University of Papua New Guinea International Economics Lecture 6: Trade Models III – The Heckscher-Ohlin Model

The University of Papua New Guinea Slide 1 Lecture 6: Trade Models III – The Heckscher-Ohlin Model Michael Cornish Overview Introduction Setting up the Model Adding in the Trade Conclusions Empirical evidence for the Heckscher-Ohlin Model

The University of Papua New Guinea Slide 2 Lecture 6: Trade Models III – The Heckscher-Ohlin Model Michael Cornish Introduction So far, we’ve looked at two Models: –The Ricardian Model: How comparative advantage leads to gains from trade –The Specific Factors Model Tracking the distributional effects of trade in the short-run These are useful models, but we really want to know what drives trade, and the long-run effects on income distribution

The University of Papua New Guinea Slide 3 Lecture 6: Trade Models III – The Heckscher-Ohlin Model Michael Cornish Introduction This is where the Heckscher-Ohlin Model comes in… It focuses on differences in resource endowments as the source of trade –Specifically, the relative abundance of factors of production (i.e. L, K, T, etc.) For this reason, the Model is often called the factor-proportions theory

The University of Papua New Guinea Slide 4 Lecture 6: Trade Models III – The Heckscher-Ohlin Model Michael Cornish Introduction Who were Heckscher and Ohlin? Two Swedish economists Heckscher Ohlin Academic Heckscher’s student; academic and politician; won the Nobel Prize for his work

The University of Papua New Guinea Slide 5 Lecture 6: Trade Models III – The Heckscher-Ohlin Model Michael Cornish Setting up the Model Assumptions: The simple version of the Model consists of: –2 economies/countries (‘Home’ and ‘Foreign’) –2 products –2 factors of production (convention is L & K) For this reason, it is sometimes known as the ‘2 x 2 x 2 Model’ Again, we assume perfectly competitive markets

The University of Papua New Guinea Slide 6 Lecture 6: Trade Models III – The Heckscher-Ohlin Model Michael Cornish Setting up the Model An example: food and cloth again! Production functions: Q C = Q C (K C, L C ) Q F = Q F (K F, L F ) K C and K F are the amounts of capital used in the production of cloth and food Similarly, L C and L F are the amounts of labour used in the production of cloth and food Note: These are different to the production functions for the Specific Factors Model! Now we only have two factors &

The University of Papua New Guinea Slide 7 Lecture 6: Trade Models III – The Heckscher-Ohlin Model Michael Cornish Setting up the Model Unit requirements: –α LC : L used to produce one unit of cloth –α KC : K used to produce one unit of cloth –α LF : L used to produce one unit of food –α KF : K used to produce one unit of food Note: Unit requirements are also different to the Ricardian Model, because it talks about units used, not units required This is because with two factors, we now have a choice of how much of each we use &

The University of Papua New Guinea Slide 8 Lecture 6: Trade Models III – The Heckscher-Ohlin Model Michael Cornish Setting up the Model To begin with, let’s assume that there is only one combination of K and L that can produce a unit of each product For the purpose of our example, we’ll use the following values: –α LC = 2 –α KC = 2 –α LF = 1 –α KF =3 &

The University of Papua New Guinea Slide 9 Lecture 6: Trade Models III – The Heckscher-Ohlin Model Michael Cornish Setting up the Model Furthermore, let’s assume that our economy has the following resource endowments: –2,000 hours of labour –3,000 hours of capital These two resource constraints are called budget constraints –And we can draw them! If it helps you, you can think of hours of capital as ‘machine-hours’ &

The University of Papua New Guinea Slide 10 Lecture 6: Trade Models III – The Heckscher-Ohlin Model Michael Cornish Setting up the Model Labour budget constraint: 2,000 hrs of L / labour unit requirement for cloth = 2,000 / α LC = 2,000 / 2 = 1,000 cloth 2,000 hrs of L / labour unit requirement for food = 2,000 / α LF = 2,000 / 1 = 2,000 food Cloth Food α LC = 2 α LF = 1 α KC = 2 α KF = 3

