1

Dr. Bill W. S. Hung

2

Neoclassical Trade Theory:

The Heckscher-Ohlin Theorem

Basic Assumptions:

1. Two countries, two goods, two factors -- 2x2x2 mode

2. Identical technological in two countries

Production functions are same in two countries

3. Constant returns to scale

The sharp of PPC is unchanged

4. Two different factor abundance countries:

Labor-abundant and capital-abundant

And Two factor intensities commodities:

Labor-intensive and Capital-intensive

3

5. Identical preference and tastes

Two countries are facing the same utility functions

6. Perfect competition

Goods market and factors market

7. Factors are perfectly mobile only within a country

Factors are restricted to move across countries

10. Increasing opportunity costs:

The PPF curve is concave but not a straight line.

8. No transportation costs

9. No restriction on trade

4

Factor abundance:

Definition:

21 )L

K()

L

K(

Suppose: Country 1 is relative abundance of capital Country 2 is relative abundance of labor

Factor Price definition: w: labor wager: rental rate of capital

2)(

1)(

w

r

w

r

2)(

1)(

rw

rw OR

The greater the relative abundance of a factor, the lower its relative price.Since Country 1 has relative abundance of capital, thus its rental rate of capital is relatively lower than its wage.

21 )K

L()

K

L( or

5

Relative Factor Intensity:

CS )LK

()LK

(

Definition:

OR

CS )K

L()

K

L(

Commodity S (steel) is a capital-intensive goods.

 

Commodity C( clothes) is a

labor-intensive goods.

Similarly in terms of factor prices:

r r(w

)c

> (w

)S

ORw w

(r

)c

< (r

)S

6

The Edgeworth Box:

K

0c L

C1

C2 C3

C4 C5

L

0sK

S1S2S3S4

S5

Contract curve: production efficiency locus

(Increasing opportunity cost)

7

Country I: Capital abundant country

K2

L2

Steel

Clothes

S3

S2

S1

S0

C3

C2

C1

C0

steel

clotheso

PPFI

8

KI

LI

Clothes

Steel

S3

S2

S1

S0

C3

C2

C1

C0

Country II: Labor-abundant country

steel

clotheso

PPF1I

9

0X -Clothes

Y-Steel

PPF

PX

PY

E

(autarky price)

XYY

X

Y

X

Y

XXY MRS

MU

MU

P

P

MC

MCMRT

Marginal rate

of transformation

(MRT)

Marginal rate

Of substitution

(MRS)

CI0

The shape or pattern of CICsrepresent the aggregate consumers’ taste

or preference

10

K

L

PPFII

S

0 C

PPFI

PII

CI0

II

IILK IIor

KLI*

PI

ILK Ior

KL

Combining two countries input space, output space and consumer preference:

11

Increasing opportunity cost incomplete specialization

Different demand condition different autarky price ratio

Classical analysis:

Two countries with identical PPF or production condition are the same, there is no incentive for trade and of course no gains from trade.

Neoclassical analysis

Even two countries have the same production condition, but when the demand conditions are different the increasing opportunity costs would drive the two countries to trade.

The different prices in autarky indicates that there is a basis for gainful trade between two countries.

12

Trade direction, incomplete specialization, and consumption

PI

CI0

A

S

0 C

CI1

PPW

C

Only when PW > PI, Country-I has incentive to reallocate the production from point A to point P and to trade with other country (world), and through exchange (import) to consume at point C.

13

The Heckscher-Ohlin TheoremThe Heckscher-Ohlin TheoremA country will have comparative advantage in, and therefore, will export, that good whose production is relatively intensive in the factor with which that country is relatively well endowed.

Labor abundant country Exports(i.e., China) Labor-intensive products

ImportsCapital-intensive products

Capital abundant country Exports(i.e., U.S.A.) Capital-intensive goods

ImportsLabor-intensive goods

14

(A) Trade between two countries withIdentical Demand & Different Production Structures:

Country I: capital abundantCountry II: labor abundantGood X-clothes: labor-intensiveGood Y-steel: capital-intensive

The H -O Model

0

PPFI PPFII

Good X-Clothes

Good Y-Steel

e1

EII

C0(PX/PY)1

(PX/PY)2

(PX/PY)3

C1

CII’, cI’

I’s imports (X)

I’s exports (Y) e’y3

x3 II’s exports (X)

II’s imports (Y)

E’y1

x1x2,x4

y4,y2

15

Country I: capital abundantCountry II: labor abundantGood X: labor-intensiveGood Y: capital-intensive

