8-1

The Basis for Trade: Factor Endowments

and the Heckscher-Ohlin

Model

Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

Chapter 8Chapter 8

8-2

Learning Objectives

• Examine how relative factor endowments affect relative factor prices.

• Demonstrate how different relative factor prices generate a basis for trade.

• Describe how trade affects relative factor prices and income distribution.

• Analyze how real-world phenomena can modify Heckscher-Ohlin conclusions.

8-3

Heckscher-Ohlin In General

• Heckscher, and his student Ohlin, worked in the early part of the 20th century.

• Paul Samuelson refined their work after WWII.

• Closer attention is paid in this model to each country’s resource endowment.

8-4

H-O-S Assumptions

• 2 countries• 2 commodities• 2 factors (labor and capital)• Perfect competition exists in all markets.• Each country’s endowment of factors is

fixed.• Factors are mobile internally, but immobile

internationally.

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H-O-S Assumptions (cont’d)

• Each producer has a wide range of options as to how to produce X or Y– if K is cheap relative to labor, a relatively

capital-intensive method will be adopted.– if K is expensive relative to labor, a

relatively labor-intensive method will be adopted.

• Each country has the same CRTS technology.• Tastes and preferences are the same for both

countries.

8-6

Concepts and Terminology

• The capital-labor ratio for good X is simply KX/LX, and for Y is KY/LY.– If KX/LX > KY/LY, production of good X is capital

intensive relative to production of good Y.– For example, the amount of capital per worker

in the U.S. petroleum and coal industry is $468,000.

– The similar figure for apparel products is $8,274.

– Therefore, petroleum and coal is produced in a relatively capital-intensive manner.

8-7

Concepts and Terminology

• Also, production of Y must be relatively labor intensive (If KX/LX > KY/LY, then LY/KY > LX/KX).– That is, clothing is produced in a labor-

intensive manner (as compared to petroleum and coal).

Relative Factor Intensities, Selected Canadian Industries (2006), in C$

Commodity Capital per employee

Petroleum and coal $617,066

Chemicals $144,029

Paper $118,777

Transportation equipment $92,315

Truck Transportation $30,180

Leather and products $12,573

Clothing $8,9548-8

8-9

Concepts and Terminology

• Country A is said to be capital abundant relative to Country B if (K/L)A > (K/L)B.– For example, if the U.S. has a capital

stock of $4.8 trillion and a labor force of 153 million, then K/L is about $32,000.

– K/L for Mexico works out to $328 billion/45 million = $7,282.

– Therefore, the U.S. is K- abundant relative to Mexico; Mexico is relatively L-abundant.

Relative Factor Endowments, Selected Countries (2007), in

U.S. $

Country Capital per worker

Japan $49,081

France $31,810

U.S. $31,657

Australia $30,792

Canada $24,700

Mexico $7,282

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8-11

Concepts and Terminology

To summarize:– goods are produced relatively K or L

intensively.– countries are relatively K or L

abundant.

8-12

Concepts and Terminology

• The factor price of labor (the wage) is denoted w.

• The factor price of capital is denoted r.• If labor is relatively expensive, w/r will be

a relatively big number.• If labor is relatively cheap, w/r will be a

relatively small number.

8-13

More on Factor Prices

• What makes labor relatively expensive?– If it is relatively scarce.

• What makes labor relatively cheap?– If it is relatively abundant.

• So: If (K/L)A is a relatively big number (that is, capital is relatively abundant), w/r will be a relatively big number, reflecting the relative scarcity of L and abundance of K.

8-14

A Review of Trade in the Neoclassical Model

• Suppose the U.S. is capital abundant relative to Mexico.

• This, of course, means that Mexico is relatively labor abundant.

• These differences affect the shape of each country’s PPF.

• Suppose that cars are produced rel. K-intensively, and textiles labor intensively.

8-15

Autarky in Mexico and the U.S.

• The relative price of textiles in autarky is greater in the U.S. than in Mexico.

• That is, the U.S.’s autarky price line is steeper than Mexico’s.

• In symbols, (PT/PC)U.S. > (PT/PC)Mex.

• This means that Mexico has the comparative advantage in textiles.

8-16

Autarky in Mexico and the U.S.

• This also means that the relative price of cars in autarky is lower in the U.S. than in Mexico.

• That is, (PC/PT)U.S. < (PC/PT)Mex.

• This means that the U.S. has the comparative advantage in cars.

Trade in the H-O Model

Mexico U.S.Cars Cars

Textiles TextilesX1

Y1

X6

Y4

E e

X2

Y2

X5

Y5

e'

E'

C'

c'

X3

Y3

X4

Y6

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8-18

The Result

• The relatively capital abundant country (U.S.) exports the relatively capital intensive good (cars).

• The relatively labor abundant country (Mexico) exports the relatively labor intensive good (textiles).

8-19

The Heckscher-Ohlin Theorem

• A country will export the commodity that uses relatively intensively the factor that country has in relative abundance.

• A country will import the commodity that uses relatively intensively the factor that is relatively scarce in that country.

8-20

The Source of Comparative Advantage

• So it is a country’s relative factor endowment that determines its comparative advantage.

• This is why the H-O-S model is also called the factor proportions theory.

