TAMÁS NOVÁK International Economics III. Specialization based on relative factor-endowment (The Heckscher-Ohlin Model)

Readings PAUL KRUGMAN – MAURICE OBSFELD: International Economics. Theory and Practice. Chapter 4.

Specialization based on relative factor-endowment Ricardian model: comparative advantage arise only because of differences in labor productivity. Trade reflects differences in countries’ resources. Hechscher-Ohlin model shows that comparative advantage is influenced by the relative abundance of factors of production (and the technology of production)

Specialization based on relative factor-endowment Let’s take a look at this table: We can see that country A is more abundant in both capital and labour than country B. According to the theory of comparative advantages country A is relatively capital-abundant compared with country B, while country B is relatively labour-abundant compared with country A. K (billion $) L (million persons) Country A 200 100 Country B 40 80

Specialization based on relative factor-endowment Comparative advantages come from the capital/labor ratio (K/L), which is 2000 in case of country A, and 500 in case of country B. From the fact that one country is relatively abundant in one factor follows that the other country is relatively abundant in the other factor. Now we would like to know the direction of specialization between a relatively labor-abundant and a relatively capital-abundant country.

Specialization based on relative factor-endowment Sometimes it is difficult to compare the absolute quantity of labor and capital of different countries. We can substitute labor and capital for the price of them. The price of labor is wage, (w) and that of capital is interest rate (i). We can assume that the ratio of interest rate/wage will be lower in a relatively capital-abundant country, and will be higher in a relatively labor-abundant country.

Specialization based on relative factor-endowment Though there is no strict relationship either between the absolute quantity of capital and interest rate or the absolute quantity of labor and wages, we can expect that in a relatively capital-abundant country the interest rate/wage ratio will be lower than in a relatively labor-abundant country. In our example the rates of interest and wages are as follows: i (%) w (thousand $) Country A 5 10 Country B 8 4

Specialization based on relative factor-endowment The ratios are the same as before: in the relatively capital-abundant country capital is relatively cheap compared with wages, while in the labor-abundant country this relationship is reversed. Now we introduce the two products that these two countries can produce: the first will be computers (c), the second: textiles (t). We assume that producing computers requires more capital than labor (it is capital-intensive), while producing clothes requires more labor than capital (it is labor-intensive).

The Production Possibility Frontier Here we can see the poduction possibility frontiers of country A and B. These represent the computer-textile combinations which are available for them using all of their production factors: t c Country B Country A

The Production Possibility Frontier On the previous figure we could also notice that country A has absolute advantage both in producing computers and textiles. However, country A is relatively better in producing computers, while country B in producing textiles. Country A has comparative advantage in producing computers, while country B in producing textiles.

Trade between Countries Now we allow the countries to exchange goods, but not production factors. The exchange rate must be between the price ratios of the two countries. For the sake of simplicity let’s suppose that the exchange rate is 1: 1.

Specialization The countries can improve further their utility by specialization. The direction of specialization will be determined by comparative advantages. The relatively capital-abundant country A will specialize in producing computers, while the relatively labor-abundant country B will specialize in producing textiles. According to this the relatively capital-abundant country will specialize in producing capital-intensive, while the relatively labor-abundant-country in labor-intensive goods. This is the so called Heckscher-Ohlin-Theorem.

Specialization During specialization the relative prices of goods are changing. The more computers are being made in country A, the higher will be the computers/textiles price ratio. The same process (in the opposite direction) takes place in country B, so here the price of textiles increase compared with that of the computers. In the end, the relative prices of goods will be equalized.

Hechscher-Ohlin-Samuelson Theorem Together with the relative price changes of goods, the relative use of the factors of productions is also changing. This leads to a change of relative prices in the factor market. As country A uses more capital, the relative price of it increases, while in country B an opposite process takes place. In the end, together with the levelling of relative prices of goods, a same process occurs in the market of factors of production, because the price is determined by the cost, i.e. by the prices of capital and labor.

Hechscher-Ohlin-Samuelson Theorem As a consequence of specialization and trade, both relative prices of goods, and those of the factors are levelling. This result has been first shown by Paul Samuelson, Nobel-laureate in economics, and has been named after him Heckscher-Ohlin-Samuelson-Theorem. The main point is that by allowing trade and specialization, but not factor mobility, relative prices of production factors do equalize.

Hechscher-Ohlin-Samuelson Theorem In reality, this levelling of interest rates and wages is not taking place. Why? Model-conditions: 1. Both countries produce both products; 2. same technology of production; 3. prices are levelled by trade. But: Not every products are produced by everyone. Different technology of production. No total convergence in prises.

The Leontief paradox In the early 50s Wasily Leontief, an American economist, empirically tested the Heckscher-Ohlin-Theorem. He found that the result didn’t support the theory. In fact, it was contradictory of it: the export of the USA (a relatively capital-abundant country) was more labor-intensive (less capital intensive) than the import of the country. This result is the so called Leontief paradox.

The Leontief paradox There are numerous explanations dealing with this situation. The most plausible of them is that there are differences between labor and labor. While American exports consist of mainly high skilled labor, imports mainly low skilled. According to this reasoning, the theory lacks the empirical power because of simplification of labor. This result already emphasized the importance of human capital 50 years ago.

Trade in the Heckscher-Ohlin Model - Conclusion An economy will be relatively efficient at (have a comparative advantage in) producing goods that are intensive in its abundant factors of production. An economy will export goods that are intensive in its abundant factors of production and import goods that are intensive in its scarce factors of production. This proposition is called the Heckscher-Ohlin theorem

Trade in the Heckscher-Ohlin Model - Conclusion Because an economy can afford to consume more with trade, the country as a whole is made better off. But some do not gain from trade, unless the model accounts for a redistribution of income. Trade changes relative prices of goods, which have effects on the relative earnings of labor and capital. A rise in the price of cloth raises the purchasing power of domestic laborers, but lowers the purchasing power of domestic capital owners. The model predicts that with trade owners of abundant factors gain, but owners of scarce factors lose.