Resources and

Trade: The Heckscher-Ohlin

Model
Preview

• Production possibilities
• Changing the mix of inputs
• Relationships among factor prices and goods prices,
and resources and output
• Trade in the Heckscher-Ohlin model
• Factor price equalization
• Trade and income distribution
• Empirical evidence
Introduction

• In addition to differences in labor productivity,

trade occurs due to differences in resources across
countries.
• The Heckscher-Ohlin theory argues that trade
occurs due to differences in labor, labor skills,
physical capital, capital, or other factors of
production across countries.
• Countries have different relative abundance of factors of
production.
• Production processes use factors of production with
different relative intensity.
Two-Factor Heckscher-Ohlin Model

1. Two countries: home and foreign.

2. Two goods: cloth and food.
3. Two factors of production: labor and capital.
4. The mix of labor and capital used varies across
goods.
5. The supply of labor and capital in each country is
constant and varies across countries.
6. In the long run, both labor and capital can move
across sectors, equalizing their returns (wage and
rental rate) across sectors.
Production Possibilities

• With more than one factor of production, the

opportunity cost in production is no longer constant
and the PPF is no longer a straight line. Why?
• Numerical example:
K = 3000, total amount of capital available for
production
L = 2000, total amount of labor available for
production
Production Possibilities (cont.)

• Suppose use a fixed mix of capital and labor in each

sector.
aKC = 2, capital used to produce one yard of cloth
aLC = 2, labor used to produce one yard of cloth
aKF = 3, capital used to produce one calorie of food
aLF = 1, labor used to produce one calorie of food
Production Possibilities (cont.)

• Production possibilities are influenced by both capital and

labor:
Total amount of
aKCQC + aKFQF ≤ K capital resources

Capital used for Capital used for

Total calories of
each yard of cloth each calorie of
Total yards of food production
production food production
cloth production
aLCQC + aLFQF ≤ L
Total amount of
labor resources

Labor used for each Labor required for

yard of cloth each calorie of food
production production
Production Possibilities (cont.)

• Constraint on capital that capital used cannot

exceed supply:
2QC + 3QF ≤ 3000
• Constraint on labor that labor used cannot exceed
labor supply:
2QC + QF ≤ 2000
Production Possibilities (cont.)

• Economy must produce subject to both constraints

– i.e., it must have enough capital and labor.
• Without factor substitution, the production
possibilities frontier is the interior of the two factor
constraints.
Production Possibilities (cont.)

• Max food production 1000 (point 1) fully uses

capital, with excess labor.
• Max cloth 1000 (point 2) fully uses labor, with
excess capital.
• Intersection of labor and capital constraints occurs
at 500 calories of food and 750 yards of cloth (point
3).
Fig. 5-1: The Production Possibility Frontier without
Factor Substitution
Production Possibilities (cont.)

• The opportunity cost of producing one more yard of cloth, in

terms of food, is not constant:
• low (2/3 in example) when the economy produces a low amount of
cloth and a high amount of food
• high (2 in example) when the economy produces a high amount of
cloth and a low amount of food
• Why? Because when the economy devotes more resources
towards production of one good, the marginal productivity
of those resources tends to be low so that the opportunity
cost is high.
Production Possibilities (cont.)

• The above PPF equations do not allow substitution

of capital for labor in production.
• Unit factor requirements are constant along each
line segment of the PPF.
• If producers can substitute one input for another in
the production process, then the PPF is curved
(bowed).
• Opportunity cost of cloth increases as producers
make more cloth.
Fig. 5-2: The Production Possibility
Frontier with Factor Substitution
Production Possibilities (cont.)

• What does the country produce?

• The economy produces at the point that maximizes
the value of production, V.
• An isovalue line is a line representing a constant
value of production, V:
V = PC QC + PF QF
• where PC and PF are the prices of cloth and food.
• slope of isovalue line is – (PC /PF)
Fig. 5-3: Prices and Production
Production Possibilities (cont.)

• Given the relative price of cloth, the economy

produces at the point Q that touches the highest
possible isovalue line.
• At that point, the relative price of cloth equals the
slope of the PPF, which equals the opportunity cost
of producing cloth.
• The trade-off in production equals the trade-off
according to market prices.
Choosing the Mix of Inputs

• Producers may choose different amounts of factors

of production used to make cloth or food.
• Their choice depends on the wage, w, paid to labor
and the rental rate, r, paid when renting capital.
• As the wage w increases relative to the rental rate r,
producers use less labor and more capital in the
production of both food and cloth.
Fig. 5-4: Input Possibilities in Food Production
Choosing the Mix of Inputs (cont.)

