LECTURE 3: TWO-FACTOR ECONOMY: THE HECKSCHER-OHLIN MODEL

1. Model of a Two-factor Economy

1.1. Prices & production
● The Heckscher-Ohlin theory:
- Shows that comparative advantage is influenced by:
+ Relative factor abundance (refers to countries);
+ Relative factor intensity (refers to goods).
- Factor-proportions theory (2 by 2 by 2): 2 factors - 2 goods - 2 countries.
● Assumption:
- Two required inputs that are in limited supply: Labour (L) and Land/Capital (K).
- Food (F) is land-intensive and Cloth (C) is labour-intensive in both countries.
- Assume that the immobile factors that were specific to each sector (capital in cloth, land in food) are now mobile in
the long run. In the long run, both capital and labour move across sectors, thus equalising their returns (rental rate
and wage) in both sectors.
𝑎𝐾𝐶 : Capital used to produce 1 yard of cloth;

𝑎𝐿𝐶 : Labour used to produce 1 yard of cloth;

𝑎𝐾𝐹 : Capital used to produce 1 calorie of food;

𝑎𝐿𝐶 : Labour used to produce 1 calorie of food.

- Amount produce:
𝑄𝐶 = 𝑄𝐶 (𝐾𝐶 , 𝐿𝐶)

𝑄𝐹 = 𝑄𝐹 (𝐾𝐹 , 𝐿𝐹)

PPF: Production Possibility Frontier (giới hạn khả năng sản xuất)
1. To produce 𝑄𝐶: 𝑄𝐶 = 𝑎 × 𝑄𝑐 + 𝑎𝐿𝐶 × 𝑄𝐶
𝐾𝐶

2. To produce 𝑄𝐹: 𝑄𝐹 = 𝑎 × 𝑄𝐹 + 𝑎𝐿𝐹 × 𝑄𝐹

𝐾𝐹

3. Constraint:
𝑎𝐾𝐶 × 𝑄𝐶 + 𝑎𝐾𝐹 × 𝑄𝐹 ≤ 𝐾

𝑎𝐿𝐶 × 𝑄𝐶 + 𝑎𝐿𝐹 × 𝑄𝐹 ≤ 𝐿

Example: Given that: 𝑎𝐾𝐶 = 2, 𝑎𝐿𝐶 = 2;

𝑎𝐾𝐹 = 3, 𝑎𝐿𝐹 = 1;

Draw the PPF graph:

We have: 2 × 𝑄𝐶 + 3 × 𝑄𝐹 ≤ 3, 000; (Capital)

2 × 𝑄𝐶 + 1 × 𝑄𝐹 ≤ 2, 000; (Labour)

For 𝑄𝐶 is x-axis and 𝑄𝐹 is y-axis, we have 2 linear equations:

3,000−2×𝑄𝐶 −2
𝑄𝐹 ≤ 3
= 3 𝑄𝑐 + 1,000 (Capital)

2,000−2×𝑄𝐶
𝑄𝐹 ≤ 1
= − 2𝑄𝑐 + 2,000 (Labour)

Therefore we construct the graph besides.

 −2
The slope of 2 lines: 3 for Capital line, − 2 for Labour line.

2
→ Opportunity cost of Cloth in terms of Food on Capital constraint = 3 , Opportunity cost of Cloth in terms of Food on

Labour constraint = 2.

● Observation:
- The PPF line is the red kinked line with minimum Quantity of Cloth produced and minimum Quantity of Food
produced (since the 2 supply restrict each other);
2
- Considering the first half side of the graph (side 1): the Opportunity cost of Cloth in terms of Food is 3 ;

- Considering the second half side of the graph (side 2): the Opportunity cost of Cloth in terms of Food is 2;
- Moving from left to right, the opportunity cost of Cloth is higher when more units of Cloth are being produced.

● When Labour and Capital can substitute each other (in the long run):

- Where to produce? Depends on prices;

- Maximize value of production:
𝑉 = 𝑝𝐶 × 𝑄𝑐 + 𝑝𝐹 × 𝑄𝐶

− 𝑝𝐶
- Isovalue lines lines have constant output value, slope = 𝑝 ;
𝐹

𝑝𝐶
The opportunity cost of cloth = The relative price of cloth = 𝑝 .
𝐹

1.2. Choosing mix of inputs

- Producer faces trade-offs of input mix Labour ↑ ⇔ Capital ↓
𝑤
- The input choice will depend on the ratio 𝑟 (factor prices)

Where: w: wage rate (Labour price);

r: rental cost (Capital price).
Selection of factors is based on the cheaper cost.

