International Economics

International Economics

Li Yumei

Economics & Management School

of Southwest University

International Economics

Chapter 5

Factor Endowments and the Heckscher-Ohlin Theory

Organization 5.1 Introduction 5.2 Assumptions of the Theory 5.3 Factor Intensity, Factor Abundance, and t

he Shape of the Production Frontier 5.4 Factor Endowments and the Heckscher-O

hlin Theory 5.5 Factor-Price Equalization and Income Dis

tribution 5.6 Empirical Tests of the Heckscher-Ohlin M

odel Chapter Summary Exercises

5.1 Introduction

Hechscher-Ohlin Trade Model To extend the trade model to identify one of the

most important determinants of the difference in the pretrade-relative commodity prices and the comparative advantage among nations;

To examine the effect that the international trade has on the relative price and income of the various factors of production

Other more recent trade models Leontief Paradox

5.1 Introduction

Answer Two Questions The basis of comparative advantage: further

explanation of the reason or cause for the difference in relative commodity prices and comparative advantage between the two nations;

The effect of international trade on the earnings of factors of production in the two trading nations: to examine the effect of international trade on the earnings of labor as well as on international differences in earnings

5.2 Assumptions of the Theory

The Assumptions Meaning of the Assumptions

The Assumptions

1. Two nations, two commodities (X and Y) and two factors (labor and capital);

2. Both nations use the same technology in production;

3. Commodity X is labor intensive, and commodity Y is capital intensive in both nations;

4. Both commodities are produced under constant returns to scale in both nations;

5. There is incomplete specialization in production in both nations;

6. Tastes are equal in both nations;

The Assumptions

7. There is perfect competition in both commodities and factor markets in both nations;

8. There is perfect factor mobility within each nation but no international factor mobility;

9.There are no transportation costs, tariffs, or other obstructions to the free flow of international trade;

10. All resources are fully employed in both nations;

11. International trade between the two nations is balanced;

Meaning of the Assumptions

More realistic case of assumption 1; Assumption 2 of same technology means that

both nations have access to and use the same general production techniques.

If factor prices were same, the two nations would use the exactly

same amount of labor and capital in the production of each

commodity; since factor prices usually differ, producers in each

nation will use more of the relatively cheaper factor in the nation to

minimize their costs of production.


Assumption 3 of the labor intensive commodity X and the capital intensive commodity Y:

It means that commodity X requires relatively more of labor to

produce than commodity Y in both nations. It also means that the

labor-capital ratio (L/K) is higher for commodity X than for

commodity Y in both nations at the same relative factor prices.

This is equivalent to saying that the K/L ratio (capital-labor ratio) is

lower for X than for Y in both nations, but not mean K/L ratio for X

is the same in both nations.


Assumption 4 of constant returns to scaleIt means that increasing the amount of labor and capital used in

Production of any commodity will increase output of that commodity

in the same proportion.

Assumption 5 of incomplete specializationIt means that even with free trade both nations continue to produce

both commodities. This implies that neither of the two nations is “very

small”.

Assumption 6 of equal tastesIt means that demand preferences, as reflected in the shape and

location of indifference curves are identical in both nations.


Assumption 7 of perfect competition

It means that producers, consumers and traders of commodity X and

commodity Y in both nations are each too small to affect the price of

these commodities. It also means that in the long run commodity

prices equal their costs of production, leaving no profit after all costs

are taken into account. It also means that all producers, consumers

and owners of factors of production have perfect knowledge of

commodity prices and factor earnings in all parts of the nation and in

all industries.


Assumption 8 of perfect internal factor mobilityIt means that labor and capital are free to move, and indeed do

move quickly from areas and industries of lower earnings to areas

and industries of higher earnings until earnings for the same type of

labor and capital are the same in all areas, uses, and industries of

the nation. On the other hand, there is zero international factor

mobility.

Assumption 9 of no transportation costs or other trade obstructions

It means that specialization in production proceeds until relative

commodity prices are the same in both nations with trade.


