Chapter 5. Resources and Trade: The Heckscher- Ohlin Model

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1 Chapter 5 Resources and Trade: The Heckscher- Ohlin Model

2 Introduction So far we learned that: Free trade leads to higher average real income per capita But not everyone within the country is better off In the specific factors model, opening a country to trade creates winners and losers: The real return to the factor specific to the expanding (or export) industry increases The real return to the factor specific to the contracting (or import) industry decreases ECON University of Notre Dame 5-2

3 Introduction The specific-factors model is a short-run model because some factors simply cannot relocate across sectors. What is the impact of trade on income distribution in the long run? We develop a long run version of the multi-factor model: the Heckscher-Ohlin model. 2 factors: capital (K) and labor (L) Both are perfectly mobile across sectors (long run assumption) ECON University of Notre Dame 5-3

4 Introduction Recall that, in the classical models, there are potential gains from trade whenever there is cross-country variation in autarky relative prices. In the Ricardian model, differences in autarky prices come from differences in technologies across countries. In the Heckscher-Ohlin model (as in the specific factors model): Technologies are the same in all countries Trade patterns are explained by cross-country differences in relative factor endowments ECON University of Notre Dame 5-4

5 Introduction A country is capital-abundant if the ratio of capital to labor available in the economy is large compared to other countries. A good is capital-intensive if the ratio of capital to labor used in its production is high compared to other goods. Cross-country differences in factor abundance interact with differences in factor intensity to generate cross-country dispersion in closed economy relative prices. ECON University of Notre Dame 5-5

6 Introduction Countries differ in their capital-abundance ECON University of Notre Dame 5-6

7 Introduction Industries differ in their capital-intensity ECON University of Notre Dame 5-7

8 Heckscher-Ohlin Model The Heckscher-Ohlin model has 2 countries: Home and Foreign (*) 2 goods: Computers (C) and Shoes (S) 2 factors of production: Labor (L) and Capital (K) The factor market clearing conditions are: K C + K S = K and L C + L S = L K * C + K * S = K * and L * C + L * S = L * ECON University of Notre Dame 5-8

9 Heckscher-Ohlin Model Assumption 1: Both factors can move freely between the industries, but cannot move between countries. Assumption 2: Shoes are labor-intensive (this is without loss of generality). L C < K C This implies that the relative demand for labor is higher in the shoes sector for any factor prices (W and R). L K S S ECON University of Notre Dame 5-9

10 Heckscher-Ohlin Model An increase in the relative price of labor (wage/rental) decreases the relative demand for labor in both industries. Because shoes are labor-intensive, the relative demand for labor is higher in the shoe industry independent of the relative factor price. ECON University of Notre Dame 5-10

11 Heckscher-Ohlin Model Assumption 3: Home is capital abundant (again without loss of generality): K > L K L * * We can use assumptions 2 and 3 to derive the PPF for each country. ECON University of Notre Dame 5-11

12 Heckscher-Ohlin Model Home is capital abundant, and computers are capital-intensive Home is capable of producing relatively more computers than shoes compared to Foreign. More generally, the PPF of a country is skewed towards the good that is intensive in the abundant factor. Qs Foreign PPF Home PPF Qc ECON University of Notre Dame 5-12

13 Heckscher-Ohlin Model Assumption 4: The final outputs (shoes and computers) can be traded at no cost between countries, but inputs (labor and capital) cannot move between countries. Assumption 5: The technologies are the same in both countries. Assumption 6: Preferences are the same in both countries and can be represented by well-behaved indifference curves. ECON University of Notre Dame 5-13

14 Heckscher-Ohlin Model In equilibrium, the slope of the PPF (MRT) is equal to the slope of the indifference curve (MRS) and the relative price: MRT = MRS = - P P C S ECON University of Notre Dame 5-14

15 Heckscher-Ohlin Model The autarky relative price of computer is higher in Foreign This reflect the variation in relative factor endowment across countries. Home is capital-abundant and has a comparative advantage in the production of the capital-intensive good (computers). Foreign is labor-abundant and has a comparative advantage in the production of the labor intensive good (shoes). ECON University of Notre Dame 5-15

16 Heckscher-Ohlin Model Q S Autarky (point A): production and consumption are equal. Slope = (P C /P S ) T Trade increases the relative price of computers at Home: supply (point B) and demand (point C). A Home exports Computers and imports Shoes B U 1 PPF The rise in utility from U 1 to U 2 is a measure of the gains from trade for the economy. Q C ECON University of Notre Dame 5-16

17 The Four Theorems Which good does each country export? (Heckscher-Ohlin theorem) What is the impact of trade on real factors prices (i.e., welfare)? (Stopler-Samuelson theorem) What is the impact of changes in endowments on production? (Rybsczynski theorem) Do factor prices differ across countries? (Factor price equalization theorem) H.O. model notes. ECON University of Notre Dame 5-17

