international economics ppt chapter 5

International EconomicsTenth EditionFactor Endowments and the Heckscher-Ohlin Theory

Dominick SalvatoreJohn Wiley & Sons, Inc.Salvatore: International Economics, 10th Edition 2010 John Wiley & Sons, Inc.CHAPTER F I V E5

Salvatore: International Economics, 10th Edition 2009 John Wiley & Sons, Inc.

In this chapter:IntroductionAssumptions of the TheoryFactor Intensity, Factor Abundance, and the Shape of the Production FrontierFactor Endowments and the Heckscher-Ohlin TheoryFactor-Price Equalization and Income DistributionEmpirical Tests of the Heckscher-Ohlin Model



IntroductionExtending trade model to include:Basis of comparative advantageEffect of international trade on return to labor



Assumptions of the TheoryHeckscher-Ohlin theory based on following assumptions:Two nations, two goods, two factors of productionTechnology same in both nationsCommodity X is labor intensive, commodity Y is capital intensive in both nationsConstant returns to scale for X and Y in both nationsIncomplete specialization in production in both nations



Assumptions of the TheoryHeckscher-Ohlin theory based on following assumptions:Tastes are equal in both nationsBoth commodities and factors are traded in perfectly competitive marketsPerfect factor mobility within each nation, but not between nationsNo transportation costs, tariffs or other barriers to free trade.All resources are fully employed in both nationsInternational trade between the nations is balanced.Salvatore: International Economics, 10th Edition 2010 John Wiley & Sons, Inc.


Factor Intensity, Factor Abundance, and the Shape of the Production FrontierFactor IntensityIn 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.Salvatore: International Economics, 10th Edition 2010 John Wiley & Sons, Inc.


FIGURE 5-1 Factor Intensities for Commodities X and Y in Nations 1 and 2.Salvatore: International Economics, 10th Edition 2010 John Wiley & Sons, Inc.


Factor Intensity, Factor Abundance, and the Shape of the Production FrontierFactor AbundanceIn 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 Intensity, Factor Abundance, and the Shape of the Production FrontierFactor AbundanceIn 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.



FIGURE 5-2 The Shape of the Production Frontiers of Nation 1 and Nation 2.Salvatore: International Economics, 10th Edition 2010 John Wiley & Sons, Inc.Nation 1 is L-abundant, and commodity X is L-intensiveNation 2 is K-abundant, and commodity Y is K-intensive


Factor Endowments and the Heckscher-Ohlin TheoryHeckscher-Ohlin (H-O) theory is based on two theorems:1. The H-O theoremA nation will export the commodity whose production requires the intensive use of the nations relatively abundant and cheap factor and import the commodity whose production requires the intensive use of the nations relatively scarce and expensive factor.Salvatore: International Economics, 10th Edition 2010 John Wiley & Sons, Inc.


Factor Endowments and the Heckscher-Ohlin TheoryHeckscher-Ohlin (H-O) theory is based on two theorems:1. The H-O theoremIn short, the relatively labor-rich nation exports the relatively labor-intensive commodity and imports the relatively

Explains comparative advantage rather than assuming it.Salvatore: International Economics, 10th Edition 2010 John Wiley & Sons, Inc.


FIGURE 5-3 General Equilibrium Framework of the Heckscher-Ohlin Theory.Salvatore: International Economics, 10th Edition 2010 John Wiley & Sons, Inc.


FIGURE 5-4 The Heckscher-Ohlin Model.Salvatore: International Economics, 10th Edition 2010 John Wiley & Sons, Inc.


Factor-Price Equalization and Income DistributionHeckscher-Ohlin (H-O) theory is based on two theorems:2. The factor price equalization theoremInternational 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 after specialization and trade has occurred.Holds only if H-O theorem holds.Salvatore: International Economics, 10th Edition 2010 John Wiley & Sons, Inc.


Factor-Price Equalization and Income DistributionHeckscher-Ohlin (H-O) theory is based on two theorems:2. The factor price equalization theoremInternational trade causes w to rise in Nation 1 (the low-wage nation) and fall in Nation 2. (the high-wage nation), reducing the pretrade difference in w between nations.Similarly, trade causes r to fall in Nation 1 (the K-expensive nation) and rise in Nation 2. (the K-cheap nation), reducing the pretrade difference in r between nations.



Factor-Price Equalization and Income DistributionHeckscher-Ohlin (H-O) theory is based on two theorems:2. The factor price equalization theoremThus, international trade causes a redistribution of income from the relatively expensive (scarce) factor to the relatively cheap (abundant) factor.



FIGURE 5-5 Relative FactorPrice Equalization.Salvatore: International Economics, 10th Edition 2010 John Wiley & Sons, Inc.


Factor-Price Equalization and Income DistributionSpecific Factors ModelTrade will:have an ambiguous effect on a nations mobile factors, benefit the immobile factors specific to a nations export commodities or sectors, andharm the immobile factors specific to a nations import-competing commodities or sectors.Salvatore: International Economics, 10th Edition 2010 John Wiley & Sons, Inc.


5.6 Empirical Tests of the H-O Model5.6A. The Leontief Paradox(1) Empirical test by Wassily Leontief (1951)- Data: U.S. data for the year 1946.- Hypothesis: Since the U.S. was the most K-abundant nation in the world, it was expected that the U.S. exported K-intensive commodities and imported L-intensive commodities.- Test method: Calculated the amount of labor and capital in a representative bundle of $1 million worth of U.S. exports and import substitutes for the year 1947.- Result: U.S. import substitutes were more K-intensive than U.S. exports. This is called the Leontief paradox.


5.6 Empirical Tests of the H-O Model- Table 5.6. Capital and Labor Requirements per Million Dollars of U.S. exports and import substitutes


Sheet1

ExportsImports SubstitutesImports

Exports

Leotief

(1947 input requirements, 1947 trade):

Capitalreserved-2550780x18reserved-3091339x18

Labor (worker-years)$182$170

Capital/worker-yearreserved-14010x18reserved-18180x181.30

Leotief





Capital/worker-year, excluding natural resources0.88

Baldwin





Capital/worker-year, excluding natural resources1.04

Capital/worker-year, excluding natural resources and human capital0.92

Sheet2

Sheet3

Empirical Tests of the Heckscher-Ohlin ModelSource of the Leontief Paradox BiasAssumed 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).Salvatore: International Economics, 10th Edition 2010 John Wiley & Sons, Inc.


5.6 Empirical Tests of the H-O ModelImplications of the conflicting empirical results

The H-O model is useful in explaining international trade in raw materials, agricultural products which is large component of trade between developing and developing countries.

There should be other basis for trade. Chapter 6.


Appendix to Chapter 5The Edgeworth Box Diagram for Nation 1 and Nation 2Once AgainFormal Proof of the FactorPrice Equalization TheoremSpecific-Factors ModelFactor-Intensity Reversal



FIGURE 5-7 The Edgeworth Box Diagram for Nation 1 and Nation 2Once Again.Salvatore: International Economics, 10th Edition 2010 John Wiley & Sons, Inc.


FIGURE 5-8 Formal Proof of the FactorPrice Equalization Theorem.Salvatore: International Economics, 10th Edition 2010 John Wiley & Sons, Inc.


FIGURE 5-9 Specific-Factors Model.Salvatore: International Economics, 10th Edition 2010 John Wiley & Sons, Inc.


FIGURE 5-10 Factor-Intensity Reversal.Salvatore: International Economics, 10th Edition 2010 John Wiley & Sons, Inc.


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