Assumption 10 of all resources fully employedIt means that there are no unemployed resources or factors of

production in either nation.

Assumption 11 of the balanced tradeIt means that the total volume of each nation’s exports equals the

total volume of the nation’s imports.

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

Factor Intensity Factor Abundance Factor Abundance and the Shape of the

Production Frontier

Factor Intensity

Figure 5.1 Factor Intensity

FIGURE 5-1 Factor Intensities for Commodities X and Y in Nations 1 and 2

Factor Intensity Explanation of Figure 5.1 Factor Intensity1. The horizontal axis refers to the amount of labor while the vertical axis refers to the amount of capital, and the slope of the ray measures the capital-labor ratio (K/L) in the production of the commodity;2. Nation 1’s slope of the rays (K/L) in the production of Commodity X and Commodity Y;1) K/L in Y=1 ( 2 K and 2 L for 1 Y, 4K and 4L for 2Y with constant

returns to scale);2) K/L in X=1/4 (1K and 4L for 1X, 2K and 8L for 2X with constant

returns to scale;3. Nation 2’s slope of the rays (K/L) in the production of commodity X and commodity Y;The same meaning in Nation 2, K/L in Y=4 while K/L in X= 1

Factor Intensity Conclusion1. Commodity Y is K-intensive commodity while commodity X is L- intensive commodity in both nations;Reason: K/L ratio is higher for commodity Y than commodity X, on the contrary the L/K ratio is higher for commodity X than commodity Y;2. K/L ratio in Nation 2 is higher than Nation 1 in both commodities X and Y; Reason: the capital must be relatively cheaper in Nation 2 than in

Nation 1, so that producers in Nation 2 use relatively more capital in the production of both commodities to minimize their costs of production. ( factor abundance and its relationship to factor prices later explanation) . In other words, the relative capital price (r/w) is lower in Nation 2 than in Nation1. If r/w declined, producers would substitute K for L in the production of both commodities to minimize their costs of production. As a result, K/L would rise for both commodities, but Commodity Y continues to be K-intensive commodity (assumption).

Factor Abundance Definition of Factor Abundance1. The terms of physical units It means the overall amount of capital and labor available to each nation.2. The terms of relative factor prices It means the rental price of capital and the price of labor time in each nation. Factor Abundance1. 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. (according to physical units of factor abundance)

Factor Abundance

2. According to the definition in terms of 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. Since the rental price of capital is usually taken t

o be the interest rate ( r ) while the price of labor time is the wage rate ( w ), PK/PL= r/w3. The relationship between the two definitions1) The definition in terms of physical units considers only the supply of factors;2) The definition in terms of relative factor prices considers both de

mand and supply;3) Derived demand: the demand for a factor of production is derived demand-derived from the demand for the final commodity that requires the factor in its production.

Factor Abundance Conclusion1. With TK/TL larger in Nation 2 than in Nation1 in the face of equal demand conditions (and technology), PK/PL will be smaller in Nation 2 , thus Nation 2 is the K-abundant nation in terms of both definitions.2. This is not always the case.Reason: the demand for Y and the demand for capital, could be so much higher in Nation 2 than in Nation 1 that the relative price of capital would be higher in Nation 2 than in Nation 1(alrough the relative greater supply of capital in Nation 2). In this case, Nation 2 would be considered K abundant according to the definition in physical terms and L abundant according to the definition in terms of relative factor prices.

Factor Abundance

In Such situation, it is the definition in terms of relative factor prices

that should be used.

3. Nation 2 is K abundant and Nation 1 is L abundant in terms

of two definitions, this assumption is the case throughout

the rest of the chapter.

Factor Abundance and the Shape of the Production Frontier

Assumptions1. Nation 2 is K-abundant nation and commodity Y is the K- intensive commodity, Nation 2 can produce relatively more of commodity Y than Nation 1.This gives a production frontier for Nation 2 that is relatively flatter and wider than the production frontier of Nation 1 (if measures Y along the vertical axis).2. Nation 1 is L-abundant nation and commodity X is the L- intensive commodities, Nation 1 can produce relatively more of commodity X than Nation 2. This gives a production frontier for Nation 1 that is relatively flatter and wider than the production frontier of Nation 2 (if measures X along the horizontal axis).