The H-O Model: alternative case:(different consumption level)Good Y-Steel

Good X-Clothes0

PPFIPPFII

(PX/PY)1

e

E

(PX/PY)II

(PX/PY)3

I

C’I

e’

I’s exports

I’s imports

C’II

E’

II

II’s imports

II’s exports

C1

C2

C3

C4

16

(B) Trade between two countries withIdentical PPFsIdentical PPFs & Different Demand ConditionsDifferent Demand Conditions:

e

(PX/PY)2

W1

x4

y4

(PX/PY)3

EI’, eI’

c’W2

S2

C’

II’s imports (X)

y3

x3 x5

y5

II’s exports (Y)

y2

I’s imports (Y)

I’s exports (X)

x2

Good Y-Steel

Good X-Cloth0

PPFII

E1 S1

(PX/PY)1

y1

x1

PPFI

17

0X -Clothes

Y-Steel

PPFI,II

(C) No Trade between two countries withIdentical PPFs & identical Demand Conditions:

CI2

CI0

A

B

(autarky price)

PX

PY

CI1

Community Indifferent utility curves

E

No Incentive to trade

Why?

18

Gains From Trade

PW

C

I1

P

PW

I1*

C*

P*

3 important assumptions3 important assumptions: 

1. No costs of factor mobility

2. Full employment of factors

3. No redistribution of income once trade

open (the different curves can show

welfare changes)

AI0

Good Y

Good X0

I0*

A*

Good X

Good Y

0

19

Gains from trade and specializationGains from trade and specialization

Good Y

Good X0

ECI1

Autarky pricePX

PY

C

CI2

( )’PX

PY

( )’PX

PY

E C: consumption gains consumption gains (or gains from exchangegains from exchange)

E’

C’

CI3

Worldtrade price

( )’PX

PY

E E’ and C C’: production gainsproduction gains (or gains from gains from specializationspecialization)

20

Concept CheckConcept Check:

Can you show that the production at less than complete specialization leads to a lower level of welfare than at complete specialization.

21

The Leontief Paradox

Leontief statistic is defined as (K/L)M

(K/L)X

Leontief’s result were startling. He found that the hypothesized reduction of US export would release $2.25 Million worth of capitalAnd 182.3 year of labor-time, for a (K/X)x of approximately $14,000Per labor-year. On the import side, to produce the foregone import would require $3.09 million worth of capital and 170,0 years ofLabor-time, yielding a (K/L)M of approximately $18,200 per labor-year.Thus, the Leontief statistic for the US was 1.3 (= $18,200/$14,000), Unexpected for a relatively capital-abundant country.

What are the implications of the Leontief Paradox?

22

Invalid assumptions to Heckscher-Ohlin Model

1. Demand reversal

2. Factor-intensity reversal

3. Transportation costs

4. Imperfect competition

5. Immobile or commodity-specific factors

6. US tariff structure

7. Different skill levels of labor

8. The role of natural resourcesothers

9. Income inequality

23

1. The Factor Price Equalization Theorem:

Given all the assumptions of the H-O model, free trade will lead to the international equalization of individual factor prices.(The impact of trade on factor prices)

2. The Stolper-Samuelson Theorem:

Free trade benefits the abundant factor and harms the scarce factor.(The impact of trade on income distribution)

3. The Rybczynski Theorem:

At constant world prices, if a country experiences an increase in the supply of one factor, it will produce more of the product intensive in that factor and loss of the other.(The effect of economic growth on trade)

24

Factor price equalization theorem

When home and foreign country trade with each other, the relative prices of goods converge. This convergence, in turn, causes convergence of the relative prices of factors.

Before trade: (w/r)II > (w/r)world > (w/r)I (Country-I wage is lower)

After trade: (w/r)I = world factor price = (w/r)II because the goods prices are equalized in two countries

Example: When trade open between China and Hong Kong, Wages increase in China, Wage decline in Hong Kong

25

(w/r)0 (w/r)1

When r, wIn Country II :(labor-abundant)

Increase produce clothes

i.e., Ic0 Ic

1

Decrease produce steel

i.e., Is0 Is

1

( K/L)c0

(w/r)0

K

LClothes

IC0

Steel

K

(w/r)0

L

(K/L)S0

IS0

(w/r)1

IC1

(K/L)c1

(w/r)1

IS1

(K/L)s1

After trade adjustment in Country II (labor-abundant) case: Producer adjusts output due to relative factor prices changes.

