Chapter 5

International

Economics Tenth Edition

Factor Endowments and the Heckscher-Ohlin Theory

Dominick Salvatore

John Wiley & Sons, Inc.

CHAPTER F I V E

5

In this chapter:

Assumptions of the Theory

Factor Intensity, Factor Abundance, and the Shape of the Production Frontier

Factor Endowments and the Heckscher-Ohlin Theory

Factor-Price Equalization and Income Distribution

Empirical Tests of the Heckscher-Ohlin Model

Assumptions of the Theory

Heckscher-Ohlin theory based on following assumptions:

1. Two nations (1 & 2) , two goods (X & Y), two factors of production (L & K)

2. Technology is the same in both nations – both nations have the same production function

3. Commodity X is labor intensive, commodity Y is capital intensive in both nations. X requires relatively more labor (less capital) than Y.

Capital-labor ratio is less in the production of X

Assumptions of the Theory

4. Constant returns to scale for X and Y in both nations. If a nation increases the amounts of L & K used in the

production of X (or Y) by 10%, the output of X (or Y) increases by the same 10%.

5. Incomplete specialization in production in both nations

6. Tastes (preferences) are equal in both nations. If prices of X and Y are the same in both nations, both

nations will consume X and Y in the same proportion.

Assumptions of the Theory

7. Both commodities and factors are traded in perfectly competitive markets All consumers and produces are price-takers

In the long-run, prices of X & Y equal their cost of production (including implicit costs) – Zero Economic Profit in LR.

Commodities and factors are homogenous (identical) in each nation and internationally.

8. Perfect factor mobility within each nation, but not between nations. That is, there is perfect internal, but no international, factor mobility. L & K freely move to the production of the commodity

where earnings are higher

Assumptions of the Theory

9. No transportation costs, tariffs or other barriers to free trade.

10. All resources are fully employed in both nations Each nation produces on its PPF.

11. International trade between the nations is balanced. Total value of exports equals total value of imports for

each nation.

Factor Intensity, Factor Abundance, and the Shape of the Production Frontier

Factor Intensity In a two-commodity, two-factor world,

commodity Y is capital intensive if the capital-labor ratio (K/L) used in the production of Y is greater than K/L used in the production of X.

It is not the absolute amount of capital and labor used in production of X and Y, but the amount of capital per unit of labor that determines capital intensity.

Factor Intensity, Factor Abundance, and the Shape of the Production Frontier

Factor Intensity Suppose that

The production of 1X in nation 1 requires 1K & 4L

The production of 1Y in nation 1 requires 2K & 2L

The production of 1X in nation 2 requires 2K & 2L

The production of 1Y in nation 2 requires 4K & 1L

Therefore, X is labor-intensive and Y is capital-intensive in both nations.

Factor Intensity, Factor Abundance, and the Shape of the Production Frontier

Factor Abundance

In terms of physical units:

Nation 2 is capital abundant if the ratio of the total amount of capital to the total amount of labor (TK/TL) available in Nation 2 is greater than that in Nation 1.

It is not the absolute amount of capital and labor available in each nation, but the ratio of the total amount of capital to the total amount of labor.

Factor Intensity, Factor Abundance, and the Shape of the Production Frontier

Factor Abundance In terms of relative factor prices:

Nation 2 is capital abundant if the ratio of the rental price of capital to the price of labor time (PK/PL) is lower in Nation 2 than in Nation 1.

Rental price of capital is usually considered to be the interest rate (r), while the price of labor time is the wage rate (w), so PK/PL = r/w.

It is not the absolute level of r that determines whether a nation is K-abundant, but r/w.

FIGURE 5-2 The Shape of the Production Possibilities Frontiers

(PPFs) of Nation 1 and Nation 2.

Nation 1 is L-abundant, and

commodity X is L-intensive

Nation 2 is K-abundant, and

commodity Y is K-intensive

Factor Endowments and the Heckscher-Ohlin Theory

Heckscher-Ohlin (H-O) theory is based on two theorems:

1. The H-O 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 nation’s relatively scarce and expensive factor.

Factor Endowments and the Heckscher-Ohlin Theory

Heckscher-Ohlin (H-O) theory is based on two theorems:

1. The H-O theorem

In short, the relatively labor-abundant nation exports the relatively labor-intensive commodity and imports the relatively capital-intensive commodity

Similarly, the relatively capital-abundant nation exports the relatively capital-intensive commodity and imports the relatively labor-intensive one

H-O Theorem Explains comparative advantage rather than assuming it.

Factor-Price Equalization and Income Distribution

Heckscher-Ohlin (H-O) theory is based on two theorems:

2. The factor price equalization theorem

International trade will bring about equalization in the relative and absolute returns to homogenous factors across nations.

In short, wages and other factor returns will be the same after specialization and trade has occurred.

Holds only if H-O theorem holds.

Factor-Price Equalization and Income Distribution

Heckscher-Ohlin (H-O) theory is based on two theorems:

2. The factor price equalization theorem

International trade causes w to rise in Nation 1 (the low-wage nation) and fall in Nation 2. (the high-wage nation), reducing the pre-trade difference in w between nations.

Similarly, trade causes r to fall in Nation 1 (the K-expensive nation) and rise in Nation 2. (the K-cheap nation), reducing the pre-trade difference in r between nations.

Factor-Price Equalization and Income Distribution

Heckscher-Ohlin (H-O) theory is based on two theorems:

2. The factor price equalization theorem

Thus, international trade causes a redistribution of income from the relatively expensive (scarce) factor to the relatively cheap (abundant) factor.

FIGURE 5-5 Relative Factor–Price Equalization.

Empirical Tests of the Heckscher-Ohlin Model

The Leontief Paradox

A 1951 test of the H-O theory

Showed that the pattern of trade did not fit the conclusions of the H-O theorem.

Exports in the U.S. seemed to be labor intensive when they should have been capital intensive.

Empirical Tests of the Heckscher-Ohlin Model

Source of the Leontief Paradox Bias

Assumed a two factor world which required assumptions about what is capital and what is labor.

Most heavily protected industries in U.S. were L- intensive, reduced imports and increased domestic production of L-intensive goods.

Only physical capital included as capital, ignoring human capital (education, job training, skills).