International Economics: Factor Endowments and The Heckscher-Ohlin Theory

CHAPTER F I V E
5 International Economics
Twelfth Edition
Factor Endowments and the

Heckscher-Ohlin Theory
Dominick Salvatore
John Wiley & Sons, Inc.
Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.
Learning Goals:
 Explain how comparative advantage is based on

differences in factor endowments across nations
 Explain how trade affects relative factor prices
within and across nations
 Explain why trade is likely to be only a small
reason for higher skilled-unskilled wage
inequalities
5.1 Introduction
 Classical economists based comparative

advantage on the productivity of labor alone.
 Heckscher-Ohlin theory extends basic trade

model to include:
 Basis of comparative advantage
 Effect of international trade on factor returns
https://www.youtube.com/watch?v=BkpCE-t6wO8
5.2 Assumptions of the Theory
 Heckscher-Ohlin theory is based on

following assumptions:
1. Two nations, two goods, two factors of
production
2. Technology is the same in both nations
3. Commodity X is labor intensive, commodity Y is
capital intensive in both nations
4. Constant returns to scale for X and Y in both
nations
5. Incomplete specialization in production in both
nations
5.2 Assumptions of the Theory
 Heckscher-Ohlin theory is based on

following assumptions (continued):
6. Tastes are the same in both nations
7. Both commodities and factors are traded in perfectly
competitive markets
8. Perfect factor mobility within each nation, but not
between nations
9. No transportation costs, tariffs or other barriers to
free trade.
10. All resources are fully employed in both nations
11. International trade between the nations is balanced.
5.3 Factor Intensity, Factor Abundance, and
the Shape of the Production Frontier
 Factor Intensity
 In a two-commodity, two factor world, commodity Y is
capital intensive if the capital-labor ratio (K/L) used in
the production of Y is greater than K/L used in the
production of X.
 It is not the absolute amount of capital and labor used
in production of X and Y, but the amount of capital per
unit of labor that determines capital intensity.
 Likewise, commodity X is labor-intensive if the
capital-labor ratio (K/L) used in the production of X is
less than K/L used in the production of Y.
FIGURE 5-1 Factor Intensities for Commodities X and Y
in Nations 1 and 2.
 Factor Abundance
 In terms of physical units:
 Nation 2 is capital abundant if the ratio of the
total amount of capital to the total amount of

labor (TK/TL) available in Nation 2 is greater
than that in Nation 1.
 It is not the absolute amount of capital and

labor available in each nation, but the ratio of
the total amount of capital to the total amount
of labor.
 Factor Abundance
 In terms of relative factor prices:
 Nation 2 is capital abundant if the ratio of the
rental price of capital to the price of labor time

(PK/PL) is lower in Nation 2 than in Nation 1.
 Rental price of capital is usually considered to

be the interest rate (r), while the price of labor
time is the wage rate (w), so PK/PL = r/w.
 It is not the absolute level of r that determines

whether a nation is K-abundant, but r/w.
Nation 2 is K-abundant, and
commodity Y is K-intensive
Nation 1 is L-abundant, and

commodity X is L-intensive
FIGURE 5-2 The Shape of the Production Frontiers of

Nation 1 and Nation 2.
5.4 Factor Endowments and the Heckscher-
Ohlin Theory
 Heckscher-Ohlin (H-O) theory is based on

two theorems (H-O and factor price
equalization):
1. The Heckscher-Ohlin theorem
 A nation will export the commodity whose
production requires the intensive use of the nation’s
relatively abundant and cheap factor and import the
commodity whose production requires the intensive
use of the nation’s relatively scarce and expensive
factor.
Ohlin Theory
H-O theorem implies:

 The relatively labor-rich nation exports the relatively
labor-intensive commodity and imports the relatively
capital-intensive commodity.
 The relatively capital-rich nation exports the relatively
capital-intensive commodity and imports the relatively
labor-intensive commodity.
 Explains comparative advantage rather than
assuming it.
 Differences in factor endowments explain pre-trade
price differentials and thus the pattern of trade.
Ohlin Theory
The H-O theorem is a general equilibrium model.

