Resources and Trade: The

Heckscher - Ohlin model

Econ 231 - Introduction to
International Economics
University of Waterloo
Department of Economics
Spring 2013

Relevant chapters
Krugman Chapter 5
Freenstra Chapter 4 (optional)
Motivation
In Chapter 3, trade between nations was motivated by
differences internationally in the relative productivity of
workers when producing a range of products.
In Chapter 5, this analysis goes a step further by introducing
the Heckscher-Ohlin theory.
The Heckscher-Ohlin theory considers the pattern of
production and trade which will arise when countries have
different endowments of factors of production, such as labor,
capital, and land.

Motivation
The basic point is that countries tend to export goods that
are intensive in the factors with which they are abundantly
supplied.
Trade has strong effects on the relative earnings of resources,
and tends to lead to equalization across countries of prices of
the factors of production.
These theoretical results and related empirical findings are
presented in this chapter.

Topics Covered
Production possibilities.
Relationship among output prices, input (factor) prices, and
levels of inputs.
Relationship among output prices, input prices, levels of
inputs, and levels of output.
Trade in the Heckscher-Ohlin model.
Factor price equalization.
Income distribution and income inequality.
Empirical evidence.
Resource Based Understanding of
International Trade
Canada has a large amount of land and it exports agricultural
and forestry products, as well as mineral products.
The US, Western Europe, Japan have many highly skilled
workers as well as capital and export sophisticated
manufactured goods and services.
China and other Asian countries have a large number of
workers and moderate amounts of capital and export less
sophisticated manufactured goods.
Introduction
While trade is partly explained by differences in labor
productivity, it also can be explained by differences in
resources across countries.
The Heckscher-Ohlin theory argues that differences in labor,
labor skills, physical capital, land or other factors of
production across countries create productive differences that
explain why trade occurs.
Countries have a relative abundance of factors of production.
Production processes use factors of production with
relative intensity.
History:Two Factor Heckscher-Ohlin
Model (H-O model)
Also referred as the factor proportions model, the H-O model was
originally developed by two Swedish economists, Eli Heckscher and his
student Bertil Ohlin in the 1920s.
Many elaborations of the model were provided by Paul Samuelson after
the 1930s and thus sometimes the model is referred to as the Heckscher-
Ohlin-Samuelson model.
In the 1950s and 60s some noteworthy extensions to the model were
made by Jaroslav Vanek and so occasionally the model is called the
Heckscher-Ohlin-Vanek model.
Two Factor Heckscher-Ohlin Model
1. Labor services and land are the resources important for production.
2. The amount of labor services and land varies across countries, and
this variation influences productivity.
3. The supply of labor services and land in each country is constant.
4. Only two goods are important for production and consumption:
cloth and food.
5. Competition allows factors of production to be paid a competitive
wage, a function of their productivities and the price of the good
that they produce, and allows factors to be used in the industry that
pays the most.
6. Only two countries are modeled: domestic and foreign
Assumptions of Heckscher-Ohlin
Model
There are two notions (Home and Foreign),two goods (cloth
and food) and two factors(labour and land) in the model.
Both nations use the same technology in the model.
Cloth is labour intensive and food is land intensive.
Both commodities are produced under constant returns to
scale in both nations.
Tastes are same in both nations.
There is perfect competition in both goods and factor markets
in both nations.

Assumptions of Heckscher-Ohlin
Model (cont.)
There is perfect factor mobility within each nations but no
international factor mobility.
There is no transportation cost, tariffs or other forms of trade
barriers.
All resources are fully utilized in both nations.

Production Possibilities
When there is more than one factor of production, the
opportunity cost in production is no longer constant and
the PPF is no longer a straight line. Why?
Lets expand the previous chapters model to include two
factors of production, labor services and land.
a
TC
= hectares of land used to produce one yard of cloth
a
LC
= hours of labor used to produce one yard of cloth
a
TF
= hectares of land used to produce one calorie of food
a
LF
= hours of labor used to produce one calorie of food
L = total amount of labor services available for production
T = total amount of land (terrain) available for production
Production Possibilities (cont.)
Production possibilities are influenced by both
land and labor (requirements):
a
TF
Q
F
+ a
TC
Q
C
T


a
LF
Q
F
+ a
LC
Q
C
L
Total amount of
land resources
Land required for
each unit of food
production
Total units
of food
production
Land required for
each unit of cloth
production
Total units
of cloth
production
Total amount of
labor resources
Labor required for
each unit of food
production
Labor required for
each unit of cloth
production
Production Possibilities (cont.)
Lets assume that each unit of cloth production uses labor
services intensively and each unit of food production uses
land intensively:
a
LC
/a
TC
> a
LF
/a
TF
Or, a
LC
/a
LF
> a
TC
/a
TF
Or, we consider the total resources used in each industry and say that
cloth production is labor intensive and food production is land
intensive if L
C
/ T
C
> L
F
/ T
F
This assumption influences the slope of the production
possibility frontier:
Fig. 4-1: The Production Possibility Frontier
Without Factor Substitution
Production Possibility Frontier

