Econ 405 Topic

Topic 2
The HeckscherOhlin Model
Slides prepared by Thomas Bishop
Copyright 2009 Pearson Addison-Wesley. All rights reserved.
Preview
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
Copyright 2009 Pearson Addison-Wesley. All rights
reserved.
4-2
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 oilfield 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).
reserved.
4-3
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.
reserved.
4-4
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.

reserved.
4-5
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.

reserved.
4-6
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
reserved.
4-7
Substitution Between Inputs

Unlike the Ricardian model, producers dont
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.

reserved.
4-8
Fig. 1: Input Possibilities in Food Production

reserved.
4-9
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.

reserved.
4-10
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 landintensive, while cloth is laborintensive (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
wont impact PC much. However, food uses
lots of T so r PF.

reserved.
4-12
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.

reserved.
4-15
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.

reserved.
4-16
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.
reserved.
4-17
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.

reserved.
4-18
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.

reserved.
4-20

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).
reserved.
4-21

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.

reserved.
4-22
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 Tintensive good, while L
expands production of the Lintensive 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
reserved.
4-25
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 pretrade 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
Or
value of production
DF QF = (PC/PF) x (QC DC)
value of food imports = value of cloth exports

reserved.
4-27
Fig. 9: Budget Constraint with Trade

QF
QFt
-(PC/PF) t = slope
DF QF = (PC/PF) x (QC DC) is the

countrys 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
QC t
QC
Fig. 10: Trading Equilibrium

Home
QF
DF
QF
MF
Foreign
QF
QF
DF
X*F
M*C
XC
DC
QC
QM
QC
DC
QC
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

Q*F
QF
(PC/PF)*t (PC/PF)*a
(PC/PF)t
(PC/PF)a
Q*t
Qa = Da
Q*a = D*a
Qt
Home
QC
Foreign
Note: a = autarky and t = trade
Q*C
Trade Between Countries (cont.)

Fig. 11: Since cloth is L-intensive good and home is L
abundant, homes 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.
reserved.
4-31
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 countrys abundant
factor gain from trade, but owners of a countrys
scarce factor lose.
reserved.
4-32
Trade and Income Distribution (cont.)

U.S. is abundant in highly skilled L and lowskilled 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!
reserved.
4-33
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.

reserved.
4-34
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 Tintensive good. Viewed this way, its not surprising
that w/r equalize.
reserved.
4-35
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 Lintensive 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.
reserved.
4-36

Problem: in real world, factor prices are not equalized.
Wages vary greatly across countries and quality of L alone
doesnt 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.
reserved.
4-37

2. Technologies are the same: FPE doesnt 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).

reserved.
4-38
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.
reserved.
4-39
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).
reserved.
4-40

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
everyones 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.

reserved.
4-41
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
hasnt happened.
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.
2.

reserved.
4-42

3.
Trade with NIE is only a small portion of spending in

advanced countries. If trade flows arent very large,
they cant 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.
reserved.
4-43
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 economys choices.
reserved.
4-44
Fig. 12: Gains from Trade in Home

QF
Before trade, Home produced

and consumed at pt 2.
With trade, produce at pt 1
and consume at pt 3.
DF
2
MF
1
QF
XC
Trade (pt 3) allows Home to

consume more of both goods
than it did in autarky (pt 2).
Homes budget constraint
(PC/PF)
DC
QC
QC
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!

reserved.
4-46
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 persons
gains against anothers 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.
reserved.
4-47
Optimal Trade Policy (cont.)
Economists dont 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 shouldnt it also
restrict any disruptive technologies or innovations
that cause some to suffer loses? (e.g., ipod, new
drug therapies, electric cars, etc)

reserved.
4-48

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.
reserved.
4-49

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 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 dont!

reserved.
4-50
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 Lintensive 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.

reserved.
4-51
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 Kintensive 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.
reserved.
4-52
Empirical Evidence (cont.)

Overall, when looking at global data, H-O doesnt 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.
reserved.
4-53

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Topic 2

The HeckscherOhlin Model

Slides prepared by Thomas Bishop

Copyright 2009 Pearson Addison-Wesley. All rights reserved.

Substitution between inputs

A more realistic view of trade incorporates

Copyright 2009 Pearson Addison-Wesley. All rights

Copyright 2009 Pearson Addison-Wesley. All rights

Assumptions of the H-O Model

Neither input is specific to an industry.

3. Define the following terms:

aTC = acres of T used to produce 1 yard of cloth

Substitution Between Inputs

Copyright 2009 Pearson Addison-Wesley. All rights

Fig. 1: Input Possibilities in Food Production

Copyright 2009 Pearson Addison-Wesley. All rights

Substitution Between Inputs (cont.)

Input choices depend on w/r ratio.

Copyright 2009 Pearson Addison-Wesley. All rights

Fig. 2: Factor Prices and Input Choices

Copyright 2009 Pearson Addison-Wesley. All rights

Fig. 3: Factor Prices and Goods Prices

Fig. 4: From Goods Prices to Input Choices

Goods Prices and Factor Prices

Copyright 2009 Pearson Addison-Wesley. All rights

Goods Prices and Factor Prices (cont.)

Copyright 2009 Pearson Addison-Wesley. All rights

Goods Prices and Factor Prices (cont.)

Stolper-Samuelson theorem: P of a good

Resources and Output

Copyright 2009 Pearson Addison-Wesley. All rights

Fig. 5: The Allocation of Resources

Resources and Output (cont.)

Copyright 2009 Pearson Addison-Wesley. All rights

Resources and Output (cont.)

Resources and Output (cont.)

Copyright 2009 Pearson Addison-Wesley. All rights

Fig. 6: An Increase in the Supply of Land

Fig. 7: Resources and PPF

Trade Between Countries

Fig. 8: Trade Leads to a Convergence of

Trade Between Countries (cont.)

With trade, this is no longer true. However, a

DF QF = (PC/PF) x (QC DC)

value of food imports = value of cloth exports

Fig. 9: Budget Constraint with Trade

DF QF = (PC/PF) x (QC DC) is the

Fig. 10: Trading Equilibrium

Trade opens: in Home (PC/PF) DF and QF exports C and imports F; in

Fig. 11: PPF for Two Countries

Trade Between Countries (cont.)

Trade and Income Distribution

Trade and Income Distribution (cont.)

Trade and Income Distribution (cont.)

Copyright 2009 Pearson Addison-Wesley. All rights

Factor Price Equalization

Home X its L embodied in the L-intensive good.

Factor Price Equalization (cont.)

Factor Price Equalization (cont.)

Problem with 3 model assumptions:

Factor Price Equalization (cont.)

Copyright 2009 Pearson Addison-Wesley. All rights

Does Trade Increase Income Inequality?

Many people attribute wage inequality to world