Transcript Chapter 4

Week 4: Part 2
Resources and
Trade: The
Heckscher-Ohlin
Model
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Factor Prices and Goods Prices
• In competitive markets, the price of a good should
equal its cost of production.
• The cost of production, in turn, depends on the factor
prices (wage w and rental r).
• How changes in the wage and rent affect the cost of
production depends on the mix of factors used.
• For instance, we have earlier assumed that (see Week
3 Slide 23):

Cloth is labor-intensive

Food is capital-intensive
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• Hence, an increase in the wages of labor (w) should
affect the price of cloth (PC) more than the price of
food (PF).

w
w/r 

PC  > PF  , PC/PF 
• Similarly, an increase in the rental rate of capital (r)
should affect the price of food (PF) more than the price
of cloth (PC).

r
w/r 

PF  > PC  , PC/PF 
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• With competition, changes in w/r are therefore directly
related to changes in PC /PW .
• In fact, there is a positive relationship between w/r and
PC /PF

w/r 
PC/PF 

w/r 
PC/PF 
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Fig. 4-6: Factor Prices and Goods Prices
The classic paper by Stolper
and
Samuelson
(1941)
demonstrates how changes in
output prices affect the prices
of the factors.
Stolper-Samuelson theorem:
if the relative price of a good
increases (say PC), then the
price of the factor used
intensively in the production of
that good increases (in this
case, wage w as cloth is laborintensive), while the price of
the other factor decreases (in
this case, renting rate r).
For details, click this website.
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Goods Prices and Input Choices
• It is possible to put our earlier figures together, i.e.,
factor prices-input choices (Slide 23) and goods
prices-factor prices (Slide 29).
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Fig. 4-7: From Goods Prices to Input Choices
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• By putting these 2 diagrams together, Figure 4-7
shows the links between goods prices and input
choices.
• When good prices = (PC /PF)1, it implies that factor
prices = (w/r)1, and input choices for food and cloth
will be (LF / KF)1 and (LC / KC)1 respectively.
• If the relative price of cloth  to (PC /PF)2, the factor
prices must  to (w/r)2. This will cause the input
choices for both food and cloth  to (LF / KF)2 and (LC /
KC)2 , respectively.
• In sum, given output prices, we can determine not
only factor prices, but also input choices in the
Heckscher-Ohlin model.
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Goods Prices and Income Distribution
• We can also see from Figure 4-7 that when the
relative price of goods changes, it will affect the
distribution of income.
• For instance, an increase in the relative price of cloth,
PC /PF, is predicted to:
  w/r (because cloth is labor-intensive), hence raising the
income of workers (wages w) relative to that of capital
owners (rental r).
 L/K  (because producers are willing to use less labor and
more capital). As a result, the marginal productivity of labor in
both industries , the marginal productivity of capital in both
industries .
Note: The marginal productivity of a factor typically
decreases when the level of that factor used in
production increases.
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 In a competitive economy, factors of production (labor and
capital) are paid their marginal product.
 Real wage = marginal productivity of labor
Real rental = marginal productivity of capital
 When the marginal productivity of labor in both industries , it
implies that the real income of workers  (hence higher
purchasing power of worker).
 When the marginal productivity of capital in both industries ,
it implies that the real income of capital owners  (hence
lower purchasing power of capital owners).
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Resources and Output
• Rybczynski theorem: If you hold output prices constant as
the amount of a factor of production , then the supply of
the good that uses this factor intensively , and the supply
of the other good .
 For instance, holding PC /PF constant, when the supply of
capital , the output of food that uses capital intensively 
(and the output of cloth ).
 The supply of food rises more than proportionately to the
increase in capital.
 For example, if capital  by 10%, food output might  by 15
or 20%.
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Fig. 4-8: Resources and Production Possibilities
To see how an increase in
capital affects the economy’s
output, we will use the PPF.
When supply of capital = TT1,
the economy produces at point
1, where the PPF touches the
highest possible isovalue line
with slope –PC/PF.
At point 1,
Cloth Production = Q
Food Production = Q
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1
C
1
F
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When supply of capital , the PPF will
shift out to TT2, indicating that the
economy could produce more food and
more cloth.
Since food is capital-intensive, the
outward shift of PPF is much larger in
the direction of food.
Holding output prices constant (the
slope –PC/PF remains unchanged), the
new production point is at 2.
At point 2,
