The Heckscher-Ohlin TheoremThe Heckscher-Ohlin Theorem says that countries will export products that use their abundant and cheap factor of production and import products that use the countries scarce factor.
Cont…The Heckscher-Ohlin theory: Emphasizes resource differences as the only source of trade Shows that comparative advantage is influenced by: Relative factor abundance (refers to countries) Relative factor intensity (refers to goods) Is also referred to as the factor-proportions theory
IntroductionGeneral equilibrium mathematical model of international tradeDeveloped by Eli Heckscher and Bertil Ohlin Developed on the Ricardian theory of IT,
The Heckscher-Ohlin Assumptions—BasicsThere are two countries, Home and Foreign two goods, Cloth and Food, and two resources, Labor and Land these are used to produce Cloth and Food
The Heckscher-Ohlin Assumptions—PreferencesThe preferences of all consumers in the world are identical.The preferences of any individual are such that the Marginal Rate of Substitution is independent of the scale of consumption. The MRS of Wine for Cheese is the additional amount of Wine that would keep the individuals level of happiness unchanged even after the consumption of Cheese is reduced by one unit. Under this assumption, if the amounts of Cheese and Wine being consumed are, say, doubled, then the MRS remains unchanged. In other words, the MRS does not change if the ratio of the amounts of Cheese and Wine consumed, Cheese/ Wine, does not change.
The Ricardian Assumptions—PreferencesThe preferences of all consumers in the world are identical.For any individual, the Marginal Rate of Substitution is independent of the scale of consumption. An individual’s MRS of wine for cheese is the maximum amount of wine that he/she would be willing to pay for one unit of cheese. Under this assumption, if the amounts of Cheese and Wine being consumed are, say, doubled, then the MRS remains unchanged. In other words, the MRS does not change if the ratio of the amounts of Cheese and Wine consumed, Cheese/ Wine, does not change.
The Heckscher-Ohlin Assumptions—Markets All markets are perfectly competitive. That is, no buyer or seller of a commodity has the power to affect the price of the commodity by himself. More specifically, the market for a commodity is said to be perfectly competitive if: There are many sellers There are many buyers All sellers sell the exact same product Individuals make decisions so as to maximize happiness, whereas Firms make decisions so as to maximize profits
The Heckscher-Ohlin Assumptions—GovernmentsGovernments do not interfere with the smooth functioning of markets There are no taxes, subsidies, tariffs, quotas, etc.However, although there is free trade in goods and services, there is no cross-border movement of resources, such as labor
The Heckscher-Ohlin Assumptions—TechnologyTechnological knowledge is the same in both countriesGoods are produced (with land and labor) using technologies that satisfy Constant Returns to Scale. That is, if the producer of a commodity, say, doubles the amounts used of all resources, then the amount produced will have to double also.
The Heckscher-Ohlin Assumptions—FactorAbundanceHome has a higher ratio of labor to land than Foreign does. That is, if TH, TF, LH, and LF denote the amounts of T (land or territory) and L (labor) that Home and Foreign are endowed with, then LH / TH > LF/ TF. L/T may be informally interpreted as the number of workers per acre of land. Home is said to be the “labor-abundant” country and Foreign is the “land-abundant” country.
The Heckscher-Ohlin Assumptions—FactorIntensitiesThe production of food is land-intensive and the production of cloth is labor-intensive That is, the number of workers per acre (L/T) is always higher in cloth production than in food production
Prices of GoodsLet PC and PF denote the nominal prices of cloth and food.Then, PC/PF is the relative price of cloth (in units of food) andPF/PC is the relative price of food (in units of cloth) See earlier lecture
Prices of FactorsLet w be the nominal price (or, wage) of labor.Let r be the nominal price (or, rent) of landThen w/r is the relative price of labor (in units of land) andr/w is the relative price of land (in units of labor) Example: If w = $10 per hour for one worker and r = $100 per hour for one acre of land, then the relative wage for one worker is 1/10 acres of land and the relative rent on an acre of land is 10 hours of labor.
