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HO Model – Factor Proportions

HO Model – Factor Proportions. INTERNATIONAL ECONOMICS, ECO 486. Bertil Ohlin 1899-1979. Eli F. Heckscher, 1879-1952. Learning Objectives. Examine the need to build a new model Understand five more assumptions Prove Rybczynski Theorem Prove HO Theorem

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HO Model – Factor Proportions

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  1. HO Model – Factor Proportions • INTERNATIONAL ECONOMICS,ECO 486 Bertil Ohlin 1899-1979 Eli F. Heckscher, 1879-1952.

  2. Learning Objectives • Examine the need to build a new model • Understand five more assumptions • Prove Rybczynski Theorem • Prove HO Theorem • Prove Factor-Price Equalization Theorem • Prove Stolper-Samuelson Theorem.

  3. Classical Model • Strengths • Trade is mutually beneficial • High & low wage countries may trade • Explains some of the trade patterns we observe • Weaknesses • Why does so much trade occur among developed countries? • Why does technology differ across countries?

  4. Heckscher-Ohlin (HO) Model • Built upon observed differences among • Factors that countries possess • Factors required to produce various goods • Insights • Causes of trade • Effects of trade on factor prices • Effect of economic growth on trade patterns • Political behavior

  5. Assumptions for HO Model • Keep assumptions 1 through 10 • Drop assumptions 11 & 12 • Add assumptions 13 through 17

  6. Assumption #13 • There are two factors of production, labor (L), and capital (K). Owners of capital are paid a rental payment (R) for the services of their assets, and labor receives a wage payment (W).

  7. Assumption #14 • The technologies available to each country are identical. • Any technology is available to any country • Factor prices determine the technology chosen • Assumes away the Ricardian explanation of the source of comparative advantage.

  8. Unit Capital input aTS , in machines per bushel Input combinations that produce one bushel of Soybeans // Unit Labor input aLF , in hours per bushel A Model of a Two-Factor Economy Input Possibilities in Soybean Production

  9. Assumption #15 • The production of T is labor intensive relative to the production of S • That is, T requires more labor per machine • Implies that production of S is capital intensive (relative to the production of T). • That is, S requires more machines per worker

  10. K per Worker for US Industries Thousands of 1972 dollars. P. 89, 6th edition, Husted & Melvin, International Economics

  11. Relative price of Textiles, PT/PS PW Wage-rental ratio, w/r The Magnification Effect A change in the relative price of a good (say, T) results in a proportionately larger change in the price of its intensive factor (Labor).

  12. Wage-rental ratio, w/r 1 2 Capital-labor ratio, K/L The relative price of a resource affects the intensity of its use. Which line represents the Capital-intensive industry, 1 or 2?

  13. Wage-rental ratio, w/r Mag. Effect Textiles Soybeans (w/r)2 (w/r)1 Capital- labor Ratio, K/L Relative price of T, PT/PS (PT/PS)1 (KS/LS)2 (KT/LT)2 (KT/LT)1 Increasing Increasing Changes in relative prices affect the distribution of income (PT/PS)2 (KS/LS)1

  14. Assumption #16 • Country A is relatively capital abundant, while B is labor abundant.

  15. K per Worker: Selected Countries 1985 international prices. Item 4.2, page 91, 6th edition Husted & Melvin

  16. Quantity definition of factor abundance • Country A is relatively capital abundant, if the ratio of its capital stock to its labor force (K/L) is greater than that of the other country:

  17. Increasing Opportunity Cost in A S is K-intensive A is K-abundant 20 18 14 America’s PPF TEXTILES, T (millions of yards per year) 12 6 0 2 4 8 12 10 16 SOYBEANS, S (millions of bushels per year)

  18. Increasing Opportunity Cost in B T is L-intensive B is L-abundant 40 TEXTILES, T (millions of yards per year) 20 Britain’s PPF 0 5 10 SOYBEANS, S (millions of bushels per year)

  19. Assumption #17 • Tastes in the two countries are identical. • Given same GDP & prices, same choice • Implies that supply conditions alone determine the direction of comparative advantage (CA). • Different tastes would imply different demand • Could reverse the direction of CA.