Factor Abundance and the Shape of the Production Frontier

Figure 5.2

FIGURE 5-2 The Shape of the Production Frontiers of Nation 1 and Nation 2

Factor Abundance and the Shape of the Production Frontier Explanation of Figure 5.2 1. Nation 1’s production frontier is skewed toward the horizontal axis, which measures commodity X. Reason: Nation 1is a L-abundant nation and commodity X is L- intensive . 2. Nation 2’s production frontier is skewed toward the vertical axis, which measures commodity Y.Reason: Nation 2 is a K-abundant nation and commodity Y is K- intensive . Case Studies1. Case study 5-1: the relative resources endowments of

various countries and regions. (page 123) 2. Case study 5-2: the capital stock per worker for a number of

leading developed and developing countries. (page 124)

5.4 Factor Endowments and the Heckscher-Ohlin Theory

The Heckscher-Ohlin Theorem General Equilibrium Framework of the Hec

kscher-Ohlin Theory Illustration of the Hechscher-Ohlin Theory

Eli Heckscher (1879 - 1952) Brief Introduction He (Stockholm November 24, 1879 - Stockholm

December 23, 1952) was a Swedish political

economist and economic historian. Heckscher was

born in Stockholm into a prominent Jewish family,

son of the Danish-born businessman Isidor

Heckscher and his spouse Rosa Meyer, and

completed his secondary education there in 1897.

He studied at university in Uppsala and Gothenburg,

completing his PhD in Uppsala in 1907. He was

professor of Political economy and Statistics at the

Stockholm School of Economics from 1909 until 1929, when he

Eli Heckscher (1879 - 1952)

exchanged that chair for a research professorship in economic

history, finally retiring as emeritus professor in 1945.

According to a bibliography published in 1950, Heckscher had as

of the previous year published 1148 books and articles, among

which may be mentioned his study of Mercantilism, translated into

several languages, and a monumental Economic history of

Sweden in several volumes. Heckscher is best known for a model

explaining patterns in international trade (Heckscher-Ohlin model)

that he developed with Bertil Ohlin at the Stockholm School of

Economics

Bertil Ohlin (1899-1979) Brief Introduction Bertil Ohlin developed and elaborated the

factor endowment theory. He was not only

a professor of economics at Stockholm, but

also a major political figure in Sweden. He

served in Riksdag (Swedish Parliament),

was the head of liberal party for almost a

1/4 of a century. He was Minister of Trade

during World War II. In 1979 Ohlin was awarded a Nobel prize jointly with James Meade for his work in international trade theory.

Bertil Ohlin (1899-1979) Bertil Gotthard Ohlin (pronounced [ˈbærtil uˈliːn]) (23 April

1899 – 3 August 1979) was a Swedish economist and politician. He was a professor of economics at the Stockholm School of Economics from 1929 to 1965. He was also chairman of the Swedish People's Party, a social-liberal party which at the time was the largest party in opposition to the governing Social Democratic Party, from 1944 to 1967. He served briefly as from 1944 to 1945 in the Swedish .

Ohlin's name lives on in one of the standard mathematical model of international free trade, the Heckscher-Ohlin model, which he developed together with Eli Heckscher. He was jointly awarded the Nobel Memorial Prize in Economics in 1977 together with the British economist James Meade "for their pathbreaking contribution to the theory of international trade and international capital movements".

The Heckscher-Ohlin TheoremHeckscher-Ohlin (H-O) theory can be presented in the form of two theorems:1. The so-called H-O theorem (which deals with and pre

dicts the pattern of trade)2. The factor-price equalization theorem (which deals w

ith the effect of international trade on factor prices)In fact, the H-O model has four major components: Heckscher-Ohlin Trade Theorem ; Stolper-Samuelson Theorem; Rybczynski Theorem; Factor Price Equalization Theorem

The Heckscher-Ohlin Theorem

H-O theorem (page 125)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.