Nominal PricesThe nominal price of a commodity is simply the number of dollars (or any other relevant unit of account) that must be paid to buy one unit of the commodityFor example, the nominal price of labor—also called the nominal wage—may be $8 per hour
Real PricesThe real price of commodity X, in units of commodity Y, is the amount of Y that costs the same as one unit of XFor example, if the nominal price of labor is $8 per hour and the nominal price of a cup of coffee is $2, then the real price of labor is 4 cups of coffee per hourReal prices are also called relative prices
Real and Nominal PricesReal Price of X, in units of Y, is equal to Nominal Price of X / Nominal Price of YSo, if w is the nominal wage and P is the nominal price of a cup of coffee, then the real wage is w / P.For example, if w is $8 per hour and P is $2, then the real wage is w / P = 8/2 = 4 cups of coffee per hour, as in the previous slide.
As labor becomes moreRelative expensive relative toprice of land, cloth, which iscloth,PC/PF labor-intensive in FPGP production, finds itself at a disadvantage and becomes relatively 17 more expensive compared to food As both Home and Foreign use the same technologies, the same 5 Wage-rent FPGP curve is applicable ratio, w/r in both countries
Under free trade, theRelative relative price of clothprice of will be the same in bothcloth,PC/PF countries FPGP Therefore, the wage- rent ratio will also be 17 the same in the two countries 5 Wage-rent ratio, w/r
As labor becomes Cloth relatively moreWage-rent production expensive, relativelyratio, w/r Food more land is used in production production… … of both food and cloth But the number of acres 5 of land per worker is always higher in food production, reflecting the assumption that 4 Acres of food production is land 12 Land per intensive worker, T/L
As both Home and Foreign use the same ClothWage-rent technologies, these two productionratio, w/r Food curves must be true in production both countries. As free trade equalizes the wage-rent ratio worldwide, acres of land per worker in cloth production must be the 5 same worldwide. Same must be true for food production. Therefore, Foreign, which has 4 12 Acres of Land per more land per worker than worker, T/L Home, must produce relatively more food …
Relative SuppliesTherefore, if the same w/r prevails in both countries, thenQF/QC must be higher in Foreign than in Home. Equivalently,QC/QF must be higher in Home than in Foreign. This result is called the Rybczynski effect; see the section “Resources and Output” in the textbook
Relative SuppliesFrom the FPGP Curve in Fig. 4-6, any particular value of w/r is linked to a specific value of PC/PF.Therefore, if the same w/r prevails in the two countries, then the same PC/PF must also prevail in the two countries. And at that common value of PC/PF … QF/QC must be higher in Foreign than in Home. Equivalently, QC/QF must be higher in Home than in Foreign.
In Figure 4-5, we saw that at w/r = 5, Foreign must RSFOREIGN produce relatively more Relative price of food and Home must RSHOME cloth, produce relatively more PC/PF cloth. In Figure 4-6 we saw that w/r =5 corresponds to PC/PF 17 = 17. Therefore, Home must produce relatively more cloth at PC/PF = 17, or indeed at any other relative price. Yards of cloth producedAs cloth becomes more expensive relative to per calorie of foodfood, the output of cloth will increase relative produced, QC/QFto food, Therefore, the relative supply curvesslope upward.
The H-O assumptions about preferences imply Relative that that consumer price of behavior can be cloth, PC/PF summarized by this Relative Demand curve and that the same curve is 17 true in both Home and Foreign 3 Yards of cloth consumedIn this figure, when the price of a yard of cloth is 17 times per calorie of foodthe price of a calorie of food, the number of yards of consumed, QC/QFcloth consumed is 3 times the number of calories of foodconsumed, for every individual worldwide. Why isn’t thelatter ratio different for different people?
