The Heckscher-Ohlin-Samuelson Model

1. The Heckscher-Ohlin-Samuelson Model Factor Proportions Theory

2. Problems with the Generic Neoclassical Model • What is the source of a country’s comparative advantage? Generic neoclassical theory doesn’t really say • Factors other than labor (especially capital) are not explicitly included

3. H-O-S In General • Heckscher, and his student Ohlin, worked in the early part of the 20th century • Samuelson refined their work after WWII • Closer attention is paid in this model to each country’s resource endowment

4. H-O-S Assumptions • 2 countries • 2 commodities • 2 factors (labor and capital) • Perfect competition exists in all markets • Each country’s endowment of factors is fixed • Factors are mobile internally, but immobile internationally

5. H-O-S Assumptions (cont’d) • Each producer has a wide range of options as to how to produce X or Y • if K is cheap relative to labor, a relatively capital-intensive method will be adopted • if K is expensive relative to labor, a relatively labor-intensive method will be adopted • Each country has the same CRTS technology

6. H-O-S Assumptions (cont’d) • Tastes and preferences are the same for both countries

7. Concepts and Terminology • The capital-labor ratio for good X is simply KX/LX, and for Y is KY/LY • If KX/LX > KY/LY, production of good X is capital intensive relative to production of good Y • Also, production of Y must be relatively labor intensive (If KX/LX > KY/LY, then LY/KY > LX/KX)

8. Concepts and Terminology • Country A is said to be capital abundant relative to Country B if (K/L)A > (K/L)B • In such a case, Country B must be relatively labor abundant • So: • goods are produced relatively K or L intensively • countries are relatively K or L abundant

9. Concepts and Terminology • The factor price of labor (the wage) is denoted w • The factor price of capital is denoted r • If labor is relatively expensive, w/r will be a relatively big number • If labor is relatively cheap, w/r will be a relatively small number

10. More on Factor Prices • What makes labor relatively expensive? • If it is relatively scarce • What makes labor relatively cheap • If it is relatively abundant • So: If (K/L)A is a relatively big number (that is, capital is relatively abundant), w/r will be a relatively big number, reflecting the relative scarcity of L and abundance of K

11. A Review of Trade in the Neoclassical Model • Suppose the U.S. is capital abundant relative to Mexico • This, of course, means that Mexico is relatively labor abundant • These differences affect the shape of each country’s PPF • Suppose that cars are produced rel. K-intensively, and textiles labor intensively

12. Autarky in Mexico and the U.S. U.S. Cars Mexico Cars (PT/PC)Mex E e Y1 Y4 (PT/PC)US X1 Textiles Textiles X4

13. Autarky in Mexico and the U.S. • The relative price of textiles in autarky is greater in the U.S. than in Mexico • That is, the U.S.’s autarky price line is steeper than Mexico’s • In symbols, (PT/PC)U.S. > (PT/PC)Mex. • This means thatMexico has the comparative advantage in textiles

14. Autarky in Mexico and the U.S. • This also means that the relative price of cars in autarky is lower in the U.S. than in Mexico • That is, (PC/PT)U.S. < (PC/PT)Mex. • This means thatthe U.S. has the comparative advantage in cars

15. Production in Trade U.S. Cars Mexico Cars (PX/PY)T e' Y5 E e Y1 Y4 E' Y2 X1 X2 Textiles Textiles X5 X4

16. Consumption in Trade U.S. Cars Mexico Cars (PX/PY)T e' Y5 C' E e Y1 Y4 c' E' Y2 X1 X2 Textiles Textiles X5 X4

17. The Result • The relatively capital abundant country (U.S.) exports the relatively capital intensive good (cars) • The relatively labor abundant country (Mexico) exports the relatively labor intensive good (textiles)

18. The Heckscher-Ohlin Theorem • A country will export the commodity that uses relatively intensively the factor that country has in relative abundance • A country will import the commodity that uses relatively intensively the factor that is relatively scarce in that country

19. The Source of Comparative Advantage • If a country has a lot of labor relative to K, its wage rates will be relatively low, so • the product that uses a lot of labor in its production (relatively speaking) will be produced at a relatively low cost, so • the country should export the labor intensive good

20. The Source of Comparative Advantage • If a country has a lot of capital relative to L, its capital price will be relatively low, so • the product that uses a lot of K in its production (relatively speaking) will be produced at a relatively low cost, so • the country should export the capital intensive good

21. The Source of Comparative Advantage • So it is a country’s relative factor endowment that determines its comparative advantage • This is why the H-O-S model is also called the factor proportions theory

22. Changes in Relative Commodity Prices • As we learned before, • (PT/PC)US falls as the U.S. moves to trade. That is, the international relative textile price is lower than the U.S.’s autarky price. • (PT/PC)Mex rises as Mexico moves to trade. That is, the international relative textile price is higher than Mexico’s autarky price.

23. Changes in Factor Prices • In autarky, the K-intensive product (cars) is less expensive to produce in the U.S. as compared to Mexico • this is because K is relatively abundant in the U.S., which makes the price of capital relatively low • As trade commences, r will rise since demand for capital will rise

24. Changes in the Price of Capital in the U.S. r SK In autarky, the price of capital (r1) is determined by supply of and demand for capital in the U.S r1 D1K QK

25. Changes in the Price of Capital in the U.S. r SK When trade starts, the U.S. increases its production of the capital intensive product, and therefore demand for capital increases in the U.S. r2 r1 D2K D1K QK

26. Changes in Factor Prices • In autarky, the L-intensive product (textiles) is more expensive to produce in the U.S. as compared to Mexico • this is because L is relatively scarce in the U.S., which makes the price of labor relatively high. • As trade commences, w will fall since demand for labor will fall

27. Changes in the Price of Labor in the U.S. w SL D1L QL

28. Changes in the Price of Labor in the U.S. w SL In autarky, the price of labor (w1) is determined by supply of and demand for labor in the U.S w1 D1L QL

29. Changes in the Price of Labor in the U.S. w SL When trade starts, the U.S. decreases its production of the labor intensive product, and therefore demand for labor decreases in the U.S. w1 w2 D1L QL

30. Commodity and Factor Prices In Trade: A Summary • When trade begins, the relative price of the good intensive in the abundant factor rises (e.g., (PC/PT)US rises) • The relative price of the good intensive in the scarce factor falls (e.g., (PT/PC)US falls) • Also, the price of the abundant factor rises, and the price of the scarce factor falls (i.e., w falls, r rises in the U.S.)