Food Production  to Q
2
Cloth Production  to Q
F
2
C
Check this conclusion with Rybczynski
theorem.
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• The biased expansion of PPF is the key to
understanding how differences in resources give
rise to international trade.
 Labor , PPF expands disproportionately in the direction of
cloth production (since cloth is labor-intensive), QC 
 Capital , PPF expands disproportionately in the direction of
food production (since food is capital-intensive), QF 
The changes in resources depend on what the country is
relatively well endowed.
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• An economy is relatively efficient at producing goods
that are intensive in the factors of production in which
the country is relatively well endowed.
Home: Labor-abundant, Cloth: Labor-intensive
Home will be relatively efficient at producing cloth.
Foreign: Capital-abundant, Food: Capital-intensive
Foreign will be relatively efficient at producing food.
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Can a country be both labor- and capital-abundant?
• Note that abundance is defined in terms of ratio and not in
absolute quantities.
Foreign:
Labor (L*) = 80 million
Capital (K*) = 200 million
Home:
Labor (L) = 20 million
Capital (K) = 20 million
In absolute term, Foreign is abundant in both labor and
capital. How about relative term??
Labor abundance (Home)
= L / K = 20/20 = 1
Labor abundance (Foreign) = L*/ K* = 80/200 = 0.4
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Capital abundance (Home)
= K / L = 20/20 = 1
Capital abundance (Foreign) = K*/ L* = 200/80 = 2.5
So, what is your answer?
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International trade in the Heckscher-Ohlin
model
Further assumptions in H-O model:
• Home and Foreign have the same consumer tastes
(hence identical relative demands for food and cloth).
• They have the same technology, with each factor of
production (labor, capital) yielding the same amount
of output in both countries.
• The only difference between Home and Foreign is in
their resources [Recall that in H-O model,
differences in resources give rise to international
trade].
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• Further assume:
 Foreign has an abundant amount of capital (capitalabundant)
 Home has an abundant amount of labor services (laborabundant)
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What happen to relative prices with international
trade?
• The RD curve is downward sloping, reflecting
substitution effects.
• Relative demand of cloth is the quantity of cloth
demanded in all countries (QC + Q*C) relative to the
quantity of food demanded (QF + Q*F) in all countries.
• As the price of cloth relative to the price of food rises
(PC /PF ), consumers in all countries will tend to
purchase less cloth and more food, so that the
relative quantity of cloth demanded falls (negative
relationship).
• We have assumed earlier that both countries have the
same consumer tastes, hence they have similar RD
curve.
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• The RS curve, on the other hand, is upward sloping.
 Relative supply of cloth is the quantity of cloth supplied in all
countries (QC + Q*C) relative to the quantity of food supplied
(QF + Q*F) in all countries.
 Given that cloth is labor-intensive and Home is laborabundant.
 At each relative price (PC /PF), Home will produce more cloth
to food than Foreign.
 Hence, Home will have a higher relative supply of cloth than
Foreign
 Home RS curve will be to the right of Foreign RS*.
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Fig. 4-9: Trade Leads to a Convergence of Relative Prices
No Trade
Home equilibrium will be at
point 1.
Foreign equilibrium will be at
point 3.
3
2
1
In the absence of trade, PC /PF
is higher in Foreign.
With Trade
PC /PF will converge with a
new world relative price
(similar to Ricardian model).
The new relative price is
between the two countries’ pretrade prices (say at point 2).
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How does the convergence of relative prices translate
into a pattern of international trade?
• Like the Ricardian model, the Heckscher-Ohlin model
predicts a convergence of relative prices when
countries engage in international trade (see Figure 49).
• With trade, the relative price of cloth (labor-intensive)
is predicted to  in the labor-abundant Home (from
point 1 to 2)
 When PC /PF , the relative production of cloth  , the relative
consumption of cloth 
 Hence RS (Cloth) > RD (Cloth), Home becomes an exporter
of cloth and an importer of food.
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• With trade, the relative price of cloth is predicted to  in
Foreign (from point 3 to 2).
 This implies that the relative price of food (capital-intensive) 
in the capital-abundant Foreign.
 When PF /PC , the relative production of food  , the relative
consumption of food 
 Hence RS (Food) > RD (Food), Foreign becomes an
exporter of food and an importer of cloth
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• Heckscher-Ohlin theorem: An economy has a
comparative advantage in producing, and thus will
export, goods that are relatively intensive in using its
relatively abundant factors of production.
Home: Labor-abundant EXPORT Labor-intensive Cloth