Relative DemandsLet’s say that Alex consumes 3 times as many yards of cloth as calories of food (relative demand is QC/QF = 3) when a yard of cloth is 17 times as expensive as a calorie of food (relative price PC/PF = 17)If Alex’s income changes, his relative demand should not change because MRS is independent of the scale of consumption
Relative DemandsSince identical preferences have been assumed, if the relative price of cloth is PC/PF = 17, then Betty’s relative demand must also be QC/QF = 3 irrespective of Betty’s incomeTherefore, the same relative demand curve represents everybodyTherefore, the same relative demand curve represents both Home and Foreign
Figure 4-11: Relative Supplies and Demands The relative supplies and demands can be combined to find the RSFOREIGN autarky relative prices inRelative Home and Foreignprice of RSHOMEcloth, Clearly, they arePC/PF different Therefore, trade will occur if it is allowed Since Home and ForeignForeign differ only in their relative factor endowments, that Home RD difference must be the reason why trade occurs Yards of cloth produced per calorie of food produced, QC/QF
Who will export what?In autarky, the labor- PC/PF intensive good is relatively cheaper in the labor- abundant country Foreign autarkyTherefore, under free trade, the labor-intensive good is Free exported by the labor- Trade Home abundant country…… and the land-intensive good is exported by the land- Foreign : land abundant, labor scarce Home: land scarce, labor abundant abundant country Cloth: labor intensive production Food: land intensive production
The Heckscher-Ohlin TheoremTo repeat, when trade occurs, the labor- abundant country (Home) exports the labor- intensive good (cloth) andThe land-abundant country (Foreign) exports the land-intensive good (food)In general, each country exports the good that makes intensive use of the resource that is abundant in that countryThis is called the Heckscher-Ohlin Theorem See the section “Relative Prices and the Pattern of Trade” in chapter 4 of the textbook
Goods Prices: from autarky to free tradeIn autarky, the labor- PC/PF intensive good is relatively cheaper in the labor- abundant country Foreign autarkyFree trade makes relative prices equal everywhere Free Trade HomeTherefore, the labor-intensive good becomes more expensive in the labor- abundant country, and less Foreign : land abundant, labor scarce Home: land scarce, labor abundant expensive in the labor-scarce Cloth: labor intensive production country. Food: land intensive production
Fig. 4-11 showed that, Relative in autarky, the relative price of price of cloth is higher cloth, PC/PF in Foreign FPGP Therefore, in autarky, the wage-rent ratio Foreign must also be higher in ForeignFree Trade Free trade makes the Home wage-rent ratio the same in the two countries Home Foreign Wage-rent ratio, w/r Free Trade
Factor Prices: from autarky tofree trade PC/PF w/rIn autarky, the wage-rent ratio is higher in the labor-scarce country and lower in the labor- Foreign abundant country autarkyWhen autarky ends and free Free trade begins, the wage-rent Trade Home ratio falls in the labor-scarce country and rises in the labor abundant country Foreign : land abundant, labor scarce Home: land scarce, labor abundant Cloth: labor intensive production Food: land intensive production
Real Wage and Real Rent w Nominal wage: currency earned per hour of a worker’s labor w/PC Real wage: yards of cloth purchasable with the nominal wage w/PF Real wage: calories of food purchasable with the nominal wage r Nominal rent: currency earned per hour per acre of land r/PC Real rent: yards of cloth purchasable with the nominal rent r/PF Real rent: calories of food purchasable with the nominal rent
Marginal Product of a ResourceThe Marginal Product (MP) of labor in cloth production is the additional amount of cloth that would be produced if an additional unit of labor is employed We can similarly define Marginal Product of labor in food production, Marginal Product of land in cloth production, and Marginal Product of land in food production
Marginal Product of a ResourceSee page Figure 7-2 of the textbook for more on the Marginal Product.
