An Introduction to International Economics

1. An Introduction to International Economics Chapter 4: The Heckscher-Ohlin and Other Trade Theories Dominick Salvatore John Wiley & Sons, Inc. Dale R. DeBoer University of Colorado, Colorado Springs

2. Theories of international trade • The previous chapter provided a framework within which international trade occurs. • This chapter extends this analysis in three ways: • The cause of comparative advantage is considered. • The implications for factors returns are considered. • Models beyond the standard model of international trade are considered.

3. Theories of international trade • The theories that will be considered are: • The Heckscher-Ohlin model of trade • An economy of scale model of trade • A product differentiation model of trade • A product cycle model of trade • A transportation cost model of trade • A environmental standards model of trade

4. The Heckscher-Ohlin theory • The Heckscher-Ohlin (H-O) theory is based on two subsidiary theorems: • The H-O theorem • A nation will export the commodity whose production requires the intensive use of the nation’s relatively abundant (and therefore, cheap) factor and import the commodity whose production requires the intensive use of the nation’s relatively scarce (and therefore, expensive) factor. • In other words, relative factor abundance drives comparative advantage and the pattern of trade.

5. The Heckscher-Ohlin theory • The Heckscher-Ohlin (H-O) theory is based on two subsidiary theorems: • The H-O theorem • The factor price equalization theorem • International trade will bring about equalization in the relative and absolute returns to homogenous factors across nations. • In other words, wages and other factor returns will be the same after specialization and trade has occurred.

6. Demonstrating the H-O theorem • Suppose there are two countries with identical technology and societal preferences. • The nations differ in that one is relatively labor abundant while the other is relatively capital abundant. • Factor abundance is determined by the ratio of capital (K) to labor (L) available in the countries. • The country with the greater K/L ratio is defined as being capital abundant.

7. Demonstrating the H-O theorem • The nations differ in that one is relatively labor abundant while the other is relatively capital abundant. • Further, the commodities produced differ in factor intensity. • Factor intensity is determined by the ratio of capital (K) to labor (L) required for the production of the commodity. • The commodity requiring the greater K/L ratio per unit of production is defined as being capital intensive.

8. Demonstrating the H-O theorem • Further, the commodities produced differ in factor intensity. • Under these assumptions, the PPFs indicated on the next slide will show the relative productive potential of the trading nations if Nation 1 is labor abundant and Nation 2 is capital abundant while commodity Y is labor intensive while commodity X is capital intensive.

9. Demonstrating the H-O theorem Nation 2 Nation 1 Y Y X X

10. For ease of presentation, the two PPFs may be overlaid in one diagram. Under the assumption of identical societal preferences, this yeilds a possible community indifference with the indicated shape. Demonstrating the H-O theorem Y X

11. This combination of PPFs and community indifference curves establishes a higher opportunity cost for Nation 1 in the production of X. Using the logic of the standard model of trade this shows that Nation1 will specialize in the production of and export Y. Demonstrating the H-O theorem Y X

12. Factor price equalization • In the H-O model of trade, the pattern of trade is driven by relative factor abundance. • Labor abundant countries export goods that are labor intensive in their production. • Capital abundant countries export goods that are capital intensive in their production.

13. Factor price equalization • In the H-O model of trade, the pattern of trade is driven by relative factor abundance. • Exported commodities experience an increase in their price relative to the autarky situation.

14. Factor price equalization • In the H-O model of trade, the pattern of trade is driven by relative factor abundance. • Exported commodities experience an increase in their price relative to the autarky situation. • The Stolper-Samuelson theorem demonstrates that an increase in the relative price of a commodity raises the return of the factor used intensively in its production. • At the same time, the return of the relative scarce factor will fall.

15. Factor price equalization • Exported commodities experience an increase in their price relative to the autarky situation. • The Stolper-Samuelson theorem demonstrates that an increase in the relative price of a commodity raises the return of the factor used intensively in its production. • Thus, the labor abundant country will see an increase in wages, but a fall in the return to capital while the capital abundant country will experience the opposite pattern of change.

16. Implications of FPE • Developed nations are expected to be capital abundant. • Therefore, following the opening of trade the return to capital in the developed countries is expected to increase and wages are expected to fall. • This pattern of change should worsen inequality in the developed countries.

17. Implications of FPE • Developed nations are expected to be capital abundant. • The change in inequality should be the opposite for the developing (and labor abundant) countries.

18. Implications of FPE • Developed nations are expected to be capital abundant. • The change in inequality should be the opposite for the developing (and labor abundant) countries. • The conclusion of worsened inequality in the developed world holds only if: • The assumptions of the H-O theory holds. • As will be seen, this may not be the case. • The Stolper-Samuelson theorem is the only force driving changes in inequality.

