Econ 405 Topic

Slides prepared by Thomas Bishop Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Topic 2

The Heckscher-Ohlin Model

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 4-2

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• Substitution between inputs

• Factor prices and goods prices

• Resources and output

• Trade in the Heckscher-Ohlin model

• Factor price equalization

• Income distribution and income inequality

• Optimal Trade Policy

• Empirical evidence


Introduction

• Ricardian Model: L is the only factor and comparative advantage arises due to productivity differences.

• But this cannot be the only reason that nations trade. E.g., Saudi Arabia X oil to U.S., not because its oil-

field workers are more productive but because Saudi Arabia has more oil!

• A more realistic view of trade incorporates differences in resources (e.g., T, L, K, and minerals).


Introduction (cont.)

• In H-O: Differences in resources are the only

source of trade.

Comparative advantage is determined by the relative abundance of the factors of production and the technology which determines the relative intensity with which different factors are used in the production of each good.



• H-O is called “factor-proportions” theory because of its emphasis on the importance of factors available to the country and the proportions of factors required to produce different goods.



• To study H-O: First, determine how factor-proportions

theory works in an economy that does not trade.

Then examine what happens when trade between 2 countries occurs.


Assumptions of the H-O Model

1. 2 goods: cloth (C) and food (F) 2. 2 inputs: labor (L) and land (T)

• Neither input is specific to an industry.

3. Define the following terms:aTC = acres of T used to produce 1 yard of cloth

aLC = hours of L used to produce 1 yard of cloth

aTF = acres of T used to produce 1 calorie of food

aLF = hours of L used to produce 1 calorie of food• L = total amount of L and T = total amount of T• w = hourly wage and r = rent for 1 acre


Substitution Between Inputs

• Unlike the Ricardian model, producers don’t have rigid input requirements so they can substitute between the inputs. E.g., A farmer may be able to grow more food per

acre if she is willing to use more L to prepare the soil. The farmer can use less T if she uses more L.


Fig. 1: Input Possibilities in Food Production


Substitution Between Inputs (cont.)

• Input choice will be determined by the relative cost of L and T. E.g., if wages are low and rental rates high,

farmers will want to use more L and less T.

• Input choices depend on w/r ratio.

Fig. 2: Factor Prices and Input Choices

CC represents the relationship between w/r and T/L in cloth production.

FF represents this relationship for food production.

CC lies to the left of FF because for any given w/r, food requires a higher T/L ratio than cloth.

The production of food is land-intensive, while cloth is labor-intensive → (T/L)F > (T/L)C


Input Choice

• If the economy produces both goods → competition drives Pgood = cost of production in each industry.

• Cost depends on factor prices → if r is high → Pgood that uses T will be higher.

• If cloth uses very little T in production → ↑r won’t impact PC much. However, food uses lots of T so ↑r →↑PF.

Fig. 3: Factor Prices and Goods Prices

There is a one-to-one relationship between the cost of labor (w) and the PC. As ↑w → ↑PC because cloth is the L-intensive good.

Fig. 4: From Goods Prices to Input Choices


Goods Prices and Factor Prices

• Fig 4. shows the close relationship between PC/PF and T/L used in producing each good.

• As ↑(w/r) → ↑(PC/PF) as cloth is L-intensive. Also as ↑(w/r) producers substitute more T for L because L is relatively expensive →↑T/L used to produce each good.


Goods Prices and Factor Prices (cont.)

• Note: ↑PC/PF will raise the income of workers relative to landowners. In fact, real wages rise in terms of both goods and rental rates fall in terms of both goods.

• Why? When ↑PC/PF → ↑T/L in production of both goods → now L has more T to work with (i.e., ↑MPL) and T has become more abundant → ↓MPT.


Goods Prices and Factor Prices (cont.)

• In H-O, changes in goods prices have strong effects on income distribution. A change in relative prices always leaves owners

of one factor better off while owners of the other factor are worse off!

• Stolper-Samuelson theorem: ↑P of a good leads to ↑real return to the factor used intensively in the production of that good and ↓real return to the other factor.


Resources and Output

• We must now analyze how factor supplies impact goods prices and output levels.

• If PC/PF is given, then so is w/r and T/L used in production. Also, the economy must fully employ all T and L –which helps determine the output mix.

• Analyze allocation of resources with a box diagram.

Fig. 5: The Allocation of Resources


Resources and Output (cont.)

• In Fig 5., width = S of L and height = S of T.