The University of Papua New Guinea Slide 11 Lecture 6: Trade Models III – The Heckscher-Ohlin Model Michael Cornish Note: The slope = – α LC / α LF Drawing the labour budget constraint

The University of Papua New Guinea Slide 12 Lecture 6: Trade Models III – The Heckscher-Ohlin Model Michael Cornish Setting up the Model Capital budget constraint: 3,000 hrs of K / capital unit requirement for cloth = 3,000 / α KC = 3,000 / 2 = 1,500 cloth 3,000 hrs of K / capital unit requirement for food = 3,000 / α KF = 3,000 / 3 = 1,000 food Cloth Food α LC = 2 α LF = 1 α KC = 2 α KF = 3

The University of Papua New Guinea Slide 13 Lecture 6: Trade Models III – The Heckscher-Ohlin Model Michael Cornish Note: The slope = – α KC / α KF Drawing the capital budget constraint

The University of Papua New Guinea Slide 14 Lecture 6: Trade Models III – The Heckscher-Ohlin Model Michael Cornish Putting them together! Note: The opportunity cost changes with the slope! Thus our PPF has two different opportunity costs

The University of Papua New Guinea Slide 15 Lecture 6: Trade Models III – The Heckscher-Ohlin Model Michael Cornish Setting up the Model Now let’s relax the restriction about having to use a fixed proportion of capital and labour for each product Our PPF becomes outwards-bending due to increasing opportunity costs But how do we determine where on our PPF we produce? –We use isovalue lines, which show the same value of output (V): V = (P C * Q C ) + (P F * Q F ) &

The University of Papua New Guinea Slide 16 Lecture 6: Trade Models III – The Heckscher-Ohlin Model Michael Cornish The Heckscher-Ohlin PPF with substitutable factors of production Remember: An outward-bending PPF means increasing opportunity costs

The University of Papua New Guinea Slide 17 Lecture 6: Trade Models III – The Heckscher-Ohlin Model Michael Cornish Now we add in isovalue lines to determine where we produce... Isovalue lines always be straight, with: slope = – P C / P F We maximise Value (V) at Q

The University of Papua New Guinea Slide 18 Lecture 6: Trade Models III – The Heckscher-Ohlin Model Michael Cornish Setting up the Model We choose our output based on where we get the maximum revenues – the maximum value (V) The next thing we want to know is – how do we choose our inputs? –I.e. what combination of L and K will we use to produce at this point of maximum value (this was Q in our previous slide) ? This will depend on the costs of L and K, which we call factor prices &

The University of Papua New Guinea Slide 19 Lecture 6: Trade Models III – The Heckscher-Ohlin Model Michael Cornish Setting up the Model The price of L is the wage (w) The price of K is called rent (r) Remember the importance of relative prices upon how we select our value-maximising output? –Similarly, we are dependent on the relative factor prices (costs) to determine how to minimise our input costs –In the Heckscher-Ohlin Model, this is the wage-rent ratio (w/r) &

The University of Papua New Guinea Slide 20 Lecture 6: Trade Models III – The Heckscher-Ohlin Model Michael Cornish Setting up the Model What does this mean in practice? If labour is relatively more expensive than capital, then producers will prefer to use more capital when making products If capital is relatively more expensive than labour, then producers will prefer to use more labour when making products Only thing is, each factor of production has diminishing returns &

The University of Papua New Guinea Slide 21 Lecture 6: Trade Models III – The Heckscher-Ohlin Model Michael Cornish Input combinations Diminishing returns means that if you use only capital inputs, or only labour inputs, you will need much more of them per unit of production than if you used some of both! This is why we have a curve

The University of Papua New Guinea Slide 22 Lecture 6: Trade Models III – The Heckscher-Ohlin Model Michael Cornish Cloth production is more labour- intensive than food production; food is more capital-intensive Relative factor demand curves

