Heckscher-Ohlin Trade Model: Resource Differences and Trade

1. Chapter 5 Resources and Trade: The Heckscher-Ohlin Model

2. Preview • Richardian Model assumes, comparative advantage could arise only because of international differences in labor productivity. • The realistic view of trade must allow for the importance not just of labor but also of other factors of production such as land, capital and mineral resources. • This chapter examines model in which resource differences are the only source of trade. • The model that we will explain will show the following:

3. Preview • The competitive advantge is influenced by the interaction between nation’s resource ( The relative abundance of factors of production) and • The technology of production (which influences the relatives intensity with which different factors of production are used in the production of different goods). • This chapter also looking the long-run outcomes when all factors of production are mobile across sectors.

4. Preview • As resources is one of the most influential theories in international economics • Two Swedish economists, Eli Heckscher and Bertil Ohlin ) ( Ohlin received Nobel prize in economics in 1977), the theory is often referred to as the Heckscher –Ohlin theory. • The theory also referred to as the factor-proportions theory.

5. Preview • To develop the factor-proportions theory, we begin by describing an economy that does not trade and then ask what happens when two such economies trade with each other.

6. Introduction • The Heckscher-Ohlin theory argues that trade occurs due to differences in labor, labor skills, physical capital, capital, or other factors of production across countries. • Countries have different relative abundance of factors of production. • Production processes use factors of production with different relative intensity.

7. Model of Two-Factor Economy • Two countries: home and foreign, both have the same technology • Two goods: cloth (C) and food (F). • Two factors of production: labor (L) and capital (K). • The mix of labor and capital used varies across goods. • cloth is labor-intensive and food is capital-intensive • The supply of labor and capital in each country is constant and varies across countries. • In the long run, both labor and capital can move across sectors, equalizing their returns (wage and rental rate) across sectors.

8. Model of Two-Factor Economy • We also assume that the immobile factors that were specific to each sector (Capital in cloth, land in food) are now mobile in the long run. • Thus, land used for farming can be used to build a textile plant; conversely , the capital used to pay for farming can be used to build a textile plant. • Conversely, the capital used to pay for a power loom can be used to pay for a tractor. • To make this simple, we construct a model with a single additional factor (Capital), which is used in conjunction with labor to produce either cloth or food. • In the long run both capital and labor can move across sectors, thus equalizing their returns ( rental rate and wages ) in both sectors.

9. Model of Two-Factor Economy- Price and Production • Both cloth and food are produced using capital and labor, The amount of each good produced is : • Qc= Qc( Kc, Lc); QF= QF( KF, LF); • Where Qc and Qf are the output levels of cloth and food ; Kc and Lc are the amounts of capital and labor employed in food production. • Overall, the economy has fixed supply of capital K and labor L that is divided between employment in the two sectors.

10. Model of Two-Factor Economy- Price and Production • We will now bring related technology in cloth and food production. • For instance production of one yard of cloth requires a combination of two-hours of labor and two-machine- hours. • The production of food is more automated, as a result, production of one calorie of food requires only one work hour labor along with three machine hours.

11. Production Possibilities • With more than one factor of production, the opportunity cost is no longer constant and the PPF is no longer a straight line. Why? • Numerical example: K = 3000, total amount of capital L = 2000, total amount of labor • Suppose a fixed mix of capital and labor in each sector. aKC = 2, capital used to produce one yard of cloth aLC = 2, labor used to produce one yard of cloth aKF = 3, capital used to produce one calorie of food aLF = 1, labor used to produce one calorie of food

12. Production Possibilities Thus production of Qc yards of cloth requires 2Qc= aKC X Qc machine hours and 2Qc= aLc X Qc work hours. For food production 3QF= aKF X QF machine hours and 1QF= aLF X QF work-hours.

13. Production Possibilities Total amount of capital resources Total amount oflabor resources Capital used for each yard of cloth production Total yards of cloth production Capital used for each calorie of food production Total calories of food production Labor used for each yard of cloth production Labor required for each calorie of food production • Production possibilities are influenced by both capital and labor: aKCQC + aKFQF≤ K aLCQC + aLFQF≤ L

14. Production Possibilities • Constraint on capital: 2QC + 3QF ≤ 3000 • Constraint on labor: 2QC + QF ≤ 2000 • Economy must produce subject to both constraints – i.e., it must have enough capital and labor. • So the PPF is the kinked ( Bowed) line shown in red

15. Fig. 5-1: The Production Possibility Frontier without Factor Substitution Max food production 1000 (point 1) fully uses capital, with excess labor. Max cloth 1000 (point 2) fully uses labor, with excess capital. Intersection of labor and capital constraints occurs at 500 calories of food and 750 yards of cloth (point 3).

16. Fig. 5-1: The Production Possibility Frontier without Factor Substitution • At point 2, the economy specilaizes in cloth and not all available machine hours involved. • At point 3, the economy employs all of its labor and capital resources. • But the important features, the opportunity cost of cloth in terms of food is not constant: it rises 2/3 to 2 when the economy’ s mix of production shift toward cloth. • When the economy is producing mostly cloth ( to right at point 3), then there is spare capital capacity. • Producing two fewer units of food releases two work hours that can be used to produce one yard of cloth. Thus the opportunity cost of cloth is 2. • Thus the opportunity cost of cloth is higher when more units of cloth are being produced.

