Heckscher ohlin

The Heckscher-Ohlin Theorem

The Heckscher-Ohlin Theorem says that countries will export products that use their abundant and cheap factor of production and import products that use the countries' scarce factor.

Cont…The Heckscher-Ohlin theory:

Emphasizes resource differences as the only source of trade

Shows that comparative advantage is influenced by: Relative factor abundance (refers to countries) Relative factor intensity (refers to goods)

Is also referred to as the factor-proportions theory

IntroductionGeneral equilibrium mathematical model

of international trade

Developed by Eli Heckscher and Bertil Ohlin

Developed on the Ricardian theory of IT,

The Heckscher-Ohlin Assumptions—BasicsThere are

two countries, Home and Foreigntwo goods, Cloth and Food, and two resources, Labor and Land

these are used to produce Cloth and Food

The Heckscher-Ohlin Assumptions—PreferencesThe preferences of all consumers in the world are

identical. The preferences of any individual are such that

the Marginal Rate of Substitution is independent of the scale of consumption. The MRS of Wine for Cheese is the additional amount of

Wine that would keep the individual's level of happiness unchanged even after the consumption of Cheese is reduced by one unit. Under this assumption, if the amounts of Cheese and Wine being consumed are, say, doubled, then the MRS remains unchanged. In other words, the MRS does not change if the ratio of the amounts of Cheese and Wine consumed, Cheese/ Wine, does not change.

The Ricardian Assumptions—PreferencesThe preferences of all consumers in the

world are identical. For any individual, the Marginal Rate of

Substitution is independent of the scale of consumption. An individual’s MRS of wine for cheese is the

maximum amount of wine that he/she would be willing to pay for one unit of cheese.

Under this assumption, if the amounts of Cheese and Wine being consumed are, say, doubled, then the MRS remains unchanged.

In other words, the MRS does not change if the ratio of the amounts of Cheese and Wine consumed, Cheese/ Wine, does not change.

Marginal Rate of SubstitutionCheese

consumed (C)

Wine consumed

(W)

Cheese-Wine Ratio

(C/W)

MRSWC

10 20 0.5 2600 1200 0.5 210 5 2 1.6

The Heckscher-Ohlin Assumptions—Markets

All markets are perfectly competitive. That is, no buyer or seller of a commodity has

the power to affect the price of the commodity by himself.

More specifically, the market for a commodity is said to be perfectly competitive if: There are many sellers There are many buyers All sellers sell the exact same product

Individuals make decisions so as to maximize happiness, whereas

Firms make decisions so as to maximize profits

The Heckscher-Ohlin Assumptions—GovernmentsGovernments do not interfere with the

smooth functioning of marketsThere are no taxes, subsidies, tariffs, quotas,

etc. However, although there is free trade in

goods and services, there is no cross-border movement of resources, such as labor

The Heckscher-Ohlin Assumptions—TechnologyTechnological knowledge is the same in both

countriesGoods are produced (with land and labor)

using technologies that satisfy Constant Returns to Scale. That is, if the producer of a commodity, say,

doubles the amounts used of all resources, then the amount produced will have to double also.

The Heckscher-Ohlin Assumptions—Factor AbundanceHome has a higher ratio of labor to land

than Foreign does.That is, if TH, TF, LH, and LF denote the amounts

of T (land or territory) and L (labor) that Home and Foreign are endowed with, then LH / TH > LF/ TF.

L/T may be informally interpreted as the number of workers per acre of land.

Home is said to be the “labor-abundant” country and Foreign is the “land-abundant” country.

The Heckscher-Ohlin Assumptions—Factor IntensitiesThe production of food is land-intensive and

the production of cloth is labor-intensiveThat is, the number of workers per acre (L/T) is

always higher in cloth production than in food production

Prices of GoodsLet PC and PF denote the nominal prices of

cloth and food. Then, PC/PF is the relative price of cloth (in

units of food) and PF/PC is the relative price of food (in units of

cloth) See earlier lecture

Prices of FactorsLet w be the nominal price (or, wage) of labor. Let r be the nominal price (or, rent) of landThen w/r is the relative price of labor (in units

of land) and r/w is the relative price of land (in units of

labor)Example: If w = $10 per hour for one worker and r

= $100 per hour for one acre of land, then the relative wage for one worker is 1/10 acres of land and the relative rent on an acre of land is 10 hours of labor.

