Heckscher-Ohlin Model and Factor Price Equalization

1. Learning Unit 9
Heckscher-Ohlin Model
and Factor Price Equalization
ECON452
International Economics

2. Objectives
1. Explain how differences in resources generate a specific pattern of
trade
2. Discuss why the gains from trade will not be equally spread even in
the long run and identify winners and losers form free trade
3. Understand the possible links between increased trade and rising
wage inequality in the developed countries
4. See how empirical patterns of trade and factor prices support some
(but not all) of the predictions of the factor-proportions theory.

3. Introduction
• Even if two countries utilize the same production technology and have the same
preferences toward products, trade occurs due to differences in resources across
countries.
• When country opens to international trade, trade will widen income gaps among
resource owners.
• A standard international economic model with 2-countries, 2-goods, and 2-
factors is applied to analyze trade issues.

4. Heckscher-Ohlin Model
Assumptions
1. Two countries, two goods, two factors of production
– Home and Foreign
– Cloth and Food
– Labor and Capital
2. Same technology in production (increasing cost)
3. Equal preference
– With the same tastes, the two countries will consume cloth and food in the
same ratio when faced with the same relative price of cloth under free
trade.

5. Heckscher-Ohlin Model (cont.)
4. Each good requires different combinations of factors of production
– Cloth is labor-intensive commodity and food is capital-intensive
5. Two nations differ in factor abundance
– Home is labor-abundant and Foreign is capital-abundant.
– The supply of labor and capital in each country is constant.

6. Heckscher-Ohlin Model (cont.)
6. Constant returns to scale
7. Incomplete specialization
8. Perfect competition in both goods and factor markets
– no economic profit in the long run
9. Perfect factor mobility within each nation, but no international factor mobility
– equal returns on factors (wage and rental rate) across sectors.

7. Heckscher-Ohlin Model (cont.)
10. No transportation costs, tariffs, or other obstructions to the free trade
– relative prices are the same in both countries with trade
11. All resources are fully employed
12. Balanced trade
• Since two countries have the same technology, the production possibilities
frontier differ only because of differences in factor abundance in two countries
and difference in factor intensity of two goods.

8. PPF of Home and Foreign
• Because Home is labor-abundant and
cloth is labor-intensive, Home can
produce relatively more of cloth than
Foreign and its production possibilities
frontier is skewed toward the
production of cloth.

9. PPF and Relative Prices
• The slope of PPF is MRT (marginal rate of
transformation) and equal to an
opportunity cost of producing Cloth (goods
measured along the horizontal axis).
• Under zero economic profit assumption, a
cost of production is equal to a price of
good.
• At Q,
Opportunity cost of Cloth = MRT = PC/PF

10. Prices and Production
• When a country faces an opportunity to trade
with the rest of the world at a relative price, it
can choose any points along the isovalue line
after trade.
– Isovalue line has a slope of PC/PF .
– Along the isovalue line, the total value
of goods is constant at V
V = PC*QC + PF*QF
– Higher (right-upper) the isovalue line,
greater the value after trade the country
can reach.
PPF

11. Prices and Production
• The country can reach the highest possible
isovalue line when it produces at point Q,
where the opportunity cost of cloth is equal to
the relative price of cloth.
– At Q, the isovalue line is tangent to
country’s PPF.
– At Q,
Opportunity cost of Cloth = MRT = PC/PF
PPF

12. Prices and Production
• At A, Opportunity cost of Cloth < PC/PF
– If a country can produce at lower cost than the
world relative price, it should produce more and sell
then to other countries.
– A country can increase its profits by producing more
Cloth.
– Production mix moves toward Q.
• At B, Opportunity cost of Cloth > PC/PF
– If a country is producing at higher cost than the
world relative price, it will cheaper to purchase from
other country than producing domestically.
– A country can increase its profits by producing less
Cloth.
– Production mix moves toward Q.
A
B
PPF

13. Production and Consumption under Autarky
in the Heckscher-Ohlin Model
• The countries are assumed to have the same
technology.
• 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.
– Without trade, a wage-rental ratio is lower in
Home, so a relative price of cloth (PC/PF) is lower
in Home than Foreign.
– Given relative prices of cloth in each country,
Home produces at AH and Foreign produces at AF.
PC/PF
H
PC/PF
F
AF
AH

14. Autarky in the Heckscher-Ohlin Model
• Under autarky (No trade)
– Wage-rental ratio is lower in Home than Foreign.
w/rH < w/rF
– Relative price of cloth is lower in Home than Foreign.
PC/PF
H < PC/PF
F
– Relative quantity of cloth is greater in Home than Foreign.
QC/QF
H > QC/QF
F

15. Relative Supply Curves
• Since cloth is relatively labor intensive, at
each relative price of cloth, Home will
produce a higher ratio of cloth to food than
Foreign.
• Home will have a larger relative supply of
cloth than Foreign.
• Home’s relative supply curve of cloth lies to
the right of Foreign’s.
• The relative demand curve for cloth is
assumed to be identical for both countries
(same taste).

16. Equilibrium under Autarky
• Under autarky (No trade), a relative price of
cloth is lower in Home than Foreign.
• Home’s equilibrium would be at point 1,
where domestic relative supply RS
intersects the relative demand curve RD.
• Foreign’s equilibrium would be at point 3.