• Assume that at any given factor prices, cloth

production uses more labor relative to capital than
food production uses:
aLC /aKC > aLF /aKF or LC /KC > LF /KF
• Production of cloth is relatively labor intensive,
while production of food is relatively land intensive.
• Relative factor demand curve for cloth CC lies
outside that for food FF.
Fig. 5-5: Factor Prices and Input Choices
Factor Prices and Goods Prices

• In competitive markets, the price of a good should

equal its cost of production, which depends on the
factor prices.
• How changes in the wage and rent affect the cost of
producing a good depends on the mix of factors
used.
• An increase in the rental rate of capital should
affect the price of food more than the price of
cloth since food is the capital intensive industry.
• Changes in w/r are tied to changes in PC /PW.
Fig. 5-6: Factor Prices and Goods Prices
Factor Prices and Goods Prices (cont.)

• Stolper-Samuelson theorem: If the relative price of

a good increases, then the real wage or rental rate
of the factor used intensively in the production of
that good increases, while the real wage or rental
rate of the other factor decreases.
• Any change in the relative price of goods alters the
distribution of income.
Fig. 5-7: From Goods Prices to Input Choices
Factor Prices and Goods Prices (cont.)

• An increase in the relative price of cloth, PC /PF, is

predicted to
• raise income of workers relative to that of capital
owners, w/r.
• raise the ratio of capital to labor services, K/L,
used in both industries.
• raise the real income (purchasing power) of
workers and lower the real income of capital
owners.
Resources and Output

• How do levels of output change when the

economy’s resources change?
• Rybczynski theorem: If you hold output prices
constant as the amount of a factor of production
increases, then the supply of the good that uses this
factor intensively increases and the supply of the
other good decreases.
Resources and Output (cont.)

• Assume an economy’s labor force grows, which implies that

its ratio of labor to capital L/K increases.
• Expansion of production possibilities is biased toward cloth.
• At a given relative price of cloth, the ratio of labor to capital
used in both sectors remains constant.
• To employ the additional workers, the economy expands
production of the relatively labor-intensive good cloth and
contracts production of the relatively capital-intensive good
food.
Fig. 5-8: Resources and Production Possibilities
Resources and Output (cont.)

• An economy with a high ratio of labor to capital

produces a high output of cloth relative to food.
• Suppose that Home is relatively abundant in labor
and Foreign in capital:
L/K > L*/ K*
• Likewise, Home is relatively scarce in capital and Foreign
in labor.
• Home will be relatively efficient at producing cloth
because cloth is relatively labor intensive.
Trade in the Heckscher-Ohlin Model

• The countries are assumed to have the same

technology and the same tastes.
• With the same technology, each economy has a
comparative advantage in producing the good that
relatively intensively uses the factors of production in
which the country is relatively well endowed.
• With the same tastes, the two countries will consume
cloth to food in the same ratio when faced with the same
relative price of cloth under free trade.
Trade in the Heckscher-Ohlin Model (cont.)

• Since cloth is relatively labor intensive, at each

relative price of cloth to food, Home will produce a
higher ratio of cloth to food than Foreign.
• Home will have a larger relative supply of cloth to food
than Foreign.
• Home’s relative supply curve lies to the right of Foreign’s.
Fig. 5-9: Trade Leads to a Convergence of Relative
Prices
Trade in the Heckscher-Ohlin Model (cont.)

• Like the Ricardian model, the Heckscher-Ohlin

model predicts a convergence of relative prices
with trade.
• With trade, the relative price of cloth rises in the
relatively labor abundant (home) country and falls
in the relatively labor scarce (foreign) country.
Trade in the Heckscher-Ohlin Model (cont.)

• Relative prices and the pattern of trade: In Home,

the rise in the relative price of cloth leads to a rise
in the relative production of cloth and a fall in
relative consumption of cloth.
• Home becomes an exporter of cloth and an importer of
food.
• The decline in the relative price of cloth in Foreign
leads it to become an importer of cloth and an
exporter of food.
Trade in the Heckscher-Ohlin Model (cont.)