Q
F

L/a
LF

A

T/a
TF E D



C
B



L/a
LC
T/a
TC
Q
C

Labour constraint
The steeper line is the labour constraint.

Q
C
= L/a
LC
when Q
F
= 0
Q
F
= L/a
LF
when Q
C
= 0
Q
F
= L/a
LC
(a
LC
/a
LF
)Q
C
: the equation for the labour constraint,
with a slope equal to (a
LC
/a
LF
).
All points on the steeper line represent combinations of cloth
and food output which could employ all of the labour
available in the economy.
Labour Constraint
Points outside the constraint, such as B and D, are not feasible
production points since there is insufficient labour resources.
All points on or within the line, such as A, C and E are feasible.

Land Constraint
The flatter line is the land constraint.
Q
C
= T/a
TC
when Q
F
= 0
Q
F
= T/a
TF
when Q
C
= 0
Q
F
= T/a
TF
(a
TC
/a
TF
)Q
C
: the equation for the land constraint,
with a slope equal to (a
TC
/a
TF
).


Land Constraint (cont.)
Points on the flatter line represent combinations of cloth and
food production which would employ all of the land in the
economy.
Points outside the constraint, such as A and D, are not
feasible production points since there is insufficient land
resources. Points on or within the line, such as B, C and E, are
feasible.
Production Possibility Frontier with
two factors
Only one point, point E, can simultaneously generate full employment of
both labour and land. Thus point E is on the PPF.
The production possibility set is the set of all output combinations that
are feasible. The PPF (the red line) satisfies both the constraints
simultaneously. It is the area bounded by the axes and the interior
section of the labour and land constraints.
At points like A there is sufficient labour to make production feasible but
insufficient land, thus point A is not a feasible production point.
Similarly, at point B there is sufficient land but not enough labour.
Points like C however, which lie inside (or on) both factor constraints do
represent feasible production points.
Production Possibilities (cont.)
The above PPF equations do not allow substitution of land for
labor services in production or vice versa.
Unit factor requirements are constant along each line segment of the
PPF.
If producers can substitute one input for another in the
production process, then the PPF becomes curved.
For example, many workers could work on a small plot of land or a few
workers could work on a large plot of land to produce the same
amount of output.
Unit factor requirements can vary at every quantity of cloth and food
that could be produced.
Production Possibilities (cont.)
The opportunity cost of producing cloth in terms
of food is not constant in this model:
its low when the economy produces a low amount of
cloth and a high amount of food.
its high when the economy produces a high amount of
cloth and a low amount of food.
Why? Because when the economy devotes all resources
towards the production of a single good, the marginal
productivity of those resources tends to be low so that the
(opportunity) cost of production tends to be high.
In this case, some of the resources could be used more
effectively in the production of another good.
The Production Possibility
Frontier with Factor Substitution
Input Possibilities in Food Production
In the production of each
unit of food, unit factor
requirements of land
and labor are not
constant in the
Heckscher-Ohlin model
Production and Prices
The production possibility frontier describes what an
economy can produce, but to determine what the economy
does produce, we must determine the prices of goods.
In general, the economy should produce at the point that
maximizes the value of production, V:
V = P
C
Q
C
+ P
F
Q
F
where P
C
is the price of cloth and P
F
is the price of food.
Production and Prices (cont.)
Define an isovalue line as a line representing a
constant value of production, V.
V = P
C
Q
C
+ P
F
Q
F
P
F
Q
F
= V P
C
Q
C

