ARANCHA OLMEDA

Problem Set 6
The Heckscher-Ohlin Model (Part C)

This problem set explores income inequality and the impact of allowing labor and/or
capital mobility instead than having free trade in goods and services. When factor
mobility is allowed, not very surprisingly, factors move towards the country where
returns are higher. The analysis is straightforward.

1. Consider two countries (Spain and Romania), two goods (textiles and cars), and
two factors of production (skilled and unskilled labour). Romania is relatively
abundant in unskilled labor, and textiles are relatively intensive in the use of
unskilled labour. Both countries use the same technologies.

(a)In the case of Spain, which group will be in favour of free trade between the
two countries.
H-O Model predicts that Spain will export cars and Romania will export textile. With
free trade, the equilibrium relative prices:

With free trade, the relative price of cars will increase in Spain, and in Romania the
relative price of textile will increase.

In Spain:

unskilled workers worse off and skilled workers better off.

In Romania:

unskilled workers better off skilled workers worse off

(b) What will happen to income distribution in Spain and Romania after free
trade?
Income distribution will be better off in Romania and worse off in Spain. Salaries in
Spain will go down and in Romania will go up. More inequality in Spain.
(c) How does free trade affects the incentives of Spanish workers to acquire skills?
Incentives of Spanish unskilled workers to acquire skills to increase their relative wage
will increase since Spanish skilled workers are better off with free trade.
(d) Which group will be in favour of free migration rather than free trade?
With labor mobility relative cost of factors will be:

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Therefore, with labor mobility:
In Spain w/r goes down so unskilled workers are worse off and skilled workers better off.
In Romania w/r goes up and unskilled workers are better off and skilled workers worse
off.
Therefore, in Spain, owners of skilled labor and producers of cars are in favor of free
trade between the two countries.

To allow labor mobility is a close substitute for free trade?

(e)
Labor mobility is a close substitute for free trade. When the H-O model conditions hold,
labor mobility and free trade have the same effects on relative prices and relative cost of
factors. Therefore, those in favor of (against) free trade, will be also in favor of (against)
labor mobility.

2. On January 1, 1994 the North American Free Trade Agreement (NAFTA)

came into force. This agreement signed by the United States, Mexico and Canada
formed a free trade area for goods and services that comprised the three
countries.

Many unskilled workers of the United States and Canada strongly opposed
(a)
this treaty from the beginning of the negotiations in 1990. Using the
Heckscher-Ohlin model discuss which may be the causes underlying their
position.
Unskilled workers in the United States and Canada assumed that Mexico had a relative
abundance in unskilled labor. Then, according to the Heckscher-Ohlin model, Mexico
would have a comparative advantage in unskilled labor-intensive goods, and will be
exporting those goods to the US and Canada.

As a result, the relative price of goods will converge, so there will be a decrease in the
relative price of unskilled labor intensive goods in the US & Canada which would also
imply a reduction the relative wage of unskilled workers in the US & Canada, which
explains why unskilled workers of the United States and Canada were opposing the
NAFTA.

(b) After 25 years most economic analyses indicate that NAFTA has been
beneficial to the North American economies and the average citizen.
Nevertheless, many Mexican workers still try to move to the United States.
Does this go against any of the conclusions of the Heckscher-Ohlin
model? (Hint 1: In order to have Factor Price Equalisation, a crucial
assumption is that both countries have the same technology, Do USA and
Mexico have the same technology? Hint 2: If factor mobility is allowed,
factors will move to the country with the highest return.)

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Economic analyses are consistent with the Heckscher-Ohlin model since all NAFTA
countries are better off with free trade. They increased their efficiency by exporting the
good in which they have a comparative advantage on.
Nevertheless, many Mexican workers still try to move to the United States. This can be
due to the no existence of Factor Price Equalization because Mexico may not have the
same technology as the US. And secondly, factors move to the country with the highest
return so that is why skilled workers will want to move from Mexico to the US.
(c) Some interest groups actively support the extension of the NAFTA to
include the free movement of capital. On the other hand, some other
groups support the creation of a complementary agreement that allows the
free movement of labor in North America. Using the Heckscher-Ohlin model
discuss whether these propositions may make sense. (Hint: Notice again that
if factor mobility is allowed, factors will move to the country with the
highest return)
According to the Heckscher-Ohlin model, US & Canadian skilled workers as well as
Mexican unskilled workers would support both, the free movement of labor and capital.
It makes sense to promote labor mobility so there are benefits from free trade.

3. Consider a world with two goods (steel and wine). There are two countries
(Germany and France) which have identical technologies and preferences.
Assume that the production of wine is relatively labour intensive while the
production of steel is relatively capital intensive. Assume that after free trade in
goods, Germany exports steel and France wine.

i)What can you say about the relative endowments of the two countries?
(a)
ii)Which trade theorem are you using to answer this question?
Germany has a comparative advantage in steel and France has it in wine. This is
because Germany is relatively capital abundant and steel is relatively capital intensive;
while France is relatively labor abundant and wine is relatively labor intensive.

(b) Before opening to trade in goods, both economies allow capital mobility. i)
Capital will flow in which directions (explain why) ? ii) What will happen
to the production of wine and steel in both countries? iii) What will be the
effect of capital mobility on factor prices in the two countries?

i) Capital will flow from Germany to France since in autarky, the relative return to
capital is higher in France.
ii) Germany will increase the production of steel and France will increase the production
of wine.
iii) The effect of capital mobility on factor prices is that they will converge.

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 (c) Instead, assume that there is labor mobility instead of capital mobility. i) In
which direction will labor flow? ii) What will happen the production of
steel and wine in both countries?
iii) What will be the effect of labor mobility on factor prices in the two
countries? iv) The persistence of regional inequalities is much worse in
Europe than in the U.S. because of the lack of labour mobility. Discuss this
statement in light of your previous answers.
i) Labor will flow from France to Germany since in autarky, the relative return to labor
is higher in Germany.
ii) Germany will increase the production of steel and France will increase the production
of wine.
iii) The effect of labor mobility on factor prices is that they will converge.
iv) Assuming a situation where there is no labor mobility, then prices will not converge,
therefore, inequalities are much worse.

4. When the EU-15 expanded towards the East of Europe, they decided to proceed in
two phases: First, they introduced free trade and then later the free movement of
labour. Using the Heckscher- Ohlin model discuss if it made sense to proceed in
this manner.
The decisions of EU-15 on how to expand towards East Europe can be explained by
using the Heckscher- Ohlin model and the factor price equalization theorem. To obtain
the latter 2 conditions, it needs to hold: (1) same technologies across countries, (2) no
transportation costs.

With free trade, convergence of relative prices of the factors is not achieved since they
don’t have the same technology. Then the free movement of labor can be used in order
to achieve the convergence of prices.