• Heckscher-Ohlin theorem: The country that is

abundant in a factor exports the good whose
production is intensive in that factor.
• This result generalizes to a correlation:
• Countries tend to export goods whose production is
intensive in factors with which the countries are
abundantly endowed.
Trade and the Distribution of Income

• Changes in relative prices can affect the earnings of

labor and capital.
• A rise in the price of cloth raises the purchasing power of
labor in terms of both goods while lowering the
purchasing power of capital in terms of both goods.
• A rise in the price of food has the reverse effect.
Trade and the Distribution of Income (cont.)

• Thus, international trade can affect the distribution

of income, even in the long run:
• Owners of a country’s abundant factors gain from trade,
but owners of a country’s scarce factors lose.
• Factors of production that are used intensively by the
import-competing industry are hurt by the opening of
trade – regardless of the industry in which they are
employed.
Trade and the Distribution of Income (cont.)

• Compared with the rest of the world, the United

States is abundantly endowed with highly skilled
labor while low-skilled labor is correspondingly
scarce.
• International trade has the potential to make low-skilled
workers in the United States worse off - not just
temporarily, but on a sustained basis.
Trade and the Distribution of Income (cont.)

• Changes in income distribution occur with every

economic change, not only international trade.
• Changes in technology, changes in consumer preferences,
exhaustion of resources and discovery of new ones all
affect income distribution.
• Economists put most of the blame on technological
change and the resulting premium paid on education as
the major cause of increasing income inequality in the US.
• It would be better to compensate the losers from
trade (or any economic change) than prohibit trade.
• The economy as a whole does benefit from trade.
Trade and the Distribution of Income (cont.)

• There is a political bias in trade politics: potential

losers from trade are better politically organized
than the winners from trade.
• Losses are usually concentrated among a few, but gains
are usually dispersed among many.
• Each of you pays about $8/year to restrict imports of
sugar, and the total cost of this policy is about $2
billion/year.
• The benefits of this program total about $1 billion, but
this amount goes to relatively few sugar producers.
North-South Trade and Income Inequality

• Over the last 40 years, countries like South Korea,

Mexico, and China have exported to the U.S. goods
intensive in unskilled labor (ex., clothing, shoes,
toys, assembled goods).
• At the same time, income inequality has increased
in the U.S., as wages of unskilled workers have
grown slowly compared to those of skilled workers.
• Did the former trend cause the latter trend?
North-South Trade and Income Inequality (cont.)

• The Heckscher-Ohlin model predicts that owners

of relatively abundant factors will gain from trade
and owners of relatively scarce factors will lose
from trade.
• Little evidence supporting this prediction exists.
1. According to the model, a change in the
distribution of income occurs through changes in
output prices, but there is no evidence of a
change in the prices of skill-intensive goods
relative to prices of unskilled-intensive goods.
North-South Trade and Income Inequality (cont.)

2. According to the model, wages of unskilled

workers should increase in unskilled labor
abundant countries relative to wages of skilled
labor, but in some cases the reverse has
occurred:
• Wages of skilled labor have increased more rapidly in
Mexico than wages of unskilled labor.
• But compared to the U.S. and Canada, Mexico is
supposed to be abundant in unskilled workers.
North-South Trade and Income Inequality (cont.)

3. Even if the model were exactly correct, trade is a

small fraction of the U.S. economy, so its effects
on U.S. prices and wages prices should be small.
• The majority view of trade economists is that the
villain is not trade but rather new production
technologies that put a greater emphasis on
worker skills (such as the widespread
introduction of computers and other advanced
technologies in the workplace).
Skill-Biased Technological Change and Income
Inequality

• Even though skilled labor becomes relatively more

expensive, in panel (b) producers in both sectors
respond to the skill-biased technological change by
increasing their employment of skilled workers
relative to unskilled workers.
• The trade explanation in panel (a) predicts an opposite
response for employment in both sectors.
• A widespread increase in the skilled labor ratios for
most sectors in the U.S. economy points to the skill-
biased technological explanation.
Skill-Biased Technological Change and Income
Inequality (cont.)

