Trade Theories:

#4 … Heckscher-Olin

Introduction: The Determinants of Comparative Advantage

• There are many factors that determine comparative advantage between countries

• The reasons why one country might be more productive than another in a particular line of production should be analyzed

Modern Trade Theory

• Adam Smith and David Ricardo assumed that each country would have its own technology, climate, and resources, and that these differences would give rise to productivity differences (and thus differences in comparative advantage)

• In the 20th century, several economists developed more detailed explanations of trade in which comparative advantage of a country depends on it’s endowments of inputs (factors of production) to produce goods

Heckscher-Ohlin (HO) Model

• Eli Heckscher and Bertil Ohlin, Swedish economists

• Model based on two concepts:

1. Factor endowments—the quantities of productive resources possessed by a country

2. Factor intensity—the amount of labor per unit of capital used in production of a product

Heckscher-Ohlin (HO) Trade Model

• A country’s factors of production (a country’s endowments of inputs) are used to make each good give rise to productivity differences between countries

• Factor endowments:

– Factor abundance versus factor scarcity: When a country enjoys a relative abundance of a factor, the factor’s relative cost is less than in countries where the factor is relatively scarce

– A country’s comparative advantage lies in the production of goods that use relatively abundant factors

Heckscher-Ohlin (HO) Trade Model

Factors?

•Labor

•Capital

Heckscher-Ohlin (HO) Trade Model

• Export goods that intensively use factor endowments which are locally abundant

• So … A country that is relatively labor abundant (capital abundant) should specialize in the production and export of that product which is relatively labor intensive (capital intensive)

• Corollary: import goods made from locally scarce factors

• Patterns of trade are determined by differences in factor endowments - not productivity

Country Factor Abundance

• Country A is relatively capital-abundant if:

KA / LA > KB / LB

Obviously, County B would be labor-abundant :

LB / KB > LA / KA

Example

• Two countries (EU and India) and two factors (labor and capital)

• EU is capital-abundant compared to India (and India is labor-abundant compared to EU) if and only if the ratio of the total amount of capital to the total amount of labor (K/L) available in EU is greater than that in India

An Example of Factor Abundance

• Indian capital-labor ratio: KInd / L Ind is 2/10 or 1/5

• EU capital-labor ratio: Kus / L us is 50/150 or 1/3

• Since the EU’s capital-labor ratio is higher, it is the relatively capital abundant country:

(KEU / L EU > KInd. / LInd. or 1/3 > 1/5 )

EU India

Capital 50 machines 2 machines

Labor 150 workers 10 workers

Factor Intensity

• Labor (capital)-intensive GOOD

– a good is labor (capital)-intensive relative to another, if its production requires more (less) labor per machine than the other good requires in its production.

– So if production of good x is more labor intensive than production of good z

Lx / K x > Lz / Kz

Factor Intensity

• So assume that the production of… Cloth requires 3 units of labor per 1 units of

capital

Machines require 2 units of capital per 1 unit labor

Obvious … Cloth is Labor intensive and Machines are Capital Intensive

Factor Intensity

• What about this… Cloth requires 3 units of labor per 1 units of

capital

Machines require 2 units of labor per 1 unit capital

Since we are looking at “relative” values … Still the same … Cloth is Labor intensive and Machines are Capital Intensive

Heckscher-Ohlin (HO) Trade Model

• Assumptions of the Heckscher-Ohlin Model– There are two countries and two goods … (2x2)

model– Production and consumption conducted under

perfect competition• Firms are price takers• Prices of factors are determined by supply and demand

in each market• In long run, prices of goods are equal to their respective

costs of production

Heckscher-Ohlin (HO)

Assumptions, continued

• No transportation costs, taxes, or other obstructions to trade

• International trade does not cause complete specialization

• Consumers in both countries have equal tastes and preferences

• Both countries are endowed with homogeneous factors of production, capital (K) and labor (L), and both are used in production

Heckscher-Ohlin (HO) Trade Model

Assumptions, continued

• Technology for production is the same in both countries and produced under constant returns to scale

• Capital and labor are mobile domestically• Labor and capital cannot move between countries

Heckscher-Ohlin (HO) Trade Model

• The EU is richly endowed with a wide variety of factors: natural resources, skilled labor, and physical capital

– Expectation: The EU will export agricultural products (particularly those requiring skilled labor and physical capital) and machinery and industrial goods (requiring physical capital and scientific and engineering skills)

– Result: Major EU exports include grain products made with small labor and large capital inputs; and commercial aircraft made with physical capital and skilled labor

Gains from Trade in the HO Model

• Ricardian (Comparative Advantage) model assumed that each country faced a constant set of tradeoffs because of only one homogeneous input: labor

• The HO model assumes: (1) multiple inputs—labor capital, land, etc.—and (2) variations in the quality of inputs

• Thus, the PPC cannot be assumed to have constant costs. Under the HO model, each country has a rising opportunity cost for each type of production

Production Possibility Frontier

• Because EU is capital-abundant and Machines are capital-intensive, IEU’s PPF will lie primarily along (or biased toward) the Machine axis

• Because India is labor-abundant and Cloth is labor-intensive, India’s PPF will lie primarily along (or biased toward) the Cloth axis

Production Possibility Frontiers

Machines

Cloth..

..Slope still equals opp. cost …. But since

the PPC is curved, the tradeoff between machines and cloth is different at each point of production

A

India

EU

Production Possibility Frontiers

Machines

Cloth..

.. A – can be the “no-trade”

Autarky position for the countries Aeu

Aind

• Domestics of India will see that relative price of machines in EU is lower than at home

• Domestics of EU will see that relative price of cloth in India is cheaper than at home

• Producers see the change in consumer patterns and will increase production of abundant factor.

• Results in an equalization of price ratios in both countries

Production Possibility Frontiers

Machines

Cloth..

.. EU will exploit their comparative advantage and increase production of Machines

Aeu

Aind

Qeu

Qind

p

p

H-O ModelFACTOR-PROPORTIONS THEORY

Capital Stock per Worker of Selected Countries in 1992 (in 1985 international dollar prices)

High-Income Country

Capital-to-Labor Ratio

Middle & Low Income Country

Capital-to-Labor Ratio

Switzerland $76,733 Mexico $11,697

Canada 44,970 Poland 11,811

Japan 41,286 Chile 11,306

Australia 38,729 Turkey 7,626

France 37,560 Thailand 5,853

United States 35,993 Philippines 3,598

Netherlands 34,084 India 1,997

Italy 33,775 Kenya 822

Spain 30,888 Nigeria 735

United Kingdom 22,509

Trade and Income Distribution

• The HO model provides a more sophisticated way to analyze gains and losses from trade because it drops unrealistic assumptions– Labor can be divided into categories of different skill levels– Other types of inputs can be included– Industries can require different mixes of various inputs

• There is a systematic relationship between the factor endowments of a country and the winners and losers from trade

• Let’s analyze this claim further…