• Allocation of resources is given by a point in the box, like pt 1.

• If we know PC/PF → T/L used in cloth and food. Slope of OCC is (T/L)C and slope of OFF is (T/L)F.

• Any point describing the allocation of resources must lie on OFF and OCC. (Pt 1 lies on both.)

• Note: OFF is steeper than OCC because (T/L)F > (T/L)C.



• How does the mix of output change when factor supplies change?

• Fig. 6 shows ↑S of T.

• If we hold PC/PF fixed → T/L are also fixed. So draw a parallel line (at OFF’) to OFF.

• Resource allocation moves from pt 1 to 2.

• Note: amounts of T and L used in cloth fall. So ↑T → ↓Q of L-intensive good (cloth) and ↑Q of T-intensive good (food).



• Rybczynski theorem: if goods prices are fixed, then ↑S of a factor leads to ↑output of the good that uses that factor intensively and ↓output of the other good.

Fig. 6: An Increase in the Supply of Land

Fig. 7: Resources and PPF

↑T shifts PPF outward and biased toward food (T-intensive good).

↑T → expands production of T-intensive good, while ↑L → expands production of the L-intensive good.

Thus, an economy with a high T/L will be more effective in producing the T-intensive good.

An economy will tend to produce goods that are intensive in the factors in which the country is well endowed.


Trade Between Countries

• Assume: 2 countries: home and foreign 2 factors: T and L 2 goods: cloth and food Same tastes: RD curve is identical Same technology CRTS Incomplete specialization Only difference: (T/L)* > (T/L) → home is L

abundant and foreign is T abundant

Fig. 8: Trade Leads to a Convergence of Relative Prices

Since cloth is L-intensive, home tends to produce more cloth relative to food.

RS of home is lower and pre-trade PC/PF is lower than in foreign.

With trade, prices must converge between two pre-trade prices (i.e., point 2).


Trade Between Countries (cont.)

• Without trade, D = S within each country. DC = QC and DF = QF

• With trade, this is no longer true. However, a country can only spend what it earns.

PC x DC + PF x DF = PC x QC + PF x QF

value of consumption value of production

Or DF – QF = (PC/PF) x (QC – DC)

value of food imports = value of cloth exports

Fig. 9: Budget Constraint with Trade

QF

QC

QFt

QCt

t

-(PC/PF) t = slope

DF – QF = (PC/PF) x (QC – DC) is the country’s budget constraint.

It is tangent to the PPF at the trade production pt (“t”) and its slope = -(PC/PF).

A country must consume somewhere on this budget line.

budget line

Fig. 10: Trading Equilibrium

ForeignQF

QCDCQC

DF

QF

M*C

X*F

a

b

HomeQF

QMQCDC

QF

DF

XC

MF

b

a

Trade opens: in Home ↑(PC/PF) → ↑DF and ↓QF → exports C and imports F; in Foreign ↓(PC/PF) → ↑DC and ↓QC → imports C and exports F.

In equilibrium, XC = M*C and X*F = MF. Shown by the shaded triangles.

Fig. 11: PPF for Two Countries

Home Foreign

Qa = Da

(PC/PF)a

(PC/PF)t

Qt

QF

QC

Q*F

Q*C

Q*a = D*a

(PC/PF)*a(PC/PF)*t

Q*t

Note: a = autarky and t = trade


Trade Between Countries (cont.)

• Fig. 11: Since cloth is L-intensive good and home is L abundant, home’s PPF is shifted out more in the direction of cloth.

• In autarky, (PC/PF)a is higher in foreign. If trade opens, goods prices equalize to (PC/PF)t.

• Home views the higher world (PC/PF)t → ↑QC and ↓QF. So home X cloth and M food.

• Foreign sees a lower world (PC/PF)t → ↓Q*C and ↑Q*F. So foreign X food and M cloth.

• Rule: Countries tend to export goods whose production is intensive in factors with which they are abundantly endowed.


Trade and Income Distribution

• Trade leads to a convergence of goods prices. And a change in goods prices leads to a change in factor rewards.

• At home: ↑(PC/PF) → workers are better off and landowners are worse off

• Foreign: ↓(P*C/P*F) → workers are worse off and landowners are better off.

• Rule: In general, owners of a country’s abundant factor gain from trade, but owners of a country’s scarce factor lose.


Trade and Income Distribution (cont.)

• U.S. is abundant in highly skilled L and low-skilled L is scarce.