  20. The importance of assuming identical tastes.

  21. 2 1 Tastes differ markedly, reversing the direction of Comparative Adv. Relative price of S, PS/PT RSB RSWORLD RSA (PS/PT )A (PS/PT )B RDA RDB Relative quantity of S, QSQ*SQS + Q*S QTQ*T,QT + Q*T

  22. Rybczynski Theorem • At constant world prices, if a country experiences an increase in the supply of one factor, it will produce more of the product intensive in that factor and less of the other. • See Figure 4.7 , page 103 • Read Item 10.1 “The Dutch Disease,” page 289, 7th edition of Husted & Melvin

  23. L__ O_ __ 1 K_ K_ __ O_ L_ Increasing Increasing Increasing Increasing Which is the K-intensive industry? Labor used in ________________ production Capital used in ________ production Capital used in _____ production Labor used in ________________ production

  24. Rybczynski Theorem • How do the outputs of the two goods change when the economy’s resources change? • Increase the amount of one factor, say K, and observe the results

  25. O2S L1S L2S O1S K1T 1 K1S T K2T K2S 2 S1 S2 OT L1T L2T Increasing Increasing Increasing Increasing K increases. S (K int.) expands. S needs more labor. T must contract L used in S production K used in S production K used in T production L used in T production

  26. Output of T, QT Slope = -PS/PT Slope = -PS/PT Output of S, QS An increase in K in Country A. 1 Q1T 2 Q2T PPF2 PPF1 Q1S Q2S

  27. Output of T, QT 2 Slope = -PS/PT Q2T Slope = -PS/PT Q1T 1 PPF2 PPF1 Output of S, QS Q2S Q1S An increase in L in country B.

  28. Rybczynski Theorem • Also helps us to understand that an economy will tend to be more productive in industries that use its abundant factor intensively.

  29. Heckscher-Ohlin Theorem • A country will export the goods whose production is intensive in the factor with which that country is abundantly endowed.

  30. General equilibrium for a closed economy; increasing opportunity costs

  31. Proof of the HO theorem

  32. With free trade, there will be one world relative price for S (PS/PT) and T (PT/PS). • As PS/PT rises in Country A, their S industry expands while their T industry contracts. • As PS/PT falls in Country B, their S industry contracts while their T industry expands. • Tricky to draw the general equilibrium solution, so let’s try it together.

  33. HO Model: Trade Equilibrium in a special case (easier to draw) Textiles, QT A’s PPF Soybeans, QS Q* A* D and D* A Q B’s PPF

  34. Autarky in A 18 a 15 CIC0 TEXTILES, T (millions of yards per year) 12 0 13 10 16 SOYBEANS, S (millions of bushels per year)

  35. Autarky in B 40 a 30 CIC0 TEXTILES, T (millions of yards per year) 20 Britain’s PPF 10 0 4 6.5 9 SOYBEANS, S (millions of bushels per year)

  36. Relative price of S, ______ RSB RSA 3 2 1 RD Relative quality of S, Trade Leads to a Convergence of Relative Prices

  37. 3 1 5 4 Trade Leads to a Convergence of Relative Prices Relative price of S, PS/PT RSB RSWORLD RSA 2 RD Relative quantity of S, QSQ*SQS + Q*S QTQ*T,QT + Q*T

  38. With free trade, there will be one world relative price for S (PS/PT) and T (PT/PS). • As PS/PT rises in Country A, their S industry expands while their T industry contracts. • As PS/PT falls in Country B, their S industry contracts while their T industry expands. • Tricky to draw the general equilibrium solution, so let’s try it together.

  39. International Trade Equilibrium • Incomplete specialization in Comparative Advantage good. • Community Indifference Curve (CIC) & Terms of Trade line (ToT) tangent at consumption point • Congruent trade triangles imply balanced trade.

  40. HO Trade Equilibrium – general case A produces more S, less T. Complete specialization in their comparative advantage good is unlikely. A exports S, imports T B produces more T, less S B exports T, imports S Their trade triangles are congruent.

  41. Derivation of national supply and demand curves; increasing opp. cost

  42. National supply and national demand in the classical and HO models.

  43. National supply and national demand in the HO model

  44. Stolper-Samuelson Theorem • Free international trade benefits the abundant factor and harms the scarce factor.

  45. As PS/PT rises in Country A, PT/PS and w/r fall. • Look back at Slide 16. • A is K abundant (L scarce) • As PS/PT falls in Country B, PT/PS and w/r rise. • B is L abundant (K scarce)

  46. Factor-Price Equalization (FPE) Theorem • Given all the assumptions of the HO model, free trade will lead to the international equalization of individual factor prices. • Look again at Slide 16. • One relative price for T, PT/PS • One wage-rental ratio, w/r

  47. Factor-Price Equalization? “There isn’t any.” Why not? • Some goods are not produced in some countries. • Productivity (technology) does differ between countries. • Goods’ prices differ due to natural and artificial barriers to trade.

  48. The End of Chapter 4 See “Isocosts, Isoquants, and Proofs”in eco486 main folder See Specific-Factors Model: 03specific_factors_jde.ppt in Krugman folder

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