The Heckscher Ohlin Model: Supplemental Material Of all the possible reasons for differences in relative commodity prices

s and comparative advantage among nations, the Heckscher- Ohlin (H-O) theory isolates the differences in relative factor abundance or factor endowments as the basic cause of comparative advantage and international trade. The H-O theory examines the basis for comparative advantage and the effect trade has on factor earnings (income distribution). Assumptions of the model: There are two notions (home and foreign), two goods (cloth and food) and two factors (labour and land) in the model. Both nations use the same technology in the model. Cloth is labour intensive and food is land intensive. Both commodities are produced under constant return to scale in both nations. There is incomplete specialization in production in both nations. Tastes are same in both nations. There is perfect competition in both goods and factor markets in both nations. There is perfect factor mobility within each nation but no international factor mobility. There is no transportation cost, tariffs or other forms of trade barriers. All resources are fully utilized in both nations. International trade between the nations is balanced.

Meaning of the assumptions: Assumption 1 is clear; it is made in order to illustrate the model with two dimensional graphs. Assumption 2 means that both nation use same production techniques. Given the same commodity prices, both nations would use the same amount of land and labour to produce cloth and food. Assumption 3 means that cloth requires relatively more labour to produce than food in both nations. More technically, land-labour ratio is lower for cloth than food. But it does not mean that landlabour ratio is same in home and foreign, only land-labour ratio is lower for cloth than food in both nations. Assumption 4 (CRS) means that doubling the inputs would double the output in both nations. Assumption 5 means that even with free trade both nations continue to produce both goods. This implies that neither of the nations is small. Assumption 6 implies that preferences (IC curve) are identical in both nations. When relative prices are same, both nations will consume the same proportion of cloth and food. Assumption 7 implies that producers and consumers are too small to affect the prices of these commodities. Perfect competition also implies that in the long run, prices equal to costs of production. No economic profit in this model. Assumption 8 means that factors are free to move across industries. On the other hand, there is zero international factor mobility so international differences in factor earnings would persist in the absence of trade.
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Assumption 9 means that specialization in production proceeds until relative prices are equalized. Assumptions 10 means that there are no unemployed resources in either nations. Assumption 11 implies that the total value of each nations exports is equal the total value of the each nations imports. Factor intensity: For two factors (land and labour) and two commodities (food and cloth) model, we say that cloth is labour intensive if the labourland ratio (LC/TC) is used in production of cloth is higher than the labour- land (L F/TF ) ratio used in food. For, example if 2 units of land and 2 units of labour are used to produce 1 unit of food then TC/LC ratio is 1. For, example if 1 unit of land and 4 units of labour are used to produce 1unit of cloth then TC/LC ratio is . In this case, food is land intensive and cloth is labour intensive in home.

Home
Land T/L in food=1

T/L in cloth=1/4

Labour 3

Foreign

Land

T/L in food = 4 T/L in cloth=1

Labour

Even though food is land intensive in relation to cloth in both nations, foreign uses a higher land-labour ratio in producing both cloth and food. Why does foreign use more land intensive production technique than home? Answer to this question must be based on the factor prices - land is cheaper in foreign than home. Why is land cheaper in foreign? In order to answer this question, we must define factor prices and factor abundance. Factor abundance:

There are two ways to define factor abundance. One way is in terms of physical units. Another way to define factor abundance is in terms of relative factor prices. According to the definition in terms of physical units, foreign is land- abundant if the ratio of total units of land to total units of labour available in foreign is greater than home. According to the definition of factor prices, foreign is landabundant if the price of land (r) to the price of labour (w) is lower in foreign. The relationship between two definitions is clear. The definition of factor abundance in terms of physical units only considers the supply of factors. The definition in terms of relative factor prices considers both supply and demand. Since, we assumed that taste and preferences are same, the two definitions give the same conclusions. Factor abundance and the shape of the PPF: Home is labour- abundant country and food is labour intensive good. Foreign is land-abundant country and food is land intensive good. Since, cloth is labour intensive good; homes PPF relative to foreign is shifted out more in the direction of cloth than in the direction of food. Thus, other things equal, home tends to produce a higher ratio of cloth to food.
Food Foreign

Home

Cloth

The H-O theory: A nation will export the commodity whose production requires the intensive use of nations relatively abundant and cheap factor and import the commodity whose production requires the intensive use of the nations relatively scarce and expensive factors. The central message concerning trade patterns of the H-O theory is that countries tend to export goods whose production is intensive in factors with which they are relatively abundantly endowed. This is demonstrated by showing that, using the relative supply and relative demand analysis, the country relatively abundantly endowed with a certain factor will produce that factor more cheaply than the other country. International trade leads to a convergence of goods prices. Thus, the results from the StolperSamuelson effect demonstrate that owners of a countrys abundant factors gain from trade, but owners of a countrys scarce factors lose. The extension of this result is the important Factor Price Equalization Theorem, which states that trade in goods leads to an equalization in the rewards to factors across countries.

A s s u m in gid e n t ic a lu t ility fu n c tio nf o rH o m e&F or e ig n

QF AF C *

H o m e&F o r e ig nP P F sd iffe rd u et od if fe r e n c e s in t e c h n olo g yo rf a c t o re n d o w m e n t s . A u t a r k yE q u ilib riu ma tA n dA Ha F O p e n in gt r a d ec h a n g e sr e la t iv ep r ic e s N e we q u ilib r iu mc o n s u m p tio na tC *. E a c hc o u n t r yh a sd iffe r e n tp r o d u c t io np o in t. AH QH (PX/PY)* PPFH

PPFF

X
2

Two important results are derived using this model. The first is known as the Rybczynski effect. Increasing the relative supply of one factor, holding relative goods prices constant, leads to a biased expansion of production possibilities favouring the relative supply of the good which uses that factor intensively. The second key result is known as the Stolper-Samuelson effect. Increasing the relative price of a good, holding factor supplies constant, increases the return to the factor used intensively in the production of that good by more than the price increase, while lowering the return to the other factor. This result has important income distribution implications.
References: Salvatore, Dominick, International Economics, eighth edition, John Wiley & Sons, Inc, 2004 Sodersten, Bo & Geoffrey reed, International economics, third edition, 1994 http://internationalecon.com/Trade/Tch40/T40-0.php