 Tastes and the distribution of income determines the
demand for commodities.
 Demand for commodities determines the derived demand for the
factors that produce them.
 Demand for factors and supply of factors (resource endowment)
determine the price of factors of production.
 Price of factors and technology determine supply of
commodities.
 Supply and demand for commodities determine output
prices.
 Difference in relative commodity prices determine the
pattern of trade. (Figure 5.3)
FIGURE 5-3 General Equilibrium Framework of the
Heckscher-Ohlin Theory.
Ohlin Theory
Illustration of the H-O Model (Figure 5.4)

 Because tastes are the same, indifference curves
are identical, but different PPFs implies different
autarky prices (points A and A’).
 With trade, prices equalize to the world price line,
PB .
 Both nations then are able to reach higher
indifference curves.
 Note that the nations do not need to start and end
on the same indifference curve; this is done for
graphical simplicity.
FIGURE 5-4 The Heckscher-Ohlin Model.
Factor price equalization
 Exported commodities experience an increase
in their price relative to the autarky situation.
 The Stolper-Samuelson theorem
demonstrates that an increase in the relative
price of a commodity raises the return of the
factor used intensively in its production.
 At the same time, the return of the relatively
scarce factor will fall.
17
Factor price equalization
 Exported commodities experience an increase
in their price relative to the autarky situation.
 The Stolper-Samuelson theorem
demonstrates that an increase in the relative
price of a commodity raises the return of the
factor used intensively in its production.
 Thus, the labor abundant country will see
an increase in wages, but a fall in the return
to capital while the capital abundant
country will experience the opposite pattern
of change. 18
Implications of FPE
 Developed nations are expected to be capital
abundant.
 Therefore, following the opening of trade the
return to capital in the developed countries is
expected to increase and wages are expected
to fall.
 This pattern of change should worsen
inequality in the developed countries.
19
Implications of FPE
abundant.
 The change in inequality should be the
opposite for the developing (and labor
abundant) countries.
20
Implications of FPE
abundant.
 The change in inequality should be the
opposite for the developing (and labor
abundant) countries.
 The conclusion of worsened inequality in
the developed world holds only if:
 The assumptions of the H-O theory holds.
 As will be seen, this may not be the case.
 The Stolper-Samuelson theorem is the only
force driving changes in inequality. 21
Factor-Price Equalization and Income
Distribution
 The second theorem that H-O theory is based

on is:
2. The factor price equalization theorem
 International trade will bring about equalization in
the relative and absolute returns to homogenous
factors across nations.
 In short, wages and other factor returns will be
the same in both nations after specialization
and trade has occurred.
 Holds only if H-O theorem holds.
5.5 Factor-Price Equalization and Income
Distribution
 Why do factor prices equalize?

 As Nation 1 increases the production of X (and
reduces the production of Y), the demand for labor
rises relative to the demand for capital.
 As Nation 2 increases the production of Y (and
reduces the production of X), the demand for
capital rises relative to the demand for labor.
 Wages (w) rise in Nation 1 (the low-wage nation) and fall
in Nation 2. (the high-wage nation).
 Interest rates (r) falls in Nation 1 (the K-expensive nation)
and rises in Nation 2. (the K-cheap nation).
Distribution
 For homogeneous factors of production, wages

and the rental rate on capital will completely
equalize.
 As long as relative factor prices differ, there are
differences in commodity prices, which expand
trade.
 Expansion of trade reduces the difference in factor
prices and thus the difference in commodity prices.
 Trade expands until commodity prices equalize,
which implies that factor prices have also
equalized. (Figure 5.8)
FIGURE 5-5 Relative Factor–Price Equalization.
Distribution
 If all the assumptions of the H-O model hold, trade

brings about both relative and absolute factor price
equalization.
 Trade is a substitute for the international mobility of

capital and labor.
 With perfect mobility, labor moves to the high-wage
country; capital moves to the high-interest country.
 Thus the supply of factors adjusts until factor prices
equalize (and commodity prices equalize.
 Trade works through the demand for factors.
Distribution
 Since trade changes the return to factors of

production, it changes the distribution of
income.
 Causes a redistribution of income from the
relatively expensive (scarce) factor to the relatively
cheap (abundant) factor.
 Thus labor gains in labor-abundant nations
(China, India), and capital gains in capital-
abundant nations (the U.S., Germany, Japan).
 Effects are greater in the long run, since factors
will be more mobile.
Distribution
 Specific Factors Model