• Trade makes low-skilled workers in U.S. worse off permanently.

• Negative impact of trade on low-skilled L is a big political problem. Industries that use low-skilled L (e.g., shoes,

textiles, apparel, rubber, leather, mining, and agriculture) consistently demand protection from foreign M and their demands attract sympathy because they are already bad off to begin with!


Trade and Income Distribution (cont.)

• Sometimes high-skilled L employed in an industry that is intensive in low-skilled L (e.g., a CPA in textiles) will favor M restrictions. In SR, she cannot immediately shift industries. Yet, in LR, trade would improve her earnings because trade favors skilled L.


Factor Price Equalization

• Without trade: PC/PF < P*C/P*F → w < w* and r > r*

• With trade: relative goods prices converge → rewards to T and L converge.

• When home and foreign exchange goods, they are indirectly exchanging factors. Home lets foreign have some of its abundant L (not by selling

L directly) but by trading goods produced with a high ratio of L/T for goods produced with a low ratio of L/T.

• Home X its L embodied in the L-intensive good. Conversely, foreign X its T embodied in the T-intensive good. Viewed this way, it’s not surprising that w/r equalize.


Factor Price Equalization (cont.)

• Intuition: as home trades it ↑QC and ↓QF. The ↓QF releases T and L into the economy but relatively more T is released because food requires a higher T/L ratio. Thus, ↓r while ↑w because ↑DL as ↑QC in the L-intensive industry.

• Exactly the opposite is happening in foreign. As trade opens, ↑Q*F and ↓Q*C. As ↓Q*C → T* and L* are released but relatively more L* is freed up. Yet, ↑D*T as ↑Q*F → ↑r* and ↓w*.

• w/r are equalized because as long as they differ, goods prices differ and trade continues to expand until goods prices and w/r are equalized.



• Problem: in real world, factor prices are not equalized. Wages vary greatly across countries and quality of L alone

doesn’t explain away the differences.

• Problem with 3 model assumptions:

1.Both countries produce both goods: A country with very high T/L may produce only food, while a country with low T/L may produce only cloth. If countries are radically different they may completely specialize without w/r equalizing. • E.g., if PC/PF < P*C/P*F → home sees higher PC abroad and

↑QC which drives ↓PC. If, however, home completely specializes in cloth, it cannot ↑QC further to drive ↓PC.



2. Technologies are the same: FPE doesn’t hold if countries have different technologies. A country with superior technical knowledge may have higher wages and rental rates than a country with inferior technology.

3. FPE relies on convergence of goods prices: In reality, goods prices are not fully equalized by trade. There are transportation costs and barriers to trade (e.g., tariffs and quotas).


Does Trade Increase Income Inequality?

• 1970 – 2001: sharp ↑wage inequality

Real wages of males at the 95th percentile rose 29%.

Real wages of males at the 10th percentile rose 0.2%.

• Many people attribute ↑wage inequality to ↑world trade and to ↑X of manufactures from NIE (e.g., South Korea and China).

• Until 1970s, trade between advanced and developing countries was called North-South trade because industrialized (developing) countries are largely in the northern (southern) hemisphere.


Does Trade Increase Income Inequality? (cont.)

• Trade was an exchange of northern manufactures for southern primary products (e.g., minerals and agriculture).

• Since 1970, former raw materials exporters began to sell manufactures to high-wage nations, like U.S.

• NIE exports to advanced countries consisted of shoes, clothing, and other non-sophisticated manufactures whose production is intensive in the use of unskilled L.

• Advanced country exports to NIE are K-intensive manufactures (e.g., scientific equipment, chemicals, and aircraft).



• Many claimed that FPE had occurred.

• Trade between advanced countries (abundant in skilled L) with NIE (abundant in unskilled L) → ↓wages of unskilled L in advanced countries.

• This argument threatens economists’ support for free trade. Even if trade makes it possible to improve everyone’s welfare (through taxes and subsidies) this is unlikely to happen. So many argue that we should stop trading with low-wage countries to maintain the middle-class.



• Most empirical studies show that trade has had a small impact on ↑wage inequality in U.S. Why?

1. H-O predicts that trade affects income distribution via a ∆ relative goods prices. So if trade is driving income inequality, then prices of skill-intensive goods should rise in advanced countries. This hasn’t happened.

2. Model predicts that relative factor prices should converge. If ↑wages of skilled L and ↓wages of unskilled L in advanced countries → reverse is true in NIE. Yet, China and Mexico have both faced ↑wage inequality.