31. Commodity and Factor Prices In Trade: A Summary • In our example, (PT/PC)US falls as trade commences • (w/r)US also falls • In Mexico, the opposite is happening: • (PT/PC)Mex rises • (w/r)Mex also rises • Therefore relative commodity and factor prices move together as trade commences

32. The Relative Cost Curve • Since relative factor and commodity prices move together as countries move from autarky to trade, we can look at a picture of these two sorts of prices • We also know that in autarky (PT/PC)Mex is lower than (PT/PC)US • (w/r)Mex is also lower in autarky than (w/r)US since Mexico is relatively labor abundant

33. The Relative Cost Curve PT/PC (PT/PC)US As trade commences, (PT/PC)US falls, and (PT/PC)Mex rises (PT/PC)Mex (w/r)Mex (w/r)US w/r

34. The Relative Cost Curve PT/PC (PT/PC)US In addition, as trade commences (w/r)US falls, and (w/r)Mex rises (PT/PC)Mex (w/r)Mex (w/r)US w/r

35. Factor Price Equalization • In fact, each country moves along the relative cost curve to a common point • We know this because there is only one international price • If the countries wind up with a common international price, they must also wind up with a common set of relative factor prices

36. The Relative Cost Curve PT/PC (PT/PC)US (PT/PC)Int Both relative commodity and factor prices equalize in trade (PT/PC)Mex (w/r)Mex (w/r)US (w/r)Int w/r

37. The Factor Price Equalization Theorem In equilibrium, with both countries facing the same relative (and absolute) product prices, both having the same technology, and with constant returns to scale, relative (and absolute) costs will be equalized. This can only happen if factor prices are equalized between countries.

38. H-O-S and the Distribution of Income • The H-O theorem, together with the FPE theorem also tell us about how the incomes of different groups within a country change as trade starts • This provides insight into the politics of free trade

39. The Stolper-Samuelson Theorem The increase in the price of the relatively abundant factor and the fall in the price of the relatively scarce factor because of trade implies that the owners of the abundant factor will find their real incomes rising; the owners of the scarce factor will find their real incomes falling.

40. H-O-S and the Distribution of Income • According to the S-S theorem, if the U.S. is a relatively K-abundant country, who in America should favor free trade? • Who in America should favor protectionism?

41. Theoretical Qualifications to H-O-S • Suppose we relax some of the many assumptions. Will the implications of the H-O-S model still be the same?

42. Qualification #1: Demand Reversal • Normally, the relative price of the commodity that uses intensively the abundant factor will be lower • In our example, (PC/PT)US < (PC/PT)Mex • Or, (PT/PC)US > (PT/PC)Mex • What causes this difference in autarky prices? Differences in supply conditions

43. Qualification #1: Demand Reversal • Suppose we let demand conditions differ • Suppose domestic demand for the good that uses relatively intensively the relatively abundant factor is very strong in each country • That is, demand for cars is very strong in the U.S., and demand for textiles is very strong in Mexico

44. Qualification #1: Demand Reversal • Such strong demand makes the autarky car price in the U.S. higher, and the textile price in Mexico higher • In the extreme, demand reversal could occur: (PC/PT)US> (PC/PT)Mex, and • (PT/PC)US< (PT/PC)Mex • So what?

45. Qualification #1: Demand Reversal • When trade begins, as usual the int’l price will lie between the two countries’ APRs • Therefore (PC/PT) for Mexico will rise as it moves to trade • Mexico, then, would export cars • Meanwhile, (PT/PC) for the U.S. will rise as it moves to trade • The U.S., then, would export textiles

46. Bottom Line on Demand Reversals • If demand reversals occur, the H-O theorem no longer holds: the K-abundant country is exporting the L-intensive good, and the L-abundant country is exporting the K-intensive good • If demand reversals are common in the real world, we’d better find a new theory

47. Qualification #2: Factor Intensity Reversal • Implicitly, we’ve assumed that if good X is K-intensive relative to good Y at one factor price ratio, it will be K-intensive at all factor prices • A FIR is when a good is relatively K-intensive at one set of factor prices, but relatively labor intensive at another

48. Qualification #2: Factor Intensity Reversal • FIRs occur when capital and labor can be substituted more easily in the production of one good than another • Example: • Suppose butane production is very inflexible: 1K + 1L = 1 butane, and if you want more butane you must add more of both K and L • Suppose apple production is much more flexible

49. Qualification #2: Factor Intensity Reversal • If w/r is very high, apple producers will choose a relatively K-intensive method (as compared with butane makers) • If w/r starts to fall, apple producers will start substituting L for K • Eventually, it’s possible that apples might be produced in a relatively L-intensive manner (as compared with butane)

50. Factor Intensity Reversal: Implications for Trade • Suppose France is K-abundant relative to Germany (that is (K/L)F > (K/L)G) • This means that (w/r)F > (w/r)G • Suppose further that there is a FIR: in France, at (w/r)F apples are produced relatively K-intensively but in Germany at (w/r)G apples are produced in a relatively L-intensive way