1 II. International Economics and Development Raul Caruso Università Cattolica del Sacro Cuore di Milano

2 The Heckscher-Ohlin Model The HO model is also called the Factor Proportions Model. Developed by Eli Heckscher and BertilOhlin. It has been enriched by Paul Samuelson and Wolfang Stolper

3 The Heckscher-Ohlin Model The Ricardian Idea of CA does not disappear. Comparative advantage is determined by: ( 1)Factor endowments of countries (2)Factor intensities of industries

4 The Heckscher-Ohlin Model 1.Countries differ in endowments of factors In its original formulation such differences relate to capital, land, labor, physical ad natural resources

5 The Heckscher-Ohlin Model 2.Industries differ in factor intensities Consider different sectors. Mechanical industry use lots of capital. Agriculture uses lots of land. ……….etc..etc..

6 Predictions of HO model ( 1) Countries tend to export goods whose production is intensive in factors with which they are abundantly endowed. (2) Owners of a country’s abundant factors gain from trade, but owners of a country’s scarce factor lose (there are winners and losers) (3) There is a convergence of factor prices. (factor prices equalization)

7 Linking with CA Heckscher-Ohlin Theorem: Countries have Comparative Advantage in, and (therefore) export, goods that use intensively the relatively abundant factors.

8 The Heckscher-Ohlin Model There are two countries Home and Foreign. They both produce cloth and food. Home is labor-abudant and Foreign is land-abundant.

9 Abundant Factors In order to verify which factor of production can be considered relatively abudant we start computing the ratio between the total supply of one factor and the total supply of the other factor. In our case

10 Abundant Factors Then, making a comparison between two countries (Home and Foreign) we will say that the home country is relatively more abundant in labour if and only if:

11 Abudant Factors Consider that US has 80 million workers and 200 million acres while UK has 20 million workers and 20 million acres. Which country is labour-abundant? Answer: UK

12 Abudant Factors Note that abundance is defined in terns of a ratio and not in absolute quantities. For example, If US has 80 million workers and 200 million acres while UK has 20 million workers and 20 million acres, we consider UK labour-abudant even if it has less total labour than US. In fact:

13 Costs and Prices If w is the hourly wage rate of labour and r is the cost of one acre of land, the relative cost can be expressed through:

14 Note We assume that relative prices depend upon relative costs. Then we have:.

15 The Heckscher-Ohlin Model Note. As long as a country produces both goods there is a one-to-one relationship between the relative prices of good and the relative prices of factor used to produce the goods. Relative abundance of a factor implies that its relative cost is less than in countries where it is relatively scarcer. Conversely, relatively scarce resources are more expensive

16 Before trade Before trade (autarky) we have that: Given that Home is a labor-intensive country. That is in Home the relative price of clothes in terms of food is lower than relative price in foreign.

17 Predictions of HO model Trade Leads to a Convergence of Relative Prices The relative price of cloth rises in Home and declines in Foreign and a new world price is established at a point between the pretrade relative prices.

18 Predictions of HO model In Home the rise in relative price of cloth leads to a rise in the production of cloth and a decline of relative consumption. So home becomes an exporter of clothes and an importer of food. The decline in relative price of clothes in foreign leads it to become an importer of cloth and an exporter of food.

19 Predictions of HO model In sum, the main result is that : Countries tend to export goods whose production is intensive in factors with wich they are abundantly endowed.

20 Distribution of income Following HO model, international trade has a powerful effect of income distribution. In Home country people who get their income from labour gain form trade but those who get their income from land are worse off. In foreign country the opposite happens: Laborers are worse off and landowners are better off. That is, owners of an abudant factor gain from trade, but owners of a country’s scarce factors lose.

21 Factor Price Equalization One of the most important prediction of HO model is that factor prices must converge. Is this true? In the real world factor prices are not equalized

22 Factor Price Equalization Factor price equalization is based upon the convergence of relative prices. Since a convergence in relative price is predicted there must be also a convergence in factor prices. For example wages should equalize. A country exporting clothing should experience a rise in wage.

23 Factor Price equalization

24 Factor Price Equalization To check for the validity we have to discuss the assumptions (1) Both countries produce both goods (2) Identical technology (3) trade actually equalize the price of goods in the two countries (4) there is free movements of factors (in particular workers) (5) An implicit assumption is that countries have similar institutional regimes.