Nominal PricesThe nominal price of a commodity is simply

the number of dollars (or any other relevant unit of account) that must be paid to buy one unit of the commodity

For example, the nominal price of labor—also called the nominal wage—may be $8 per hour

Real PricesThe real price of commodity X, in units of

commodity Y, is the amount of Y that costs the same as one unit of X

For example, if the nominal price of labor is $8 per hour and the nominal price of a cup of coffee is $2, then the real price of labor is 4 cups of coffee per hour

Real prices are also called relative prices

Real and Nominal PricesReal Price of X, in units of Y, is equal to

Nominal Price of X / Nominal Price of YSo, if w is the nominal wage and P is the

nominal price of a cup of coffee, then the real wage is w / P.

For example, if w is $8 per hour and P is $2, then the real wage is w / P = 8/2 = 4 cups of coffee per hour, as in the previous slide.

Wage-rent ratio, w/r

Relative price of cloth, PC/PF

As labor becomes more expensive relative to land, cloth, which is labor-intensive in production, finds itself at a disadvantage and becomes relatively more expensive compared to food

FPGP

As both Home and Foreign use the same technologies, the same FPGP curve is applicable in both countries

5

17



Under free trade, the relative price of cloth will be the same in both countries

FPGP

Therefore, the wage-rent ratio will also be the same in the two countries

5

17


Acres of Land per worker, T/L

Cloth production

Food production

As labor becomes relatively more expensive, relatively more land is used in production…

But the number of acres of land per worker is always higher in food production, reflecting the assumption that food production is land intensive

… of both food and cloth

4 12

5



Cloth production

Food production

As both Home and Foreign use the same technologies, these two curves must be true in both countries.

4 12

5

As free trade equalizes the wage-rent ratio worldwide, acres of land per worker in cloth production must be the same worldwide.

Therefore, Foreign, which has more land per worker than Home, must produce relatively more food …

Same must be true for food production.


Yards of cloth produced per calorie of food produced, QC/QF

RSFOREIGN

RSHOME

17

In Figure 4-5, we saw that at w/r = 5, Foreign must produce relatively more food and Home must produce relatively more cloth.

In Figure 4-6 we saw that w/r =5 corresponds to PC/PF = 17.

Therefore, Home must produce relatively more cloth at PC/PF = 17, or indeed at any other relative price.

As cloth becomes more expensive relative to food, the output of cloth will increase relative to food, Therefore, the relative supply curves slope upward.

17

3


Yards of cloth consumed per calorie of food consumed, QC/QF

The H-O assumptions about preferences imply that that consumer behavior can be summarized by this Relative Demand curve and that the same curve is true in both Home and Foreign

In this figure, when the price of a yard of cloth is 17 times the price of a calorie of food, the number of yards of cloth consumed is 3 times the number of calories of food consumed, for every individual worldwide. Why isn’t the latter ratio different for different people?

Relative DemandsLet’s say that Alex consumes 3 times as many

yards of cloth as calories of food (relative demand is QC/QF = 3) when a yard of cloth is 17 times as expensive as a calorie of food (relative price PC/PF = 17)

If Alex’s income changes, his relative demand should not change because MRS is independent of the scale of consumption

Relative DemandsSince identical preferences have been

assumed, if the relative price of cloth is PC/PF = 17, then Betty’s relative demand must also be QC/QF = 3 irrespective of Betty’s income

Therefore, the same relative demand curve represents everybody

Therefore, the same relative demand curve represents both Home and Foreign

RSHOME

RSFOREIGN

RD

Foreign

Home

Figure 4-11: Relative Supplies and Demands

The relative supplies and demands can be combined to find the autarky relative prices in Home and Foreign

Clearly, they are different

Therefore, trade will occur if it is allowed

Since Home and Foreign differ only in their relative factor endowments, that difference must be the reason why trade occurs


Yards of cloth produced per calorie of food produced, QC/QF

Who will export what?In autarky, the labor-

intensive good is relatively cheaper in the labor-abundant country

Therefore, under free trade, the labor-intensive good is exported by the labor-abundant country…