Explanation of H-O theorem (factor endowment)1. The basis for trade: Relative factor abundance or factor

endowments as the basis for international trade or the basic

cause or determinant of comparative advantage.

The Heckscher-Ohlin Theorem2. Patterns of trade: each nation specializes in the production of an

d exports the commodity intensive in its relatively abundant and cheap factor and imports the commodity intensive in its relatively scarce and expensive factor. ConclusionH-O theorem explains comparative advantage rather than assuming it . That is H-O theorem postulates that the difference in relative factor abundance and prices is the cause of the pretrade difference i

n relative commodity prices between two nations. This difference in relative factor and relative commodity prices is then translated into a difference in absolute factor and commodity prices between the two nations. It is this difference in absolute commodity prices in the two nations that is the immediate cause of trade.

The Heckscher-Ohlin Theorem ConclusionThe H-O theorem predicts the pattern of trade between countries based on the characteristics of the countries. The H-O theorem says that a capital-abundant country will export the capital-intensive good while the labor-abundant country will export the labor-intensive good. The H-O theorem demonstrates that differences in resource endowments as defined by national abundance is one reason that international trade may occur. Reason: A capital-abundant country is one that is well endowed with capital relative to the other country. This gives the country a propensity for producing the good which uses relatively more capital in the production process .

General Equilibrium Framework of the Heckscher-Ohlin Theory Figure 5.31. The tastes and the distribution in the ownership of factors of

production together determine the demand for commodities.

2. The demand for commodities determines the derived demand for

the factors required to produce them.

3. The demand for factors of production, together with the supply of

the factors, determines the price of factors of production under

perfect competition.

4. The price of factors of production, together with technology,

determines the price of final commodities.

5. The difference in relative commodity prices between nations determines comparative advantage and the pattern of trade

FIGURE 5-3 General Equilibrium Framework of the Heckscher-Ohlin Theory

General Equilibrium Framework of the Heckscher-Ohlin Theory Conclusion1. The general equilibrium framework of H-O theory shows clearly

how all economic forces jointly determine the price of final

commodities.

2. Out of all economic forces working together, H-O isolates the

difference in the physical availability or supply of factors of

production among nations ( in the face of equal tastes and

technology) to explain the difference in relative commodity prices

and trade among nations. And different supply of factors of

production in different nations have different factor prices.

3. The same technology but different factor prices lead to different

relative commodity prices and trade among nations.

Illustration of the Hechscher-Ohlin Theory

Figure 5.4

FIGURE 5-4 The Heckscher-Ohlin Model

Illustration of the Hechscher-Ohlin Theory Explanation of Figure 5.4 1. Left panel: it shows the production frontier of Nation 1 and 2

1) Nation 1’s production frontier is skewed along the X-axis;

2) Nation 2’s production frontier is skewed along the Y-axis;

3) Indifference curve is tangent to Nation 1’s production frontier Ⅰ at point A while point A’ in Nation 2’s (due to the equal tastes);

4) A represents Nation 1’s equilibrium points of production and

consumption while A’ represents Nation 2’s equilibrium points of

production and consumption in the absence of trade;

5) Since the equilibrium-relative commodity prices of PA P﹤ A’,

Nation has a comparative advantage in commodity X while

Nation 2 in Commodity Y.

Illustration of the Hechscher-Ohlin Theory

2. Right panel: With trade the equilibrium point1) Nation 1 specializes in the production of commodity X while Nation 2 in commodity Y;2) Specialization in production proceeds until the transformation curves of the two nations are tangent to the common relative price line PB. 3) After trade, Nation 1 will export commodity X in exchange for commodity Y and consume at point E on indifference curve . Ⅱ Nation 2 will export commodity Y in exchange for commodity X and consume at point E’ on indifference curve . Ⅱ4) PX/PY=PB, equilibrium point; if PX/PY P﹥ B, Nation 1 wants to export more of commodity X than Nation 2 wants to import at this high relative price of X, and PX/PY falls toward PB; on the contrary, if PX/PY PB, Nation 1 wants to export less of commodity X ﹤ than Nation 2 wants to import , and PX/PY rises toward PB.