17. Relative Supply and Equilibrium under Trade
• The relative supply curve of cloth
under trade lies between two pre-
trade relative supply curves.
• Trade leads to a world relative price
that lies between the pre-trade
prices, such as at point 2.

18. Comparative Advantage in the Heckscher-
Ohlin Model
• Under autarky, a relative price of cloth is lower in Home than Foreign.
– Home has a comparative advantage in production of cloth.
– Foreign has a comparative advantage in production of food.
• Under trade,
– Home should specialize to produce cloth and export it to Foreign.
– Foreign should specialize to produce food and export it to Home.

19. Specialization in the Heckscher-Ohlin Model
• As Home produces more cloth and less food, it
moves along its PPF toward lower-right from AH to BH.
– Home’s opportunity cost to produce cloth
increases.
• As Foreign produces less cloth and more food, it
moves along its PPF toward upper-left from AF to BF.
– Foreign’s opportunity cost to produce cloth
decreases.
• Once both countries reach their opportunity costs of
cloth equal to the world equilibrium level at PC/PF (at
BH and BF), both countries stop specialization.
• Both countries are incomplete specialization.
PC/PF
H
PC/PF
F
PC/PF
PC/PF
AH
BH
AF
BF

20. Convergence of Relative Prices
• 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.
PC/PF
H ↑ < PC/PF
F ↓
• The equilibrium relative price of cloth under trade must be the same in both
countries.
• To have mutually beneficial trade, the equilibrium relative price of cloth must be
between two pre-trade prices.

21. Trade in the Heckscher-Ohlin Model
• 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.
– Export of cloth = Production of cloth ↑ – Consumption of cloth ↓
• In Foreign, the fall in the relative price of cloth leads to a fall in the relative
production of cloth and a rise in relative consumption of cloth.
– Foreign becomes an importer of cloth and an exporter of food.
– Import of cloth = Production of cloth ↓ – Consumption of cloth ↑

22. Equilibrium under Trade
• At the equilibrium under trade,
– To have mutually beneficial trade, the equilibrium relative price of cloth must be
between two pre-trade prices.
PC/PF
H < PC/PF < PC/PF
F
– With the assumption of same tastes in two countries, both countries will consume
cloth to food in the same ratio when faced with the same relative price of cloth
under trade. Then, the relative quantity of cloth under trade must also lie between
the pre-trade quantities.
QC/QF
H > (QC
H+QC
F)/(QF
H+QF
F) > QC/QF
F
– Since the equilibrium relative price of cloth is between two pre-trade prices, the
wage-rental ratio must be between two pre-trade ratios as well.
w/rH < w/r < w/rF

23. Heckscher-Ohlin Theorem
• Heckscher-Ohlin theorem: The country that is abundant in a factor
exports the good whose production is intensive in that factor.
• This theorem suggests that countries tend to export goods whose
production is intensive in factors with which the countries are
abundantly endowed.
– The U.S. is abundant in capital and skilled workers, so the U.S. should export
high-tech products such as airplanes.
– Jamaica is abundant in land resource to produce tropical fruits, so Jamaica
should export tropical fruits such as banana.
– Bangladesh is abundant in unskilled labor, so Bangladesh should export low-
tech manufacturing goods such as apparel.

24. Trade and the Distribution of Income
• Changes in relative prices due to trade can affect the earnings of labor and capital.
– Cloth is labor-intensive good.
– A rise in the relative price of cloth increases a wage-rental ratio.
– It raises the purchasing power of labor in terms of both goods while lowering
the purchasing power of capital in terms of both goods.
– In Home, labor are better off but capital owners are worse off after trade.
– In Foreign, a relative price of cloth falls after trade, so capital owners are better
off and labor are worse off after trade.

25. Trade and the Distribution of Income
• 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.
• 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.

26. Change in the Distribution of Income
• 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.

27. Politics on International Trade
• 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.

28. North-South Trade and Income Inequality in
the U.S.
• 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.
• Since 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, did the former trend cause the latter trend?
– Little evidence supporting this prediction exists.
– 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).

29. Factor Price Equalization Theorem
• Factor-price equalization (H-O-S) theorem: International trade will
bring about equalization in the relative and absolute returns to
homogeneous factors across nations.
w = w* and r = r*, and r/w = r/w*
• International trade is a substitute for the international mobility of
factors (Learning Unit #7).
– Labor immigration occurs from low wage country to high wage country, and
depresses wages in high wage country and raises wages in low wage country.

30. Factor Price Equalization - Diagram
• Trade equalizes relative output prices.
• Due to the connection between output
prices and factor prices, factor prices
are also equalized.
• As the relative price of cloth increases
in Home, the wage-rental ratio
increases. On the other hand, as the
relative price of cloth decreases in
Foreign, the wage-rental ratio falls.

31. Comparative International Wage Rates
(United States = 100)
• 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.
• The model also ignores trade barriers and
transportation costs, which may prevent
output prices and thus factor prices from
equalizing.

32. Empirical Evidence of the Heckscher-Ohlin
Model (1)
• 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.

33. Empirical Evidence of the Heckscher-Ohlin
Model (2)
• 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.

34. Disclaimer
Please do not copy, modify, or distribute
this presentation
without author’s consent.
This presentation was created and owned
by
Dr. Ryoichi Sakano
North Carolina A&T State University
Disclaimer
Please do not copy, modify, or distribute
this presentation
without author’s consent.
This presentation was created and owned
by
Dr. Ryoichi Sakano
North Carolina A&T State University