17. Fig. 5-2: The Production Possibility Frontier with Factor Substitution The PPF equationsfrompreviousslides do not allow substitution of capital for labor in production. If producers can substitute one input for another in the production process, then the PPF is curved (bowed). Opportunity cost of cloth increases as producers make more cloth. When the economy devotes more resources towards production of one good, the marginal productivity of those resources tends to be low so that the opportunity cost is high.

18. Production Possibilities • What does the country produce? • The economy produces at the point that maximizes the value of production, V. • An isovalue line is a line representing a constant value of production, V: V = PC QC + PF QF • where PC and PF are the prices of cloth and food. • slope of isovalue line is – (PC /PF)

19. Fig. 5-3: Prices and Production Given the relative price of cloth, the economy produces at the point Q that touches the highest possible isovalue line. At that point, the relative price of cloth equals the slope of the PPF, which equals the opportunity cost of producing cloth. The trade-off in production equals the trade-off according to market prices.

20. Choosing the Mix of inputs • A farmer for example can choose between using relatively more mechanized equipment (CAPITAL) and fewer workers. Thus the farmer can choose how much labor and capital to use per unit of output produced. • Thus producers will face not fixed input requirements but trade-offs like the combinations that can be used to produce one calorie of food. • Thus a farmer can produce a calorie of food with less capital if he or she use more labor and vice versa. • Then in regards to input choices depends on relative costs of capital and labor. • If capital rental rates high and wages low, farmers will choose to produce using relatively little capital and a lot of labor. • On the other hand , if rental rates are low and wages high , they will save on labor and use a lot more capital .

21. Choosing the Mix of inputs • If W is the wage rate and r is the rental cost of capital , then the input choice will depend on the ratio of these two prices , w/ r. • Based on the next figure we can say that production of cloth is labor-intensive , while production of food is capital intensive. • The intensity depends on the ratio of labor to capital used in production, not the ratio of labor or capital to output. • Thus a good can not be both capital and labor intensive

22. Fig. 5-5: Factor Prices and Input Choices Producers may choose different amounts of factors of production used to make cloth or food. Their choice depends on the wage, w, paid to labor and the rental rate, r, paid when renting capital. As the wage w increases relative to the rental rate r, producers use less labor and more capital in the production of both food and cloth.

23. Fig. 5-5: Factor Prices and Input Choices • Assume that at any given factor prices, cloth production uses more labor relative to capital than food production uses: • aLC /aKC > aLF /aKF • LC /KC > LF /KF • Production of cloth is relatively labor intensive, while production of food is relatively capital intensive. • Relative factor demand curve for cloth CC lies outside that for food FF.

24. Fig. 5-6: Factor Prices and Goods Prices Assumes for a moment the economy produce s both cloth and food (SS) In competitive markets, the price of a good should equal its cost of production, which depends on the factor prices. How changes in the wage and rent affect the cost of producing a good depends on the mix of factors used. An increase in the rental rate of capital should affect the price of food more than the price of cloth since food is the capital intensive industry. Changes in w/r are positivelytied to changes in PC /PF. If food production makes use of very little labor , then the rise of wage will not have much effect on food price, where production of cloth uses great amount of labor , a rise in the wage will have a large effect on the price.

25. Factor Prices and Goods Prices • Stolper-Samuelson theorem: If the relative price of a good increases, then the real wage or rental rate of the factor used intensively in the production of that good increases, while the real wage or rental rate of the other factor decreases. • Any change in the relative price of goods alters the distribution of income. • A labor-intensive country (China) exports labor-intensive goods like apparel. INSIGHT #2: The Stolper-Samuelson Theorem: Trade leads to an increase in the return to a country's abundant factor (ie capital and skilled labor in the USA) and a fall in the return to its scarce factor (ie unskilled labor in the USA).

26. Fig. 5-7: From Goods Prices to Input Choices

27. Factor Prices and Goods Prices • Given the relative price of cloth (PC /PF)1, the ratio of the wage rate to the capital rental rate must equal (w/r)1. • This wage –rental ratio then implies that the ratios of labor to capital employed in the production of cloth and food must be ( Lc/Kc)1 and (LF/KF)1. • If the relative price of cloth rises , the wage rental ratio must rise to (w/r)2. • This will cause the labor –capital ratio used in the production of both goods to drop.

28. Factor Prices and Goods Prices • In a competitive economy , factors of production are paid their marginal product- the real wage of workers in terms of cloth is equal to the marginal productivity of labor in cloth production and so on. • When the ratio of labor to capital falls in producing either goods, the marginal product of labor in terms of that goods increases- so workers find their real wages higher in terms of both goods. • On the other hand, the marginal product of capital falls in both industries, so capital owners find their real incomes lower in terms of both goods. • Thus changes in relative prices have strong effect on income distribution. • Thus owners of one factors of production gain while owners of other are made worse off.