Illustration of the Hechscher-Ohlin Theory ConclusionBoth nations gain from trade because they consume on higher

indifference curve .Ⅱ Case Study5-3 (page 130) examines the pattern of revealed comparative

advantage and disadvantage of various countries or regions.

5.5 Factor-Price Equalization and Income Distribution

The Factor-Price Equalization Theorem Relative and Absolute Factor-Price

Equalization Effect of Trade on the Distribution of

Income The Specific-Factors Model Empirical Relevance

The Factor-Price Equalization Theorem The Content of Factor-Price Equalization

TheoremThe factor-price equalization theorem says that when the

prices of the output goods are equalized between countries,

as when countries move to free trade, then the prices of the

factors (capital and labor) will also be equalized between

countries. This implies that free trade will equalize the wages

of workers and the rents earned on capital throughout the

world.

The factor-price equalization theorem was rigorously proved

by Paul Samuelson (1970 Nobel prize in economics) , so it was

also called H-O-S theorem. ( page 129)

The Factor-Price Equalization Theorem

Explanation of H-O-S Theorem1. In Nation 1 the relative price of commodity X is lower than in

Nation 2, it means that the relative price of labor or wage

rate is lower in Nation1 in the absence of trade;

2. With trade, Nation 1 specializes in the production of

commodity X (L-intensive commodity) and reduces its

production of commodity Y(K-intensive commodity), the

demand for labor rises causes the wages to rise while the

relative demand for capital falls and its rate falls; on the

other hand, in Nation 2 wages fall and rate rises;

The Factor-Price Equalization Theorem

Conclusion1. International trade tends to reduce the pretrade difference i

n

w and r between the two nations;

2. International trade keeps expanding until relative

commodity prices are completely equalized, which means

that relative factor prices have also become equal in two

nations.

Relative and Absolute Factor-Price Equalization To show the relative factor-price equalization

graphically (see figure 5-5)

FIGURE 5-5 Relative Factor–Price Equalization

Relative and Absolute Factor-Price Equalization

To explain Figure 5-51. The horizontal axis measures the relative price of labor (w/r) while the vertical axis measures the relative price of commodity X (PX/PY);2. Each w/r is associated with a specific PX/PY ratio (due to the perfect competition and uses the same technology, one to one relationship between w/r and PX/PY);3. Without trade, Nation 1 is at Point A with w/r=(w/r)1 and PX/PY=PA while Nation 2 is at Point A’ with w/r=(w/r)2 and PX/PY=PA’;4. With trade, Nation 1 will produce more of commodity X due to the PA P﹤ A’ in the relative price of commodity X in Nation 1 than Nation 2 while Nation 2 will produce more of commodity Y .


5. With trade in Nation 1 , the increase production of commodity X,

the increase demand of labor leads to the relative higher price of

labor compared with the capital, w/r will rise in the end;

6. With trade in Nation 2 , the increase production of commodity Y,

the increase demand of capital leads to the relative higher price

of capital compared with the labor, r/w will rise (w/r will fall) in the

end;

7. The upward movement in Nation 1 and downward movement in

Nation 2 will continue until point B=B’, at which PB=PB’ and

w/r=(w/r) (only at this point both nations operate under ﹡ perfection competition and use the same technology by

assumption)


To summarize

PX/PY will become equal as a result of trade, and this will only

occur when w/r has also become equal in the two nations (as long

as both nations continue to produce both commodities).

Absolute factor-price equalizationIt means that free international trade also equalizes the real

wages for the same type of labor in the two nations and the

real rate of interest for the same type of capital in the two

nations.