The University of Papua New Guinea Slide 23 Lecture 6: Trade Models III – The Heckscher-Ohlin Model Michael Cornish Setting up the Model Now we want to link our understanding of input costs (w/r) to relative prices (P C /P F ) Because cloth production is more labour-intensive, the wage-rental ratio (w/r) will have a positive relationship with the relative price of cloth (P C /P F ) –I.e.  w =>  (P C / P F ), and  r =>  (P C / P F ) &

The University of Papua New Guinea Slide 24 Lecture 6: Trade Models III – The Heckscher-Ohlin Model Michael Cornish Linking relative product prices (P C /P F ) with relative factor prices (w/r)

The University of Papua New Guinea Slide 25 Lecture 6: Trade Models III – The Heckscher-Ohlin Model Michael Cornish And now linking it all together: relative product prices (P C /P F ), relative factor prices (w/r), & input combinations If we increase P C / P F … Then we decrease the L-K ratio used in both products The textbook (p117) is wrong!

The University of Papua New Guinea Slide 26 Lecture 6: Trade Models III – The Heckscher-Ohlin Model Michael Cornish Adding in the Trade Finally, time to add in the trade! We have 2 economies in the Heckscher-Ohlin Model –But how do we know what the world relative price will be? Remember how we worked out the world relative price when we looked at the Ricardian Model...? –Relative demand and relative supply

The University of Papua New Guinea Slide 27 Lecture 6: Trade Models III – The Heckscher-Ohlin Model Michael Cornish General equilibrium analysis: relative demand and relative supply Note: Relative demand is assumed to be universal (the same regardless of the country) RS* = Relative Supply in Foreign

The University of Papua New Guinea Slide 28 Lecture 6: Trade Models III – The Heckscher-Ohlin Model Michael Cornish We end up with a world relative price that is between each economy’s equilibrium in autarky –This new equilibrium relative price is at (2) To see the effect on production and consumption is relatively simple – we simply put the world relative price (of cloth in terms of food) onto our PPF (P C */P F *) –The economy will now produce and consume according to this world price instead of the domestic price in autarky Remember: Autarky means ‘without trade’ Adding in the Trade

The University of Papua New Guinea Slide 29 Lecture 6: Trade Models III – The Heckscher-Ohlin Model Michael Cornish 1. Production Opening to trade shifts production from Q A to Q* With trade, more cloth is produced and less food 2. Consumption Consumption can now be at any point along the red ‘trade’ line!

The University of Papua New Guinea Slide 30 Lecture 6: Trade Models III – The Heckscher-Ohlin Model Michael Cornish Conclusions The Heckscher-Ohlin Theorem: The country that is relatively abundant in a factor, will export the product that uses that factor intensively in its production –E.g. In our example, Home was relatively more abundant in labour than Foreign, and ended up exporting the labour-intensive product, cloth

The University of Papua New Guinea Slide 31 Lecture 6: Trade Models III – The Heckscher-Ohlin Model Michael Cornish Conclusions An increase in the price of a labour-intensive product will increase the wages of workers in both sectors –Real wages will increase, and real rents on capital will decrease Conversely, an increase in the price of a capital- intensive product will increase the rental incomes of the owners of capital in both sectors –Real rents will increase, and real wages will decrease

The University of Papua New Guinea Slide 32 Lecture 6: Trade Models III – The Heckscher-Ohlin Model Michael Cornish Conclusions Owners of the country’s abundant factor gains from trade, but owners of a country’s scarce factors lose This is because opening to trade equalises the prices of factors –This is known as factor price equalisation »We’ll return to this later…

The University of Papua New Guinea Slide 33 Lecture 6: Trade Models III – The Heckscher-Ohlin Model Michael Cornish Empirical evidence for the Model Short version? Strong evidence! However, empirical evidence exposed a fundamental (but easily fixed) flaw of the basic Heckscher-Ohlin Model –This is the Leontief Paradox »But we will also look at this later!