The Heckscher-Ohlin Theory

Chapter 4

Problems with Classical Model

It has some of the strict assumptions
The assumption of constant opportunity costs The notion that trade arose due to the differences in productivity level between countries

It also offers some of the extreme predictions that are not borne out in real world trade pattern

Heckscher-Ohlin Model
Based on two different characteristics of countries and products
Countries differ from each other according to the factors of production they possess Goods differ from each other according to the factors that are required in their production

H-O model argued that a country will be able to produce at lower cost those products whose production requires large amounts of factors of production with which the country is relatively well endowed

Assumptions
Keep all the seven assumptions we discussed in developing model for autarky model and first three assumptions for trade model We drop 2 assumptions:1) labor is the only relevant factor of production and 2) technology can be described only with unit of labor inputs In addition, HO model has five more assumptions.

HO Model
We add five new assumptions (Assumption 13) There are two factors of production: labor (L) and capital (K). Also, owners of capital are paid a rental payment (R) for the services of their assets. Labor receives a wage payment (W).
This assumption relaxes one of the strict assumptions of the classical model, i.e., labor was the only relevant factor of production and used in the same proportion along with machines in the production process.

Assumptions
(Assumption 14) The technology sets available to each country are identical.
One of the crucial assumptions in HO model. It implies that for production of any good, producers in both countries have ready access to the same choices of production techniques.

Assumptions
(Assumption 15) In both countries, the production of T always requires more labor per machine than the production of S. The production of both goods in both countries is subject to constant return to scale.
The first part of this assumption says that T is more labor intensive than S or S is more capital intensive than T. LT/KT > LS/KS or KT/LT < KS/LS

Assumptions
The second part of the assumption says that proportionate changes in the use of capital and labor lead to equiproportionate changes in the output.
To double the output of textiles would require doubling of the amount of labor and capital employed in the textile industry.

Assumptions
(Assumption 16) Countries differ in their endowments of factors of production, L and K. In this case, we assume that A is relatively capital abundant while B is relatively labor abundant.

Assumptions
Combining the implications of the last two assumptions allows us to develop graphically the shapes of the production possibility frontiers for both countries
The PPF of each country will show increasing opportunity costs

Assumptions
The last assumption refers to the demand (Assumption 17) Tastes in the two countries are identical This states that community indifference curve in both the countries are identical
It implies that given the same prices and income, both countries would consume exactly the same amounts of two goods

The HO Theorem
It states that a country will have comparative advantage in, and therefore will export, that good whose production is relatively intense in the factor with which that county is relatively well endowed For example: A capital abundant country will export in the good that requires more capital per worker to produce

Graphical Representation of The HO Theorem

The Effects of Rising Prices of good S on Country As Trade

Trade Equilibrium in the HO Model

Some Features of HO Model

Incomplete specialization in production as compared to complete specialization in Classical model. The manner in which the process of reciprocal demand leads to an equilibrium terms of trade.

Reciprocal Demand in the Classical and HO Model