Relative and Absolute Factor-Price Equalization Assumptions of the relative and absolute factor-

price equalization Perfect competition in all commodities and factor

markets; The same technology; The constant returns to scale;

Conclusion Trade equalizes the relative and absolute returns to

homogeneous factors; Trade acts as a substitute for the international mobility of

factors of production in its effect on factor prices; Trade operates on the demand for factors, factor mobility

operates on the supply of factors.

Effect of Trade on the Distribution of Income International trade on the effect of relative facto

r prices within each nation Trade increases the price of the nation’s abundant and ch

eap factor and reduces the price of its scarce and expensive factor.

E.G. W rises and r falls in Nation 1 while w falls and r rises in Nation 2.

International trade on the effect of income within each nation

The real income of labor and the real income of owners of capital move in the same direction as the movement in factor prices

E.G. Trade causes the real income of labor to rise and the real income of owners of capital to fall in Nation 1 while in Nation 2 the situation is the opposition. (Stolper-Samuelson Theorem)

Effect of Trade on the Distribution of Income Stolper-Samuelson Theorem: (Details in 8.4c page 251)

The theorem postulates that an increase in the relative price of

a commodity raises the return or earnings of the factor used

intensively in the production of the commodity.

Application Developed countries

Developed countries are the relatively capital abundant factor,

international trade tends to reduce the real income of labor and

increase the real income of owners of capital. This is why labor

union generally favor trade restrictions.( Case study 5-4 page 135) Developing countries

Effect of Trade on the Distribution of Income Conclusion International trade on the effect of relative factor prices and t

he distribution of income within each nation in the long run;

According to H-O-S theorem and Stolper- Samuelson theorem, international trade causes real wages and the real income of labor to fall in a capital-abundant and labor –scarce nation (such as developed countries). On the contrary, international trade causes real interests and the real income of capital to fall in a labor-abundant and capital scarce nation (such as developing countries);

Unequal distribution of income needs an appropriate distribution policy of the government. (detail in Chapter 8)

The Specific-Factors Model Specific –Factor Model (Appendix Figure 5-9 page 155)

FIGURE 5-9 Specific-Factors Model

The Specific-Factors Model Explanation- Ambiguous effect on mobile factor1. Nation 1 is L-abundant nation and the labor is mobile between industries but capital is not;2. The wage of labor will be the same in the production of commodities of X and Y in Nation 1 and given by the intersection of the value of the marginal product of labor curve in the production of X and Y; (VMPLY and VMPLX);3. The horizontal axis measures the total supply of labor available to Nation 1 while the vertical axis measures the wage rate;4. No-trade, the equilibrium point is at E with wage rate ED, OD of labor

in X and DO’ of labor in Y;5. With trade, PX/PY rises, VMPLX moves upward to VMPLX’, the result is that the wage rate increase (from ED to E’D’) less than the price increase (EF) proportionately, and DD’ is the increased labor of X, w falls in X and rises in Y (due to the unchanged price of commodity Y).

The Specific-Factors Model Explanation- Unambiguous effect on immobile factor

1. Nation 1 is L-abundant nation and the labor is mobile between

industries but capital is immobile;

2. More labor work for the production of X with given amount of capital,

it means that VMPKX and r increase in terms of both commodities,

while less labor is used with the fixed capital in the production of Y,

VMPKY and r fall in terms of Y;

3. With trade, the real income of the immobile capital (the nation’s

scarce factor) rises in the production of X and falls in the production

of Y while real wages fall in terms of X and rise in terms of Y.

The Specific-Factors Model

Conclusion

In the short run when some factors my be immobile or

specific to some industry or sector. In this case, it postulates

that trade will have an ambiguous effect on the nation’s

mobile factors : It will benefit the immobile factors that are

specific to the nation’s export commodities or sectors, and

harm the immobile factors that are specific to the nation’s

import-competing commodities or sectors.

The Specific-Factors Model

Conclusion

In the long run when all input are mobile among all industries

of a nation, the H-O model postulates that the opening of

trade will lead to an increase in the real income or return of

the inputs used intensively in the nation’s export sectors and

to a reduction in the real income or return of the inputs used

intensively in the production of the nation’s import-competing

sectors.