19. Empirical tests of the H-O theory • The Leontief Paradox • A 1951 test of the H-O theory • Showed that that pattern of trade did not fit the conclusions of the H-O theorem. • Imports in the U.S. were capital intensive when they should have been labor intensive.

20. Empirical tests of the H-O theory • The Leontief Paradox • Is the paradox real? • The test assumed a two factor world which required assumptions about what is capital and what is labor. • The test assumed consistent technology between nations. • However, technology varies so this assumption may have biased the test.

21. Empirical tests of the H-O theory • The Leontief Paradox • Is the paradox real? • The test assumed a two factor world which required assumptions about what is capital and what is labor. • The test assumed consistent technology between nations. • The test assumes perfect mobility between factors of production. • In practice, some factors of production are specific to sectors of the economy. • Sector specific factors alter the predictions of the H-O theory and require a different testing procedure.

22. Empirical tests of the H-O theory • The Leontief Paradox • Is the paradox real? • More current test of the H-O theory are built on multiple factor (including sector specific factors) models that extend the basic H-O framework. These show good predictive ability.

23. An economy of scale model of trade • Some productive relationships are characterized by increasing returns to scale. • A production situation where output grows proportionally more than the increase in inputs to the productive process. • A doubling of inputs more than doubles outputs.

24. An economy of scale model of trade • Some productive relationships are characterized by increasing returns to scale. • In this situation, production on a larger scale lowers per unit costs of production and provides a new source of cost advantage on which to base exports.

25. Product differentiation based trade • Differentiated products • Similar products produced by different manufacturers in the same industry or general trade group. • Toyota and Ford automobiles are differentiated products

26. Product differentiation based trade • Differentiated products • Intra-industry trade may arise from product differentiation. • Intra-industry trade is international trade in differentiated products.

27. Product differentiation based trade • Differentiated products • Intra-industry trade may arise from product differentiation. • Reasons for intra-industry trade • Allows producers to exploit product specific economies of scale. • Allows consumers to benefit from product variety that would not exist without international trade.

28. The product cycle model of trade • Advanced industrialized countries develop and introduce new products • While only one country possess the product, it possesses international monopoly power and will be the sole exporter of the product.

29. The product cycle model of trade • Advanced industrialized countries develop and introduce new products • As the technology producing the product becomes more widespread, production will spread to other nations. • This moves international trade to a standard comparative advantage framework.

30. The product cycle model of trade • Advanced industrialized countries develop and introduce new products • As the technology producing the product becomes more widespread, production will spread to other nations. • As production becomes standardized, the original introducer of the product loses its technologically based comparative advantage in the production of the product and becomes an importer of the product.

31. Examples of product cycles • Television • The Television History WWW site provides a nice discussion of the history of television. A look at the manufacturers of televisions provides a good example of the product cycle model. • WWW link to the Television History Site • WWW link to the list of television manufacturers

32. Transportation cost models of trade • Transportation costs • Transportation costs are the freight charges, warehousing costs, costs of loading and unloading, insurance premiums, and interest charges incurred while goods are in transit between nations.

33. Transportation cost models of trade • Transportation costs • The introduction of transportation costs into the standard model of trade may eliminate a country’s comparative advantage in the production of an item. • High enough costs may result in an item not being able to be traded. • Highly perishable food products may suffer this fate.

34. Transportation cost models of trade • Transportation costs may provide an advantage for trade between geographically close countries. • This serves as partial explanation for why Canada and Mexico are the two largest trading partners of the US. • WWW link to International Trade Administration data on major US trading partners

35. Environmental standards and trade • A nation’s environmental standards determine the level of acceptable pollution that may be generated from production.

36. Environmental standards and trade • A nation’s environmental standards determine the level of acceptable pollution that may be generated from production. • Strict environmental standards are expected to raise the costs of production. • These increased costs may reduce (or remove) a country’s comparative advantage in production and alter the pattern of trade.

37. Environmental standards and trade • A nation’s environmental standards determine the level of acceptable pollution that may be generated from production. • Strict environmental standards are expected to raise the costs of production. • In order to maintain comparative advantage, a nation may reduce its environmental protections. • This may spur a “race to the bottom.”

38. Environmental standards and trade • In order to maintain comparative advantage, a nation may reduce its environmental protections. • This concern has spurred calls for inclusion of environmental legislation along with agreements to lower barriers to trade. • For instance, the environmental rider attached to the NAFTA. • The Foreign Trade Information System has a good discussion of this policy by Hufbauer and Oreja. • WWW link