… and the land-intensive good is exported by the land-abundant country

Foreign

Home

Free Trade

PC/PF

autarky

Foreign : land abundant, labor scarceHome: land scarce, labor abundantCloth: labor intensive productionFood: land intensive production

The Heckscher-Ohlin TheoremTo repeat, when trade occurs, the labor-

abundant country (Home) exports the labor-intensive good (cloth) and

The land-abundant country (Foreign) exports the land-intensive good (food)

In general, each country exports the good that makes intensive use of the resource that is abundant in that country

This is called the Heckscher-Ohlin TheoremSee the section “Relative Prices and the Pattern

of Trade” in chapter 4 of the textbook

Goods Prices: from autarky to free trade

In autarky, the labor-intensive good is relatively cheaper in the labor-abundant country

Free trade makes relative prices equal everywhere

Therefore, the labor-intensive good becomes more expensive in the labor-abundant country, and less expensive in the labor-scarce country.

Foreign

Home

Free Trade

PC/PF

autarky


Fig. 4-11 showed that, in autarky, the relative price of cloth is higher in Foreign

Therefore, in autarky, the wage-rent ratio must also be higher in Foreign

Free trade makes the wage-rent ratio the same in the two countries


Relative price of cloth, PC/PF FPGP

Foreign

Foreign

Home

Home

Free Trade

Free Trade

Factor Prices: from autarky to free trade

In autarky, the wage-rent ratio is higher in the labor-scarce country and lower in the labor-abundant country

When autarky ends and free trade begins, the wage-rent ratio falls in the labor-scarce country and rises in the labor abundant country

Foreign

Home

Free Trade

w/r

autarky

PC/PF


Real Wage and Real Rentw Nominal wage: currency earned per hour of a worker’s labor

w/PC Real wage: yards of cloth purchasable with the nominal wage

w/PF Real wage: calories of food purchasable with the nominal wage

r Nominal rent: currency earned per hour per acre of land

r/PC Real rent: yards of cloth purchasable with the nominal rent

r/PF Real rent: calories of food purchasable with the nominal rent

Marginal Product of a ResourceThe Marginal Product (MP) of labor in cloth

production is the additional amount of cloth that would be produced if an additional unit of labor is employedWe can similarly define

Marginal Product of labor in food production, Marginal Product of land in cloth production, and Marginal Product of land in food production

Marginal Product of a ResourceSee page Figure 7-2 of the textbook for more

on the Marginal Product.

Example: Level of Resource UseSuppose an additional worker produces an

additional 5 yards of cloth in one hour’s work. Then MP = 5.See page Figure 7-2 of the textbook for

more on the Marginal Product.Therefore, to make one additional yard of

cloth, you need only 1/5 of a worker. In general, the labor needed to make one

unit of cloth can be calculated as 1/MPMarginal Cost is the additional cost of an

additional unit of outputTherefore, MC = w × (1/MP) = w/MP

Price = Marginal CostIf P > MC at the current level of

production, additional production would increase profit

If P < MC at the current level of production, reduced production would increase profit

Therefore, profit is maximized only if P = MC

Therefore, if a good is being produced, P = MC must be true

Real Wage and Real RentTherefore, P = MC = w / MPTherefore, w/P = MPThis implies that the real wage in

units of, say, cloth is the Marginal Product of labor in the production of cloth

Similarly, the real rent in units of food is the Marginal Product of land in food production

CL

C

MPP

w

FT

F

MPP

r

Real Factor Rewards and ProductivityIn general, the real payment to a resource

is equal to its productivity (or, marginal product)This is the main conclusion of the Marginal

Productivity Theory of Income Distribution

Factor Use and Factor Productivity—Labor-Abundant Country

We saw earlier that when autarky ends and free trade begins w/r rises in the labor-abundant country (Home). Therefore,

More land is used per worker in cloth production and in

food production This makes labor more

productive… …and land less productive Therefore,

w/PC and w/PF both increase, and

r/PC and r/PF both decrease.• Abundant resource

benefits from globalization

• Scarce resource loses



Cloth production

Food production


Foreign

Home

Free trade

Factor Use and Factor Productivity—Land-Abundant Country

When autarky ends and free trade begins w/r falls in the land-abundant country (Foreign). Therefore,