Empirical Relevance Unreal Assumptions In reality, the equalization of the returns to homogeneous

factors is not the case said as H-O-S model in different nations

with trade. The reasons as follows: Such as same technology, no

transportation cost, free trade, perfect competition and constant

returns to scale.

Adjustment of H-O-S Model: International trade can reduce the

international difference in the returns to homogeneous factors.

Reason: even if international trade has operated to reduce the

absolute difference in factor returns among nations, many other

forces were operating at the same time, preventing any such

relationship from becoming clearly evident (e.g. trade restrictions).

Empirical Relevance Factor-price equalization theorem Usefulness The reason is that it identifies crucial forces affecting factor prices and provides important insights into the general equilibrium nature of out trade model and of economics in general. Shortcoming It doesn’t say that international trade will eliminate or reduce international differences in per capita incomes. It only predicts international trade will eliminate or reduce international differences in the returns to homogeneous factors. Reason: Per capita incomes depend on other many forces ( the ratio of skilled to unskilled labor and so on). Even if real wages were to be equalized among nations, their per capita incomes could be still wider.

5.6 Empirical Tests of the Heckscher-Ohlin Model

Empirical Results-The Leontief Paradox Explanations of the Leontief Paradox Factor-Intensity Reversal

Empirical Results-The Leontief Paradox Wassily Leontief (1906–99) American economist, b. Russia, grad. Univ. of Berlin (Ph.D., 1928). The son of a Russian economist, he and his family left the Soviet Union in 1925 because of their opposition to the Bolshevik government. After serving as an adviser on railroad construction to the Chinese government (1929), he emigrated to the United States. He joined the faculty of Harvard in 1931, rising to therank of professor in 1946. In 1975, he left Harvard to teach at New York Univ. Leontief is best known for his development of the input-output method of economic analysis, used by most industrialized nations for planning and predicting economic progress. He was awarded (1973) the Nobel Memorial Prize in Economic Sciences.

Wassily Leontief Paradox

Leontief's paradox in economics is that the country with the w

orld's highest capital-per worker has a lower capital-labour ratio

in exports than in imports.

This econometric find was the result of Professor Wassily

W. Leontief's attempt to test the Heckscher-Ohlin theory empiri

cally. In 1954, Leontief found that the U.S. (the most

capital-abundant country in the world by any criteria) exported

labor-intensive commodities and imported capital-intensive com

modities, in contradiction with Heckscher-Ohlin theory ("H-O th

eory").

Measurements

In 1971 Robert Baldwin showed that US imports were 27% more capital-intensive than US exports in the 1962 trade data [1]using a measure similar to Leontief's.

In 1980 Leamer questioned Leontief's original methodology or Real exchange rate grounds, but acknowledged that the US paradox still appears in the data (for years other than 1947). [2]

A 1999 survey of the econometric literature by Elhanan Helpman concluded that the paradox persists, but some studies in non-US trade were instead consistent with the H-O theory.

In 2005 Kwok & Yu used an updated methodology to argue for a lower or zero paradox in US trade statistics, though the paradox is still derived in other developed nations. [3]

Responses to the Paradox

For many economists, Leontief's paradox undermined the validity of the H-O theory, which predicted that trade patterns would be based on countries' comparative advantage in certain factors of production (such as capital and labor). Many economists have dismissed the H-O theory in favor of a more Ricardian model where technological differences determine comparative advantage. These economists argue that the U.S. has an advantage in highly skilled labor more so than capital. This can be seen as viewing "capital" more broadly, to include human capital. Using this definition, the exports of the U.S. are very (human) capital-intensive, and not particularly intensive in (unskilled) labor.