18 Theorems Heckscher-Ohlin Theorem: An economy will export the good that is intensive in its abundant factor of production and import the good that is intensive in its scarce factor of production. Stopler-Samuelson Theorem: In the long run when all factors of productions are mobile, an increase in the relative price of a good will increase the real earnings of the factor used intensively in the production of that good and decrease the real earnings of the other factor. ECON University of Notre Dame 5-18

19 Theorems Rybczynski Theorem: If the relative commodity prices are constant and if both commodities continue to be produced, an increase in the supply of a factor will lead to an increase in the output of the commodity using that factor intensively and a decrease in the output of the other commodity. Factor Price Equality Theorem: Under identical constant returns to scale production technologies, free trade in commodities will equalize relative factor prices through the equalization of relative commodity prices, so long as both countries produce both goods. ECON University of Notre Dame 5-19

20 Stopler-Samuelson Theorem K There is an increase in the price of shoes I R B I R A Computers Shoes A B Shoes B A B A The shoes isovalue shifts towards the origin The slope of the isocost tangent to both isoquant is now steeper s.th. W/R is higher. The capital-labor ratio goes up in both sectors I I L W B W A ECON University of Notre Dame 5-20

21 Rybczynski Theorem K Computers L 2 L 1 K E1 E2 K C1 K C2 Shoes L S1 L 1 L S2 L 2 L ECON University of Notre Dame 5-21

22 Empirical Evidence 1. Leontief s Paradox HO theorem: Countries export the good that is intensive in their abundant factor of production. Wassily Leontief performed the first test of the Heckscher-Ohlin theorem in 1953 using data for the U.S. from In 1947 the U.S. was capital abundant relative to the rest of the world. The U.S. should export capital intensive goods and import labor intensive goods. ECON University of Notre Dame 5-22

23 Empirical Evidence He measured the amounts of labor and capital (direct and indirect) used to produce $1 million of U.S. exports and to produce $1 million of imports into the U.S. It was impossible for Leontief to get information on the amount of labor and capital used to produce imports. But the H.O. model assumes that technologies are the same across countries. He used data on U.S. technology to calculate estimated amounts of labor and capital used in imports from abroad. ECON University of Notre Dame 5-23

24 Empirical Evidence Leontief s Data In 1947, the capital labor ratio for U.S. imports was higher than for exports. This contradiction came to be called Leontief s paradox. ECON University of Notre Dame 5-24

25 Empirical Evidence Baldwin s test 1947 is just after the 2 nd world war: maybe data is not representative Baldwin tested the Heckscher-Ohlin theory using US trade data from 1962 and production information from 1958 His results confirm the Leontief paradox ECON University of Notre Dame 5-25

26 Empirical Evidence 2. Sign Test We can make the HO model more realistic by allowing for more than two goods, factors, and countries. How do we measure factor abundance when there is more than two inputs? We can compare the country s share of a factor (S F ) with its share of world GDP (S GDP ). If S F > S GDP, the country is abundant in that factor. If S F < S GDP, the country is scarce in that factor. ECON University of Notre Dame 5-26

27 Empirical Evidence The sign test is based on the idea that trade in goods is an indirect way of trading factors of production Countries should be net-exporter of their abundant factor. Sign of ( Factor share GDP share) = Sign of factor content of net export ECON University of Notre Dame 5-27

28 Empirical Evidence Consider a world with 2 countries and 3 factors Suppose that the factors are evenly distributed across countries. Since technologies are the same: S F1 = S F2 = S F3 = S GDP = 1/2 Now suppose we move all of factor 1 to country 1 and all of factor 2 to country 2 but GDP is still ½ S F2 = 0 < S F3 = ½ = S GDP = ½ < S F1 =1 S F1 = 0 < S F3 = ½ = S GDP = ½ < S F2 = 1 ECON University of Notre Dame 5-28

29 Empirical Evidence Since income is the same and preferences are the same the factor content of consumption will also be the same in both countries But, in this case, the factor content of production is not the same. Country 1 has all of factor 1 Country 2 has all of factor 2 The factor content of net export will reflect differences in relative factor endowment across countries Country 1 will export factor 1 Country 2 will export factor 2 ECON University of Notre Dame 5-29

30 Empirical Evidence Bowen, Leamer and Sveikauskas (1987) applied the sign test in a sample of 27 countries and 12 factors of production. ECON University of Notre Dame 5-30

31 Empirical Evidence 3. Relaxing assumptions of the HO model (A1) The strongest assumption is that technology is the same across countries Estimated Technological Efficiency relative to United States (i.e., US wages = 1), 1983 ECON University of Notre Dame 5-31

32 Empirical Evidence Other assumptions include (A2) All countries produce all goods (A3) Prices are the same across countries (i.e., no barriers to trade) ECON University of Notre Dame 5-32

33 Conclusions The HO framework is a widely used model to explain trade patterns. It isolates the effect of differences in relative factor endowments across countries on trade patterns, relative prices, and factor returns. By focusing on the differences in relative factor intensities among goods, the HO model also provides clear guidance as to which factor gains and which factor loses from trade. However, on its own, the HO model does not do a particularly good job of explaining trade patterns we need technological differences. ECON University of Notre Dame 5-33