● Factor intensity: At any given factor prices, production of cloth will

always use more labour relative to capital (L/K) than will production
of food.
- From assumption:
Food is land-intensive → FF curve should be under CC curve.
Cloth is labour-intensive → CC curve should be above FF curve.

𝐿𝐶 𝐿𝐹
𝐾𝐶
> 𝐾
𝐹
 Example 1: If food production uses 80 workers and 200 land acres, while cloth production uses 20 workers and 20 acres.
𝐿𝐶 20 𝐿𝐹 80
𝐾𝐶
= 20 > 𝐾 = 20
𝐹

Therefore, Food production is land-intensive, Cloth production is labour-intensive.

Example: If Computer production requires 2 hours of machine, 10 hours of labour researching, while Chair production requires 2
hours of machine, 1 hour of labour researching
𝐿𝐶𝑜 10 𝐿𝐶ℎ 1
𝐾𝐶𝑜
= 2 > 𝐾 = 2
𝐶ℎ

Therefore, Computer production is labour-intensive, Chair production is capital-intensive.

● Substitution effect in producer’s factor demand: As wage rises relative to rental, producer substitutes capital for labour
in their production decisions
𝑤 𝐿
𝑟
↑ ⇒ 𝐾
↓
- If the salary of the workers is expensive as compared to the renting price for machines, then the producer should
reduce the number of workers and replace them with machines, and vice versa.

1.3. Factor prices & Good prices

- Factor prices: Wages rate & Rental price;
- Goods prices: Prices of Clothes and Food.
● Assumptions:
- The economy produces both Food and Clothes; (only happen when a country produces both types of goods);
- The economy is perfect competition (Price of product = Cost of production → Zero profit & zero cost)
𝑤 𝑃𝑐
→ Cost of production depends on the factor prices ( 𝑟 ) and relative price of cloth ( 𝑃𝑓 ).

● Given that:
- Food is capital-intensive;
- Clothes is labour-intensive.
● The relationship:
𝑝𝐶
- Wage-rental ratio increases → 𝑝 increases;
𝑓

→ When the wage is larger than the rent, then the price of
Clothes is more expensive than that of Food.
𝑝𝐶
- Wage-rental ratio decreases → 𝑝 decreases;
𝑓

→ When the wage is larger than the rent, then the price of
Clothes is cheaper than that of Food.

Conclusion: The importance of wage to pay labour in the cost of producing Clothes depends on how much labour the Clothes
production involved.
Explanation:
- If Clothes production uses a lot amount of labour: a small increase in wages would lead to a large increase in relative price.
- If Clothes production uses a little amount of labour: a large increase in wages would only lead to a small increase in relative
price.

● NOTE:
 Consider 1 country producing 2 goods (Clothes and Food):
- If the relative price of Clothes grows beyond a given upper bound limit
→ The economy will specialize in producing Clothes.
- If the relative price of Clothes grows under a given lower bound limit
→ The economy will only produce Food.

CONSIDER THE GRAPH:

The combination graph of CC-FF Relative factor demand curve and Factor prices - Goods prices curves.
● Assumption:
- Clothes is labour-intensive;
- Food is capital-intensive.
𝑤
● Observing the graph, when 𝑟 increase from 1 to 2:

- Wages increase compared to Rental → Workers earn more, Capital owners (Machines) earn less.
𝑝𝐶
- Relative price of Clothes 𝑝 increases → Clothes is more expensive than Food.
𝑓

𝐿𝐶 𝐿𝐹
- Labour-Capital ratio ( 𝐾 & 𝐾 ) decreases → Workers work less, Capital owners work more.
𝐶 𝐹

The change of Relative Price has strong effect on

Income distribution:
𝑝𝐶
- Relative price of Clothes 𝑝 increase, Clothes is
𝑓

more expensive than Food, labour are better off (earn

more).
𝑝𝐶
- Relative price of Clothes 𝑝 increase, Food is
𝑓

cheaper than Clothes, capital owners (machines) are

worse off (earn less).