Responses to the Paradox Some explanations for the paradox dismiss the importance of

comparative advantage as a determinant of trade. For instance, the Linder hypothesis states that demand plays a more important role than comparative advantage as a determinant of trade--with the hypothesis that countries which share similar demands will be more likely to trade. For instance, both the U.S. and Germany are developed countries with a significant demand for cars, so both have large automotive industries. Rather than one country dominating the industry with a comparative advantage, both countries trade different brands of cars between them. Similarly, New Trade Theory argues that comparative advantages can develop separately from factor endowment variation (e.g. in industrial increasing returns to scale).

Explanations of the Leontief Paradox

The used data was not representative; Two-factor model (L, K) , ignoring the natural resources;

(Many production process using natural resources) U.S. Trade policy (heavy protection of domestic labor-

intensive industries, so more labor –intensive goods

export); Only the measure of physical capital and ignoring the

human capital and “knowledge” capital;

At the same time there are many strong and convincing

evidences verifying H-O theory. (See Figure 5-6)

Case Study 5-7 (page 143)

FIGURE 5-6 Comparative Advantage with Skills and Land

Factor-Intensity Reversal ConceptIt means refers to the situation where a commodity is L intensive

in the L-abundant nation and K intensive in the K-abundant

nation. This may occur when the elasticity of substitution of factors

in production varies greatly for the two commodities.

With factor-intensity reversal, both H-O theorem and the factor-

price equalization theorem fail. Controversial topic

Some tests show that factor reversal was fairly prevalent, some tests

provide strong confirmation of the H-O model.

Chapter Summary

Further the explanation of the comparative advantage;

(factor abundance → factor prices →the cost of production →the comparative advantage)

The explanation of international trade on the effect of factor prices and the returns of factors in different countries;

1. Effect on factor prices: the abundant factor’s price will rise while the scarce factor’s price will fall (factor- price equalization);

Chapter Summary

2. Effect on returns of factors:

(1) In the long run: the abundant factor’s return will rise while the scarce factor’s returns will fall (exported industries’

income will rise while import competing industries will fall ); (2) in the short run: the specific-factor model postulates that

trade will have an ambiguous effect on the nation’s mobile factors; It will benefit the immobile factors that are specific to the nation’s export commodities or sectors, and harm the immobile factors that are specific to the nation’s import-competing commodities or sectors;

Chapter Summary

H-O Theory as the centerpiece of modern trade theory for explaining not only trade between developed countries and developing countries but also trade among developed countries and among developing countries;

Although the theory is controversial in empirical

studies, but most of studies provide strong and

convincing evidence .

Exercises

Discussion Questions:

Page 148 from 1 to 15 questions

Exercises

Additional ReadingThe original sources for the Hechscher-Ohlin theory are: E.F.Hechscher, “ The Effect of Foreign Trade on the Distributi

on of Income,” Ekonomisk Tideskrift, 1919, pp. 497-512 B. Ohlin, Interregional and International Trade (Cambridge, M

ass.: Harvard University Press, 1983)The original proof of the factor-price equalization theorem is found in: P.A. Samuelson, “International Trade and the Equalization of

Factor Prices,” Economic Journal, June 1948, pp. 165-184 P.A. Samuelson, “International Factor-Price Equalization Onc

e again.”, Economic Journal, June 1949, pp.181-197

Exercises

Additional ReadingFor the effect of international trade on the distribution of

Income, see: W.F. Stolper and P.A.Samuelson, “ Protection and Real Wage

s,” Review of Economic Studies, November 1941, pp. 58-73.

For excellent surveys of the Heckscher-Ohlin theory, see: J.N.Bhagwati, “ The Pure Theory of International Trade: A Sur

vey,” Economic Journal, 1964. pp. 1-84 J.S. Chipman, “A Survey of the Theory of International Trade,”

Econometrica, 1965

Internet Materials http://www.imf.org http://www.ita.doc.gov/td/industry/otea http://www.un.org http://www.bls.gov/news.release/ichcc.toc.ht

m http://webhost.bridgew.edu/baten http://www.worldbank.org http://www.un.org

International Economics

Documents

labor intensive commodity

factor endowments

relative factor prices

international factor

capital intensive commodity

factor abundance

factor intensity

factor markets