Less land is used per worker in cloth production and in

food production This makes labor less

productive… …and land more productive Therefore,

w/PC and w/PF both decrease, and

r/PC and r/PF both increase.• Abundant resource

benefits from globalization

• Scarce resource loses



Cloth production

Food production


Foreign

Home

Free trade

Trade: Who Gains and Who Loses?In short, each country’s abundant resource

benefits from trade andEach country’s scarce resource loses from

trade

Factor Price EqualizationFree trade

equalizes the wage-rent ratio

Therefore, the land-per-worker ratio in cloth production is also equalized

This equalizes the productivity of labor in cloth production in the two countries

This equalizes w/PC in the two countries

In a similar way, w/PF, r/PC, and r/PF each become equalized worldwide



Cloth production

Food production


Foreign, autarky

Home, autarky

Free trade

Factor Price Equalization TheoremThe Factor Price Equalization Theorem:

When there is free trade in goods, the real reward for any resource (in units of either good) becomes the same in both countries!An implication of this result is that if there is

free trade in goods, resources will have no incentive to move from one country to another

Factor Price Equalization TheoremHeckscher-Ohlin theory implies FPE. But does FPE imply that free trade will make

everybody equally rich?Certainly not!

Not every individual is endowed with the same amount of resources

How accurate is the Heckscher-Ohlin theory?

Sadly, it’s not very accurate by itselfIt explains North-South trade quite well…But not trade within the North

But, if modified to take cross-country differences in technology into account, it fits the data well

So, a theory that combines the insights of Ricardo and Heckscher-Ohlin might be best

The contribution of Heckscher-Ohlin theoryThe theory’s main contribution is to point

out that cross-country differences in relative resource availability can explain trade

It does not claim that differences in relative resource availability are the only reason why trade occurs

CriticismPoor predictive powerFactor equalization theoremIdentical production functionCapital as endowmentHomogeneous capitalNo unemploymnentNo room for firms

List of Economies by GDP

List by the International Monetary Fund(2011)

Growth Rate of major economies

10 largest economies in 2030

ChinaCurrent GDP (IMF-list): $10,050GDP 2015 (IMF-estimate): $17,120Projected GDP growth rate (real): 11%Estimated GDP 2030: $83,778

United States:Current GDP (IMF-list): $14,256GDP 2015 (IMF-estimate): $18,029Projected GDP growth rate (real): 4.4%Estimated GDP 2030: $33,785

IndiaCurrent GDP (IMF-list): $4,001GDP 2015 (IMF-estimate): $6,384Projected GDP growth rate (real): 9.8%Estimated GDP 2030: $25,942

JapanCurrent GDP (IMF-list): $4,308GDP 2015 (IMF-estimate): $5,070Projected GDP growth rate (real): 3.3%Estimated GDP 2030: $8,266

RussiaCurrent GDP (IMF-list): $2,218GDP 2015 (IMF-estimate): $2,944Projected GDP growth rate (real): 5.8%Estimated GDP 2030: $6,878

BrazilCurrent GDP (IMF-list): $2,181GDP 2015 (IMF-estimate): $2,878Projected GDP growth rate (real): 5.7%Estimated GDP 2030: $6,611

GermanyCurrent GDP (IMF-list): $2,932GDP 2015 (IMF-estimate): $3,449Projected GDP growth rate (real): 3.3%Estimated GDP 2030: $5,619

IndonesiaCurrent GDP (IMF-list): $1,027GDP 2015 (IMF-estimate): $1,531Projected GDP growth rate (real): 8.3%Estimated GDP 2030: $5,075

MexicoCurrent GDP (IMF-list): $1,549GDP 2015 (IMF-estimate): $2,067Projected GDP growth rate (real): 5.9%Estimated GDP 2030: $4,907

United KingdomCurrent GDP (IMF-list): $2,181GDP 2015 (IMF-estimate): $2,642Projected GDP growth rate (real): 3.9%Estimated GDP 2030: $4,702

Heckscher ohlin

Career

cheese wine

amounts of cheese

consumption of cheese

individuals mrs of wine

unit of cheese

contthe heckscherohlin

amountsof cheese

wine beingconsumed