3. Trade with NIE is only a small portion of spending in advanced countries. If trade flows aren’t very large, they can’t have a large impact on income distribution.

• Most economists believe ↑wage inequality in U.S. is caused by technological advances, which have devalued unskilled L.

E.g., Most HS educated L could not operate machinery in a typical auto plant in U.S.


Gains from Trade Revisited

• Without trade, nations must produce what they consume. CPF = PPF.

• A nation can consume more of both goods with trade than in autarky.

• If a nation can consume more of both goods with trade, then it is feasible to give more to everyone.

• Trade expands the economy’s choices.

Fig. 12: Gains from Trade in Home

QF

QCQCDC

DF

QF

MF

XC

3

1

2

(PC/PF)

Before trade, Home produced and consumed at pt 2.

With trade, produce at pt 1 and consume at pt 3.

Trade (pt 3) allows Home to consume more of both goods than it did in autarky (pt 2).

Home’s budget constraint


Gains from Trade (cont.)

• So why is trade so controversial?

• In reality, that everyone could gain from trade does not mean that everyone actually does!


Optimal Trade Policy

• If every person were identical (tastes and incomes were the same), the government (G) would just choose a policy of free trade.

• If people differ, the G must weight 1 person’s gains against another’s losses. E.g., if some workers are already very poor

(apparel workers in U.S.) → sympathy for trade restrictions among the public. Rich consumers are helped by paying lower prices for clothing while poor workers are hurt by falling wages or layoffs.


Optimal Trade Policy (cont.)

• Economists don’t favor these arguments for 3 reasons.

1. Any economic change (e.g., relative goods’ prices, regulation, domestic tastes, or new technologies) alters the income distribution.

• If one argues that the G should restrict trade because some are injured, then shouldn’t it also restrict any disruptive technologies or innovations that cause some to suffer loses? (e.g., ipod, new drug therapies, electric cars, etc)



2. Always better to allow trade and compensate the losers because the costs of trade restrictions are so enormous to consumers.

Compensate losers with programs like TAA; or wage subsidies for workers who enter new industries or seek early retirement.

E.g., the annual cost to U.S. consumers per job saved in specialty steel is $1 million/yr; $240,000 in frozen oj; $150,000 motorcycles; $60,000 in sugar.



3. Those who lose are often better organized than those who gain which biases the political process.

• E.g., U.S. sugar industry has benefited from tariffs and quotas for years. Our price is x2 world price. Costs to U.S. consumers = $2 billion/yr or $8 for every person. Gains to producers are ½ as large. If consumers lobbied Congress as much as sugar growers do, then protection would stop. However, $8 loss for a consumer vs. $100,000 to a sugar grower means they lobby and consumers don’t!


Empirical Evidence

• H-O is a major trade theory and its been extensively tested. Overall, the tests are not supportive.

• U.S. Tests: U.S. is a special case –very wealthy vs rest of the world and K/L is high.

• Expect U.S. to export K-intensive goods and import L-intensive goods.

• In 1953, Leontief showed a paradox: (K/L)X < (K/L)M.• In 1962, Baldwin also showed the “Leontief paradox.”

But found U.S. exported goods that were more skilled L-intensive than its imports. And U.S. exported goods that were “technology-intensive” requiring scientists and engineers. Data is consistent with the view that U.S. is a skilled L country that

makes sophisticated products.


Empirical Evidence (cont.)

• Perhaps Leontief paradox is explained by U.S. advantage in developing new high tech products such as aircraft, computer chips, and pharmaceuticals.

• These products may use K and skilled L but be less K-intensive than older, established heavy industries (e.g., steel, autos, or oil).

• U.S. does export goods using skilled L, scientists, and entrepreneurship; while importing heavy manufactures (like cars and oil) that use lots of K.

• Clearly, goods the U.S. exports to Bangladesh match H-O theory. U.S. exports industrial machinery and Bangladesh exports clothing.


Empirical Evidence (cont.)

• Overall, when looking at global data, H-O doesn’t hold up!

• This puts trade economists in an awkward position!

• Empirical evidence does support Ricardian theory. But the model is too limited to address ∆ income distribution.

• Most trade economists believe that assumption of identical technologies should be dropped. E.g., U.S. can produce more than China from any set of

inputs.

E.g., can alter H-O to allow 1 (U.S). L = 1.5 (U.K.) L. Because of technology, U.S. labor is 50% more effective.

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