Both industries now employ more capital

26

0w/r

Pc/Ps

(Pc/Ps) I

<(w/r)I

Capital

abundant

country(w/r)I

(Pc/Ps)I(Pc/Ps)II

(w/r)II <

Labor

abundant

country(w/r)II

(Pc/Ps)II

< <

Trade Condition

(Pc/Ps)

(w/r)

world trade price

w/r

Pc/Ps

One important assumption is market perfect competitionBut in real world it seems FPE theorem does not work well.

27

The Stolper-Samuelson Theorem

With full employment both before and after trade, the increase in the price of the abundant factor and the fall in the price of the scare factor because of trade imply that the owners of abundant factor will find their real incomes rising and the owners of scarce factor will find their real incomes falling.

In labor-abundant country: if price of labor-intensive goods ---> wage ---> producer of labor-intensive goods and labor income

In capital-abundant country: if price of capital-intensive goods ---> capital rent ---> producer of capital-intensive goods and capital owner income

28

Steel

0 Clothes

Example: Tariffs can increase the trade prices. (From red to green line) i.e., production point shifts from P point to T point

Policy implication:Policy implication:Producer of steel and the capital owner will gain from the tariff. (Pro-tariff or welcome any protection).Producer of clothes and the labor will loss from the tariff.(Against tariff or reject any protection)

PC

PS( ) II

A

Country II’s PPF

PC

PS( ) II

PC W

PS r A to P :

T

[Pc/(Ps+ tariff )]w

PC W

(PS+ t) r

P to T :

PC

PS( ) < World price

P

PC

PS( ) World price

29

Rybczynski Theorem: The effect of factor endowment change

Autos

a0

t0Textiles

0

(PT/PA)

Example: The Growth Effects of Labor-Market Adjustment and MigrationMigration ---Labor Endowment moves out, PPF shifts in.

(PT/PA)

a1

t1

30

Autos(PT/PA)

a0

t0

Textiles0

Rybczynski Theorem:

a1

t1

(PT/PA)

Labor endowment increases, PPF shifts out

31

Exercise:Exercise:

One of the important changes in the world economy over the past three decades has been the rapid increase in capital investment in the countries of the Pacific Basin (notably Japan, Korea).

What are the implications of this investment for the commodity patterns of trade of these two countries, say, with respect to the United States? Explain.

(Hint: Think about Rybczynski theorem)

32

Invalid assumptions to Heckscher-Ohlin ModelCase of Demand ReversalCase of Demand Reversal

Demand Reversal outcome:Country 2: now exports S and imports CCountry 1: now exports C and imports S

P2

Country 2’s imports of C

Country 2’s exports of S

P1

Country 1’s imports of S

Country 1’s exports of C

Prediction of trade pattern from H-O model Country 2: exports C and imports SCountry 1: exports S and imports C

(Pc/Ps) world price

C1

CI11

C2

CI21

A1 CI10

A2

CI20

Now Country-1 prefers more steelBut Countyr-2 prefers more clothes

Steel

ClothPPF2PPF1

Steel: capital-intensiveClothes: labor-intensive

Country-1: capital abundantCountry-2: labor abundant

33

K

0LaborW

r( ) 1

A

B

Cloth

Steel

Case of Factor-intensity: No matter factor prices change, factor relative requirement ratio is always unchanged. If steel is capital-intensive, cloth is labor-intensive,then at any factorprices ratio, the factor input ratio is always (K/L)s > (K/L)c

KL( ) S1

KL( ) C1

At (w/r)1 :K K

(L

)S1

> (L

)C1

KL( ) S2

KL( ) C2

W r( ) 2

F

G

At (w/r)2 :K K

(L

)S2

> (L

)C2

Steel: capital-intensiveClothes: labor-intensive

34

Invalid assumptions to Heckscher-Ohlin Model

Case of Factor intensity Reversal

K

0L

Steel

At (w/r) 1 :K K

(L

)C1

< (L

)S1

(k/L) S1

(k/L) C1

Clothes

(w/r) 1

BA

(k/L) C2

(k/L) S2

(w/r) 2

F

G

At (w/r) 2 :K K

(L

)C2

> (L

)S2

35

Question:

Can you give any example of tradable goods that may have such factor-intensity-reversal problem?

Exercise:Show in a graph to illustrate that factor-intensity reversal can also occur of the two industry isoquants do not cross each other but are tangent to one another.