1.4. Resources & Output

Notation: TT: PPF of the country (in the long run).
● Given that:
- Clothes is labour-intensive;
- Food is capital-intensive.
● If we have:
𝑝𝐶
- Fixed relative price of Clothes (slope = − 𝑝 )
𝑓

𝐿
- Increase in labour force ( 𝐾 )

→ More workers choose to work in Clothes production compared to

Food production.
→ PPF shifts outward much more toward Clothes production direction
than that of Food.
 Biased expansion of production possibilities (where the output of Clothes and Food increases disproportionally).

Rybczynski Theorem (effect):

If a factor of production (Capital K or Labour L) increases, then the supply of the good that uses this factor intensively
increases and the supply of the other good decreases for any given commodity prices.
Example: Consider computer and coffee:
- There is an increase in technological knowledge in a country;
- To use up this technological knowledge, more computers will be produced rather than coffee;
→ Relative quantity of computers = The ratio of computers over coffee = increasing.
→ The speed of producing/supplying computers increases.

2. Effects of International trade between Two-factor Economies

● Assumptions of the Heckscher-Ohlin model:
- There 2 countries (Home and Foreign) that have:
+ Same tastes (identical relative demand given relative price);
+ Same technology;
+ Different resources.
○ Home is labour-abundant;
○ Foreign is capital-abundant.
(Abundant: referred to ratio, not absolute value)
● Each country has the same production structure of a two-factor economy.

2.1. Relative prices & the pattern of trade

● Factor Abundance:
Home country: labor-abundant Scarce factor: land
Foreign country: land abundant Scarce factor: labor
𝐿 𝐿*
𝐾
> 𝐾*

Example: If America has 80 million workers and 200 million acres, while Britain has 20 million workers and 20 million acres,
then Britain is labour-abundant and America is land-abundant.
→ The scare factor in Home is land (capital) and in Foreign is labour.

Observing the graph:

𝑄𝐶
- Home has larger relative supply of cloth (higher 𝑄 ):
𝐹

+ Cloth is labour-intensive, Home is labour-abundant;

𝑝𝐶 𝑄𝐶
+ With fixed 𝑝 , Home will always produce higher 𝑄 ;
𝑓 𝐹

→ Home supply curve (RS) lies further to the right than Foreign’s (RS*).
- RD: relative demand curve.
- No international trade: Home equilibrium is point 1, Foreign’s is point 3.
𝑝𝐶 𝑝𝐶*
𝑝𝑓
< 𝑝*
𝑓

- With trade, relative prices converge to point 2.

● When Home and Foreign trade with each other, their relative prices converge:
𝑝𝐶
- Home: 𝑝 increases → a rise in production of cloth and a decline in relative consumption.
𝑓

→ becomes an exporter of cloth and an importer of food.

𝑝𝐶
- Foreign: 𝑝 decreases → becomes an importer of cloth and an exporter of food.
𝑓

Heckscher-Ohlin Theorem:
A country will export that commodity which intensively uses its abundant factor and import that commodity which
intensively uses its scarce factor.

2.2. Trade and the distribution of income

- Changes in relative prices have strong effects on the relative earnings of labour and land in both countries:
+ In Home, where the relative price on the cloth rises: Laborers are made better off and landowners (capital
owners) are made worse off;
+ In Foreign, where the relative price of cloth falls, the opposite happens: Laborers are made worse off and
landowners are made better off.
- Owners of a country’s abundant factors gain from trade, but owners of a country's scarce factors lose from trade.

2.3. Factor-price equalization

- In the absence of trade: labour would earn less in Home than in
Foreign, and land would earn more.
- Factor-Price Equalization Theorem:
+ International trade leads to complete equalization in factor prices
of homogeneous factors across countries.
→ It implies that international trade is a substitute for the international mobility
of factors. Home exports its labour (by exporting cloths), Foreign exports its
capital.

- Has international trade equalized the returns to homogeneous

factors in different countries in the real world?
+ Even casual observation clearly indicates that it has not.
Example: Wages are much higher for doctors, engineers, technicians, mechanics, and labourers in the United
States and Germany than in Korea and Mexico.
+ Under these circumstances, it is more realistic to say that international trade has reduced, rather than
completely eliminated, the international difference in the returns to homogeneous factors.
- Three assumptions crucial to the prediction of factor price equalization are in reality untrue:
+ Both countries produce both goods;
+ Both countries have the same technologies in production;
+ Both countries have the same prices of goods due to trade.