Versus Incomplete Specialization
It is also possible for one of the countries to be completely specialized
If a country is specialized, it must specialize in the good in which it
has a comparative advantage
When is such complete specialization more likely? A country is much
more likely to be completely specialized when there are large
differences in relative factor abundance and its trading partner is
relatively much larger
Is it possible for both countries to be completely specialized? Yes, if
there are very large differences in relative factor abundance:

International Trade 28 / 28
Appendix

International Trade 1/3

Differences in Technology and Relative Factor Demands
Consider the following differences between the unit isoquants:

Definition of factor intensity in production: C is relatively labor

intensive if, at any given relative factor price w /r
LC a L a
= LC > F = LF
KC aKC KF aKF
So producers of C will always hire relatively more L (and inversely for
producers of F ) main
International Trade 2/3
Firm Input Choice and Cost Minimization main

Under constant returns to scale production, a firm will always produce

QC units of output with the same LC /KC as it uses to produce one
unit of output
At given w and r , a firm choose unit input used aLC and aKC such
that MPLC /MPKC = w /r

The minimized unit cost is waLC + raKC (constant AC = MC )

Firm produces QC units of output using LC = QC aLC , KC = QC aKC
Thus only need to solve cost minimization for QC = 1
International Trade 3/3