 Assume that within Nation 1, labor is mobile
but capital is specific to each industry.
 Opening trade increases the production of X
and raises wages (which must be equal
between sectors since labor is mobile).
 The effect on the real wage is unclear since the
increase in relative commodity prices must be
greater than the increase in the nominal wage, as
long as the supply of labor is not perfectly
inelastic.
Distribution
 Opening trade cannot cause capital to move, since it

is industry-specific.
 The return on capital in the production of X rises.
 The return on capital in the production of Y falls.
 Thus overall, trade will:
 have an ambiguous effect on a nation’s mobile
factors,
 benefit the immobile factors specific to a nation’s
export commodities or sectors, and
 harm the immobile factors specific to a nation’s
import-competing commodities or sectors.
Distribution
 Has trade equalized the return to homogenous

factors?
 Has reduced rather than eliminated differences.
 Not all H-O assumptions hold.
 Other forces have had effects on factor prices as well,
particularly technological change.
 Does not imply that differences in per capita
incomes will be eliminated or reduced.
 Other forces, such as the participation rate, the
dependency ratio, and the ratio of skilled to unskilled
labor have major effects.
5.6 Empirical Tests of the Heckscher-Ohlin
Model
 Difficult to test empirically
 The Leontief Paradox

 A 1951 test of the H-O theory
 Estimated K/L for import substitutes since import data
was not available.
 Showed that the pattern of trade did not fit the
conclusions of the H-O theorem.
 Exports in the U.S. seemed to be labor intensive
when they should have been capital intensive.
Empirical Tests of the Heckscher-Ohlin Model
 Source of the Leontief Paradox Bias

 Assumed a two factor world which required
assumptions about what is capital and what is labor.
 Most heavily protected industries in U.S. were L-
intensive, reduced imports and increased domestic
production of L-intensive goods.
 Only physical capital included as capital, ignoring
human capital (education, job training, skills).
 Many later studies have generally supported H-O,

but empirical testing remains difficult.
Empirical Tests of the Heckscher-Ohlin Model
 Factor-Intensity Reversal
 A commodity is the L-intensive commodity in the L-
abundant nation and the K-intensive commodity in the
K-abundant nation.
 Elasticity of substitution measures the ease with which one
factor can be substituted for another in the production of a
given commodity.
 When countries have very different elasticities of
substitution, factor-intensity reversal is more likely to occur.
 If this occurs, neither H-O nor factor price equalization
theorems hold.
 Rare in the real world, and usually occurs only where there
is a significant natural resource input in an industry.
Case Study 5-1 Relative Resource
Endowments of Various Countries
Case Study 5-2 Capital-Labor Ratios of
Selected Countries
Case Study 5-3 Classification of Major Product
Categories in Terms of Factor Intensity
Case Study 5-5 Has International Trade
Increased U.S. Wage Inequalities?
Case Study 5-6 Convergence of Real Wages
among Industrial Countries
Case Study 5-7 Capital and Labor Requirements
in U.S. Trade
Case Study 5-8 The H-O Model with Skills and
Land

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CHAPTER F I V E

Factor Endowments and the

 Explain how comparative advantage is based on

 Classical economists based comparative

 Heckscher-Ohlin theory extends basic trade

 Heckscher-Ohlin theory is based on

 Heckscher-Ohlin theory is based on

total amount of capital to the total amount of

 It is not the absolute amount of capital and

rental price of capital to the price of labor time

 Rental price of capital is usually considered to

 It is not the absolute level of r that determines

Nation 1 is L-abundant, and

FIGURE 5-2 The Shape of the Production Frontiers of

 Heckscher-Ohlin (H-O) theory is based on

H-O theorem implies:

The H-O theorem is a general equilibrium model.

Illustration of the H-O Model (Figure 5.4)

 The second theorem that H-O theory is based

 Why do factor prices equalize?

 For homogeneous factors of production, wages

 If all the assumptions of the H-O model hold, trade

 Trade is a substitute for the international mobility of

 Since trade changes the return to factors of

 Specific Factors Model

 Opening trade cannot cause capital to move, since it

 Has trade equalized the return to homogenous

 Difficult to test empirically

 The Leontief Paradox

 Source of the Leontief Paradox Bias

 Many later studies have generally supported H-O,

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