Chapter 5: Factor Endowments and the Heckscher-Ohlin Theory In this chapter, we ask two important questions which the Ricardian model leaves unaddressed: What determines the pattern of comparative advantage? How does international trade affect factor returns?

Bertil Ohlin

Important assumptions in the HO model Two nations, two commodities and two factors of production Identical technology in production One commodity is labour intensive in production and the other is capital intensive in production Constant returns to scale in production Incomplete specialisation Tastes are equal in both nations

Important assumptions in the HO model Perfect competition in goods and factor markets Factors of production are mobile nationally, but immobile internationally No transport costs or other barriers to trade Trade is balanced

Factor intensity What do we mean by factor intensity? Note that this refers to relative factor use in production and not absolute amounts A good X is labour intensive if the labour – capital ratio (L/K)X > (L/K)Y This is the same as saying that the capital – labour ratio (K/L)X < (K/L)Y

Factor intensity

Factor abundance What do we mean by factor abundance? Factor prices Factor supply A country is said to be capital abundant if the ratio of Capital – Labour (TK/TL) is greater than in another country, which should also give a relatively low price of capital (interest) Note that we again talk of ratios and not absolute amounts

Factor abundance and PPF Nation 2 is assumed to be K abundant and good Y is capital intensive in production, the PPF curve in nation 2 is skewed towards good Y Nation 1 is assumed to be L abundant and good X is labour intensive in production

Why all these assumptions ? The strict assumptions are made to enable us to focus on one aspect – factor proportions and trade The H-O theory can be presented in a nutshell in the form of two theorems The H-O theorem (also called the structure theorem) The factor price equalisation theorem

The Heckscher-Ohlin theorem A nation will export the commodity whose production requires the intensive use of the nation's relatively abundant and cheap factor and import the commodity whose production requires the intensive use of the nations relatively scarce and expensive factor If this actually is true, is another question…

H-O and general equilibrium

Free trade equilibrium and H-O

Factor-price equalisation Paul Samuelson (Nobel Prize 1970) has also made important contributions to the H-O model Most well known is the H-O-S theorem ”International trade will bring about equalisation in the relative and absolute returns to homogenous factors across nations”

Factor-price equalisation

Trade and factor prices Recall that trade arises because factor inputs and factor prices are different between nations Labour is ”cheap” in countries well endowed with labour, and capital is ”cheap” in countries well endowed with capital Trade will affect prices of finished goods, and then factor prices must change too, meaning there will be winners and losers from trade within a nation

Trade in the long run In the long run, factors of production (even capital) can move between sectors Suppose the US has a comparative advantage in wheat, and the UK in cloth Wheat is cheap in the US, and cloth is cheap in the UK The US will export wheat to the UK, and import cloth Production of wheat is capital intensive (land), production of cloth labour intensive

Trade in the long run When trade starts, US production of wheat will increase, and production of cloth will decrease Factors of production will move from the cloth sector to the wheat sector, because the wheat sector has become more profitable How does this affect factor prices ?

What will happen in the US ? Pre trade, W is cheap and C expensive With trade - the US will export W to the UK Increased demand for W - price will increase, increased supply of C, price will fall In response to prices, production of W will increase, production of C will fall

What will happen in the US ? Recall: W is capital intensive, C is labour intensive When production of C decreases, ”a lot” of labour and ”a little” capital will be released When production of W increases, ”a lot” of extra capital and ”a little” more labour will be needed

What will happen in the US ? More workers released from C than what is demanded in W - supply > demand, wages will fall More capital demanded in W than what is released from C, demand > supply, rents will rise In the US, workers lose and capital owners gain from trade

What will happen in the U.K ? In the UK, the opposite changes in prices and production will take place Production and prices of C will increase, production and prices of W will fall Since C is labour intensive, workers will gain and capital owners lose

Winners and Losers

What does this mean? Owners of the production factor used intensively in the production of the export good will gain, owners of the production factor used intensively in the import good will lose

Stolper - Samuelson

Stolper - Samuelson An increase in good price raises the real returns to the factor used intensively in the production of that good, and lowers the real return to the factor used intensively in the production of the other good The factor price which increases, increase relatively more than the price of the good

Stolper – Samuelson, contd. Lets use the following symbols: a = land used to produce 1 W b = labour used to produce 1 W c = land used to produce 1 C d = labour used to produce 1 C r = rental rate on land w = wage rate Pwheat and Pcloth are goods prices

Production costs and prices Since we assume competition, it must be that marginal costs of production equals price PW = ar + bw PC = cr + dw Assume the price of wheat increases by 10 % Returns to at least one factor must increase Safe to assume that land prices (r) will increase since land is used intensively in the production of wheat Since the price of cloth is unchanged and the price of land has risen, wages (w) must fall. Since the price of wheat has increased by 10 % and w has fallen, r has to increase by more than 10 %

Wassilly Leontief (1906-1999) Nobel Prize 1973 Does the H-O model actually explain trade patterns ? Leontief assumed and tested The US is well endowed with capital The US should export capital intensive goods and import labour intensive goods The opposite appeared to be true – hence the Leontief paradox