Example: Level of Resource UseSuppose an additional worker produces an additional 5 yards of cloth in one hour’s work. Then MP = 5. See page Figure 7-2 of the textbook for more on the Marginal Product.Therefore, to make one additional yard of cloth, you need only 1/5 of a worker.In general, the labor needed to make one unit of cloth can be calculated as 1/MPMarginal Cost is the additional cost of an additional unit of outputTherefore, MC = w × (1/MP) = w/MP
Price = Marginal CostIf P > MC at the current level of production, additional production would increase profitIf P < MC at the current level of production, reduced production would increase profitTherefore, profit is maximized only if P = MCTherefore, if a good is being produced, P = MC must be true
Real Wage and Real RentTherefore, P = MC = w / MP wTherefore, w/P = MP = MPLCThis implies that the real wage in units of, say, cloth is the Marginal PC Product of labor in the production of cloth rSimilarly, the real rent in units of food is the Marginal Product of = MPTF land in food production PF
Real Factor Rewards and ProductivityIn general, the real payment to a resource is equal to its productivity (or, marginal product) This is the main conclusion of the Marginal Productivity Theory of Income Distribution
Factor Use and Factor Productivity— Labor-Abundant Country Cloth Wage-rent production ratio, w/r Food We saw earlier that when production autarky ends and free trade begins w/r rises in the labor- abundant country (Home). Foreign Therefore, More land is used per worker Free trade in cloth production and in food production Home This makes labor more productive… …and land less productive Therefore, w/PC and w/PF both increase, and r/PC and r/PF both decrease. Acres of • Abundant resource Land per benefits from Foreign : land abundant, labor scarce worker, T/L globalization Home: land scarce, labor abundant • Scarce resource loses Cloth: labor intensive production Food: land intensive production
Factor Use and Factor Productivity— Land-Abundant Country Cloth Wage-rent production ratio, w/r Food When autarky ends and free production trade begins w/r falls in the land-abundant country (Foreign). Therefore, Foreign Less land is used per worker Free trade in cloth production and in food production This makes labor less Home productive… …and land more productive Therefore, w/PC and w/PF both decrease, and r/PC and r/PF both increase. Acres of • Abundant resource Land per benefits from Foreign : land abundant, labor scarce worker, T/L globalization Home: land scarce, labor abundant • Scarce resource loses Cloth: labor intensive production Food: land intensive production
Trade: Who Gains and Who Loses?In short, each country’s abundant resource benefits from trade andEach country’s scarce resource loses from trade
Factor Price Equalization ClothFree trade equalizes Wage-rent production the wage-rent ratio ratio, w/r FoodTherefore, the land- production per-worker ratio in cloth production is Foreign, autarky also equalizedThis equalizes the Free trade productivity of labor in cloth production in the Home, autarky two countriesThis equalizes w/PC in the two countriesIn a similar way, Acres of w/PF, r/PC, and r/PF Land per each become Foreign : land abundant, labor scarce worker, T/L equalized Home: land scarce, labor abundant worldwide Cloth: labor intensive production Food: land intensive production
Marginal Marginal Productivity of LaborProductivity = Real Wage, w/PC These curves reflect Diminishing Returns to each resource, which, in turn, is a consequence of the assumption of Constant Returns to Scale Marginal Productivity of Land = Real Rent, r/PC Acres of land per Similar curves can worker, T/L be drawn for food production
Factor Price EqualizationWe saw earlier that free trade makes w/r equal in Home and ForeignSince both countries use the same technology, the equalization of w/r implies that the number of workers used per acre of land in the production of, say, cloth will also become the same in both countries
Factor Price EqualizationTherefore, the productivity (or MP) of labor in the production of cloth will become the same in both countries andThe productivity (or MP) of land in the production of cloth will become the same in both countries
Factor Price EqualizationTherefore, the real wage in units of cloth, w/PC, will become the same in both countries (since the real wage is equal to the marginal product) andr/PC will become the same in both countriesIn the same way, one can show that w/PF will become the same in both countries and r/PF will become the same in both countries.
Factor Price Equalization TheoremThe Factor Price Equalization Theorem: When there is free trade in goods, the real reward for any resource (in units of either good) becomes the same in both countries! An implication of this result is that if there is free trade in goods, resources will have no incentive to move from one country to another
Factor Price Equalization TheoremHeckscher-Ohlin theory implies FPE.But does FPE imply that free trade will make everybody equally rich?Certainly not! Not every individual is endowed with the same amount of resources
How accurate is the Heckscher-Ohlintheory? Sadly, it’s not very accurate by itself It explains North-South trade quite well… But not trade within the North But, if modified to take cross-country differences in technology into account, it fits the data well So, a theory that combines the insights of Ricardo and Heckscher-Ohlin might be best
The contribution of Heckscher-Ohlin theory The theory’s main contribution is to point out that cross-country differences in relative resource availability can explain trade It does not claim that differences in relative resource availability are the only reason why trade occurs
CriticismPoor predictive powerFactor equalization theoremIdentical production functionCapital as endowmentHomogeneous capitalNo unemploymnentNo room for firms
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