• Trade likely has been an indirect contributor to

increases in wage inequality, by accelerating the
process of technological change.
• Firms that begin to export may upgrade to more skill-
intensive production technologies.
• Trade liberalization can then generate widespread
technological change by inducing a large proportion of
firms to make such technology-upgrade choices.
• Breaking up the production process across
countries can increase the relative demand for
skilled workers in developed countries similar to
skill-biased technological change.
Fig. 5-10: Increased Wage Inequality: Trade or Skill-Biased
Technological Change?
Factor Price Equalization

• Unlike the Ricardian model, the Heckscher-Ohlin

model predicts that factor prices will be equalized
among countries that trade.
• Free trade equalizes relative output prices.
• Due to the connection between output prices and
factor prices, factor prices are also equalized.
• Trade increases the demand of goods produced by
relatively abundant factors, indirectly increasing the
demand of these factors, raising the prices of the
relatively abundant factors.
Factor Price Equalization (cont.)

• In the real world, factor prices are not equal across

countries.
• The model assumes that trading countries produce
the same goods, but countries may produce
different goods if their factor ratios radically differ.
• The model also assumes that trading countries have
the same technology, but different technologies
could affect the productivities of factors and
therefore the wages/rates paid to these factors.
Table 5-1: Comparative International Wage Rates
(United States = 100)
Factor Price Equalization (cont.)

• The model also ignores trade barriers and

transportation costs, which may prevent output
prices and thus factor prices from equalizing.
• The model predicts outcomes for the long run, but
after an economy liberalizes trade, factors of
production may not quickly move to the industries
that intensively use abundant factors.
• In the short run, the productivity of factors will be
determined by their use in their current industry, so that
their wage/rental rate may vary across countries.
 Empirical Evidence on the
Heckscher-Ohlin Model

• Tests on US data
• Leontief found that U.S. exports were less capital-
intensive than U.S. imports, even though the U.S. is the
most capital-abundant country in the world: Leontief
paradox.
• Tests on global data
• Bowen, Leamer, and Sveikauskas tested the Heckscher-
Ohlin model on data from 27 countries and confirmed the
Leontief paradox on an international level.
Empirical Evidence of the
Heckscher-Ohlin Model (cont.)

• Because the Heckscher-Ohlin model predicts that

factor prices will be equalized across trading
countries, it also predicts that factors of production
will produce and export a certain quantity goods
until factor prices are equalized.
• In other words, a predicted value of services from factors
of production will be embodied in a predicted volume of
trade between countries.
Empirical Evidence of the
Heckscher-Ohlin Model (cont.)

• But because factor prices are not equalized across countries,

the predicted volume of trade is much larger than actually
occurs.
• A result of “missing trade” discovered by Daniel Trefler.

• The reason for this “missing trade” appears to be the

assumption of identical technology among countries.
• Technology affects the productivity of workers and therefore the
value of labor services.
• A country with high technology and a high value of labor services
would not necessarily import a lot from a country with low
technology and a low value of labor services.
Empirical Evidence of the
Heckscher-Ohlin Model (cont.)

• An important study by Donald Davis and David Weinstein

showed that if relax the assumption of common
technologies, along with assumptions underlying factor price
equalization (countries produce the same goods and costless
trade equalizes prices of goods):
• then the predictions for the direction and volume of the factor
content of trade line-up well with empirical evidence and ultimately
generate a good fit.
• Difficulty finding support for the predictions of the “pure”
Heckscher-Ohlin model can be blamed on some of the
assumptions made.
Empirical Evidence of the
Heckscher-Ohlin Model (cont.)

• Contrast the exports of labor-abundant, skill-scarce

nations in the developing world with the exports of
skill-abundant, labor-scarce (rich) nations.
• The exports of the three developing countries to the
United States are concentrated in sectors with the lowest
skill-intensity.
• The exports of the three skill abundant countries to the
United States are concentrated in sectors with higher skill
intensity.
Fig. 5-12: Export Patterns for a Few Developed and Developing
Countries, 2008–2012
Empirical Evidence of the
Heckscher-Ohlin Model (cont.)

• Or compare how exports change when a country

such as China grows and becomes relatively more
skill-abundant:
• The concentration of exports in high-skill sectors steadily
increases over time.
• In the most recent years, the greatest share of exports is
transacted in the highest skill-intensity sectors, whereas
exports were concentrated in the lowest skill-intensity
sectors in the earlier years.
Fig. 5-13: Changing Pattern of Chinese Exports over
Time