25 Factor Price Equalization (1) Both countries produce both goods In other terms, this assumption can be generalized saying that countries have very similar factor endowments. Of course this is not always the case.

26 Factor Price Equalization (2) Identical Technologies Techonology differs a lot between countries. A country with superior technology can have higher wages which are not converging. Recent works suggest that considering such differences would reconcile the HO model with actual data on world trade.

27 Factor Price Equalization (3) trade actually equalize the price of goods in the two countries Prices differ. Some basic reasons are (i) natural barriers of trade (ii) Trade Policies (Tariffs, quotas and so on) (iii) existence of non-traded goods Note that these elements hold also for ricardian theory

28 Factor Price Equalization (4) there is free movements of factors (in particular workers) Free movements of factors do not exist in reality. Pay particular attention to mobility of people. Restrictive immigration policies hinders the equalization of wages.

29 Factor Price Equalization (5) An implicit assumption is that countries have similar institutional regimes. In particular, consider labour markets. Some countries have a more flexible labour market (USA for example). Other countries have sticky labour markets (european countries for example)

30 North-South trade Although the overall pattern of international trade does not seem to fit the HO predictions, North-South trade in manufactures seem to fit the HO theory much better. HO model performs quite well when we analyse the patterns of trade of (i) labour-intensive goods and (ii) primary agricultural commodities.

31 North-South trade It is common knowledge that NIE export labor- intensive manufactures (textile for example) to industrialized economies. Consider for example trade patterns between USA or EU and asian countries.

32 In 2003 China imported Capital-Intensive Goods from EU, USA and Japan and exported labor-intensive goods

33 Departure from HO predictions and empirical evidence.

34 Leontieff’s Paradox (1953) In 1953 Vassily Leontieff noted that US exports were less capital-intensive than US imports. According to the HO theory US would have been expected to export more capital-intensive goods. The possible explanation of Leontieff’s Paradox………………………………………….. …………….is the presence of High skilled work in USA. That is, Human Capital was the abudant factor in USA.

35 Leontieff’s Paradox (1953) Leontieff’s paradox suggests that when Human Capital is relatively abundant the country would export in particular goods emboding high levels of human capital (high-tech industry is the current example) Intuition: As a measure of economic policy investiment in Human Capital today could lead to more exports tomorrow. This is also true in a Ricardian world.

36 ‘O Rourke and Williamson (1999) ‘O Rourke and Williamson in 1999 published a work giving evidence that HO predictions about Factor Price equalization hold. The story is about the convergence of western economies between 1830 and (i) there is evidence of convergence for real wages (ii) there is evidence of convergence of rental prices for land.

37 Trefler (1995) In 1995 Trefler publishedd ‘The case of the missing trade and other mysteries” on AER. Trefler pointed out that the HO model predicts not only the direction but also the volume of trade. That is, the volume of trade between a labour abundant country and and a capital abudant country should be huge. Unfortunately for HO, volumes of trade were less than predicted.

38 Trefler (1995) All data are from 1983 and there 33 countries considered accounting for 76% of world exports and 79% of world GNP. Nine factors are considered: capital, cropland, pasture and six categories of labor (among them you find: technical workers, agriculture workers, unskilled workers) Trefler claims that HO theorem is rejected because trade departs from its endowmwnt-based prediction in systemtic ways. Trade is Missing relative to its HO prediction.

39 Trefler (1995) The final result of Trefler is that the HO prediction are rejected in favour of a modification that allows for (1) home bias in consumption [home market effect] and (2) international technology differences.

40 Egger (2002) Egger (2002) unvoluntarily shows that differences in relative factor endowments also matter. This result partly follows HO predictions. He estimates a panel data for OECD and Central and Eastern European Countries. In particular, there is a positive association between differences in relative factor endowments and volume of trade.

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42 HO Model’s Legacy (1)HO model applied to North-South trade perfoms quite good. (2)Differences in factor endowment partly matter (Egger, 2002). (3)we have an intuition about the relationshiop between trade and distribution of income.

43 HO Model’s Unpredicted Legacy (1)we understood that Human capital is a factor of production (thanks to Leontieff Paradox) (2)Tecnological differences or similarities play a role (as in a Ricardian world) (3) We also understood that geography matters because size of countries affects trade patterns (home market effect)