8-21

Changes in Relative Commodity Prices : Review

• As we learned before,

– (PT/PC)US falls as the U.S. moves to trade. That is, the international relative textile price is lower than the U.S.’s autarky price.

– (PT/PC)Mex rises as Mexico moves to trade. That is, the international relative textile price is higher than Mexico’s autarky price.

8-22

Changes in Factor Prices

• In autarky, the K-intensive product (cars) is less expensive to produce in the U.S. as compared to Mexico.– This is because K is relatively abundant

in the U.S., which makes the price of capital relatively low.

• As trade commences, r will rise since demand for capital will rise.

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Changes in Factor Prices

• In autarky, the L-intensive product (textiles) is more expensive to produce in the U.S. as compared to Mexico.– This is because L is relatively scarce in

the U.S., which makes the price of labor relatively high.

• As trade commences, w will fall since demand for labor will fall.

8-24

Commodity and Factor Prices In Trade: A Summary

• In our example, (PT/PC)US falls as trade commences.

• (w/r)US also falls.• In Mexico, the opposite is happening:

– (PT/PC)Mex rises.

– (w/r)Mex also rises.• Therefore relative commodity and factor

prices move together as trade commences.

The Relative Cost Curve

PT/PC

w/r(w/r)Mex

(PT/PC)Mex

(w/r)US

(PT/PC)US

Both relative commodity and factor prices equalize in trade.

(PT/PC)Int

(w/r)Int8-25

8-26

The Factor Price Equalization Theorem

In equilibrium, with both countries facing the same relative product prices, relative costs will be equalized. This can only happen if relative factor prices are equalized between countries.

8-27

H-O and the Distribution of Income

• The H-O theorem, together with the FPE theorem, also tell us about how the incomes of different groups within a country change as trade starts.

• This provides insight into the politics of free trade.

8-28

The Stolper-Samuelson Theorem

As trade commences, the owners of the relatively abundant factor will find their real incomes rising; the owners of the relatively scarce factor will find their real incomes falling.

8-29

H-O and the Distribution of Income

• According to the S-S theorem, if the U.S. is a relatively K-abundant country, who in America should favor free trade?

• Who in America should favor protectionism?

8-30

Theoretical Qualifications to H-O

• Suppose we relax some of the many assumptions. Will the implications of the H-O-S model still be the same?

8-31

Qualification #1: Demand Reversal

• Suppose we let demand conditions differ.• Suppose domestic demand for the good

that uses relatively intensively the relatively abundant factor is very strong in each country.

• That is, suppose demand for cars is very strong in the U.S., and that demand for textiles is very strong in Mexico.

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Qualification #1: Demand Reversal

• Such strong demand makes the autarky car price in the U.S. higher, and the textile price in Mexico higher.

• In the extreme, demand reversal could occur: (PC/PT)US > (PC/PT)Mex, and

• (PT/PC)US < (PT/PC)Mex

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Bottom Line on Demand Reversals

• If demand reversals occur, the H-O theorem no longer holds: the K-abundant country is exporting the L-intensive good, and the L-abundant country is exporting the K-intensive good.

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Qualification #2: Factor Intensity Reversal

• Implicitly, we’ve assumed that if good X is K-intensive relative to good Y at one factor price ratio, it will be K-intensive at all factor prices.

• A FIR is when a good is relatively K-intensive at one set of factor prices, but relatively labor intensive at another.

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Qualification #2: Factor Intensity Reversal

• FIRs occur when capital and labor can be substituted more easily in the production of one good than another.

8-36

Factor Intensity Reversal: Implications for Trade

• Suppose France is K-abundant relative to Germany (that is (K/L)F > (K/L)G).

• This means that (w/r)F > (w/r)G.• Suppose further that there is a FIR: in

France, at (w/r)F apples are produced relatively K-intensively but in Germany at (w/r)G apples are produced in a relatively L-intensive way.

8-37

Factor Intensity Reversal: Implications for Trade

• If trade begins, according to the H-O theorem the relatively K-abundant country (France) will export the rel. K-intensive good (apples) and the rel. L-abundant country will export the rel. L-intensive good (also apples).

• H-O theorem breaks down.

8-38

Qualification #3: Transportation Costs

• In the real world, it is costly to transport goods internationally.

• How do the implications of our model change if we allow for transportation costs?

• Consider the supply and demand curves for textiles in Mexico and the U.S.

8-39

Adding Transportation Costs

• Unless Mexico is the only seller in the world, transportation costs will be borne by both the consumer (the U.S.) and the seller (Mexico).

• How does this look on the graph?

Adding Transportation Costs

U.S.Mexico

SText

DText

PT

QT

SText

DText

PT

QT

PIntlPIntl

q1 q2q1 q2

Imp.

Exp.t-costs

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8-41

Adding Transportation Costs: the Bottom Line

• In general, the H-O theorem will still hold.• The FPE theorem breaks down, since

factor prices only equalize if the commodity prices do.

• Therefore, in the presence of transportation costs, factor prices have a tendency to move towards each other, but we should not expect equalization.

8-42

Relaxing Other Assumptions

• One can relax many other assumptions and examine how the implications of the model change:– perfect competition– CRTS– identical production technologies– lack of policy obstacles– factors being perfectly transferable