Foreign: Capital-abundant EXPORT Capital-intensive Food
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4-49
How does the convergence of relative prices affect
income distribution?
• International trade leads to convergence of relative
prices (see Figure 4-9).
• Changes in relative prices will affect the relative
earnings of labor and capital.
• With trade, the relative price of cloth (labor-intensive)
is predicted to  in the labor-abundant Home (see
slide 47)
 When PC /PF , the real income/purchasing power of workers
, but the real income/purchasing power of capital owners 
(see Slides 33-34)
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• With trade, the relative price of food (capital-intensive)
is predicted to  in the capital-abundant Foreign (see
slide 48)
 When PF /PC , the real income/purchasing power of capital
owners , but the purchasing power of workers  (see Slides
33-34)
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The Heckscher-Ohlin model predicts that owners of
abundant factors gain with trade, but owners of scarce
factors lose.
Home: Labor-Abundant
Workers Gain
Capital owners Lose
Foreign: Capital-Abundant Capital owners Gain
Workers Lose
Unlike Ricardian model, not everyone gains from trade
in the H-O model.
For “Trade and Income Distribution”, Read the Case
Study in Textbook, page 122-126.
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How does the convergence of relative prices lead to
equalization of input (factor) prices?
• Unlike the Ricardian model, the Heckscher-Ohlin
model predicts that input (factor) prices will be
equalized among countries that trade (wages and
rental will be the same in Home and Foreign).
• From Figure 4-6 (see Slide 29), given the goods prices
(PC /PF), we can determine w/r.
• With trade, relative goods prices converged in both
countries (see Figure 4-9).
• If Home and Foreign face the same relative prices,
they will also have the same factor prices (due to the
positive relationship).
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• In the real world, factor prices are not equal across
countries (see Table 4-1 for differences in wages).
• Why the H-O model does not give an accurate
prediction? Look at the underlying assumptions.
1. The model assumes that trading countries produce the same
goods (cloth and food), so that prices for those goods will
equalize, but countries may produce different set of goods.
2. The model also assumes that trading countries have the same
technology (see Slide 42), but different technologies could
affect the productivities of factors and therefore the
wages/rental paid to these factors.
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Table 4-1
Comparative International Wage Rates (United States = 100)
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3. The model also ignores trade barriers (e.g., tariffs, import
quotas) and transportation costs, which may prevent output
prices and factor prices from equalizing.
4. The model predicts outcomes for the long run, but after an
economy liberalizes trade, factors of production may not quickly
move to the industries that intensively use abundant factors.
 In the short run, the productivity of factors will be determined
by their use in their current industry, so that their wage/rental
may vary across industries.
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Empirical evidence on the Heckscher-Ohlin
Model
• Tests on the U.S. data
 U.S. is the most capital-abundant country in the world (higher
capital-labor ratios)
 One would expect U.S. would be an exporter of capitalintensive goods and an importer of labor-intensive goods
 However, Leontief found that U.S. exports were less capitalintensive than U.S. imports (Leontief paradox)
 Table 4-2 illustrates the paradox, where U.S. exports were
produced with a lower capital-labor ratio than U.S. imports
(see line 3).
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Table 4-2
Factor Content of U.S. Exports and Imports for 1962
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• Tests on global data
 Bowen, Leamer, and Sveikauskas tested the HeckscherOhlin model on data from 27 countries and confirmed the
Leontief paradox on an international level.
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• Looking at changes in patterns of exports
between developed (high income) and
developing (low/middle income) countries
supports the theory.
• US imports from Bangladesh are highest in
low-skill-intensity industries, while US imports
from Germany are highest in high- skillintensity industries.
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Fig. 4-10
Skill Intensity and the Pattern of U.S. Imports from Two Countries
Source: John Romalis, “Factor Proportions and the Structure of Commodity Trade,” American Economic Review
94 (March 2004), pp. 67–97.
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• As Japan and the four Asian “miracle”
countries became more skill-abundant, U.S.
imports from these countries shifted from less
skill-intensive industries toward more skillintensive industries.
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Fig. 4-11A
Changing Patterns of Comparative Advantage (1960)
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Fig. 4-11B
Changing Patterns of Comparative Advantage (1998)
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