Q
F
= V/P
F
(P
C
/P
F
)Q
C
The slope of an isovalue line is (P
C
/P
F
)
Prices and Production
Production and Prices (cont.)
Given prices of output, a point on one isovalue line
represents the maximum value of production, say at
a point Q.
At that point, the slope of the PPF equals (P
C
/P
F
),
so the opportunity cost of cloth equals the relative
price of cloth.
In other words, the trade-off in production equals the
trade-off according to market prices.
Factor Prices, Output Prices,
and Levels of Factors of Production
Producers may choose different amounts of factors of
production to make cloth or food.
Their choice depends on the wage rate, w, and the
(opportunity) cost of using land, the rate r at which land can
be lent to others or rented from others.
As the wage rate increases relative to the lending/ renting
rate r, producers are willing to use less labor services and
more land in the production of food and cloth.
Recall that food production is land intensive and cloth production is
labor intensive.
Factor Prices and Input Choices
Factor Prices, Output Prices,
and Levels of Factors (cont.)
In competitive markets, the price of a good should be
reduced to the cost of production, and the cost of
production depends on the wage rate and the
lending/renting rate.
The effect of changes in the wage rate depend on the
intensity of labor services in production.
The effect of changes in the lending/renting rate of land
depend on the intensity of land usage in production.
An increase in the lending/renting rate of land should
affect the price of food more than the price of cloth
since food is the land intensive industry.
With competition, changes in w/r are therefore directly
related to changes in P
C
/P
W
.
Factor Prices and Goods Prices
Factor Prices, Output Prices,
and Levels of Factors (cont.)
We have a relationship among input (factor) prices and output
prices and the levels of factors used in production:
Stolper-Samuelson theorem: if the relative price of a good
increases, then the real wage or real lending/ renting rate of
the factor used intensively in the production of that good
increases, while the real wage or real lending/renting rate of
the other factor decreases.
Under competition, the real wage/rate is equal to the marginal
productivity of the factor.
The marginal productivity of a factor typically decreases as the level of
that factor used in production increases.
From Goods Prices to Input Choices
Factor Prices, Output Prices,
and Levels of Factors (cont.)
We have a theory that predicts changes in the distribution of
income when the relative price of goods changes, say because
of trade.
An increase in the relative price of cloth, P
C
/P
F
, is predicted
to:
raise income of workers relative to that of landowners, w/r.
raise the ratio of land to labor services, T/L, used in both industries
and raise the marginal productivity of labor in both industries and
lower the marginal productivity of land in both industries.
raise the real income of workers and lower the real income of land
owners.
Factor Prices, Output Prices, Levels of Factors,
and Levels of Output
The allocation of factors used in production
determine the maximum level of output (on the
PPF).
We represent the amount of factors used in the
production of different goods using the following
diagram:
The Allocation of Resources
Factor Prices, Output Prices, Levels of Factors,
and Levels of Output
How do levels of output change when the economys
resources change?
If we hold output prices constant as the amount of a
factor of production increases, then the supply of the
good that uses this factor intensively increases and
the supply of the other good decreases.
This proposition is called the Rybczynski theorem.
An Increase in the Supply of Land
Resources and Production Possibilities
Factor Prices, Output Prices, Levels of Factors,
and Levels of Output
An economy with a high ratio of land to labor services is
predicted to have a high output of food relative to cloth and a
low price of food relative to cloth.
It will be relatively efficient at (have a comparative advantage in)
producing food.
It will be relatively inefficient at producing cloth.
An economy is predicted to be relatively efficient at producing
goods that are intensive in the factors of production in which
the country is relatively well endowed.
Trade in the Heckscher-Ohlin Model
Suppose that the domestic country has an abundant amount
of labor services relative to land.
The domestic country is abundant in labor services and the foreign
country is abundant in land: L/T > L*/ T*
Likewise, the domestic country is scarce in land and the foreign
country is scarce in labor services.
However, the countries are assumed to have the same technology and
same consumer tastes.
Because the domestic country is abundant in labor services, it
will be relatively efficient at producing cloth because cloth is
labor intensive.
Trade in the Heckscher-Ohlin Model (cont.)
Since cloth is a labor intensive good, the domestic
countrys PPF will allow a higher ratio of cloth to food
relative to the foreign countys PPF.
At each relative price, the domestic country will
produce a higher ratio of cloth to food than the
foreign country.
The domestic country will have a higher relative supply of
cloth than the foreign country.
Trade Leads to a Convergence of Relative Prices
Trade in the Heckscher-Ohlin Model (cont.)
Like the Ricardian model, the Heckscher-Ohlin model
predicts a convergence of relative prices with trade.
With trade, the relative price of cloth is predicted to rise in
the labor abundant (domestic) country and fall in the labor
scarce (foreign) country.
In the domestic country, 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; the domestic country becomes an exporter
of cloth and an importer of food.
The decline in the relative price of cloth in the foreign country
leads it to become an importer of cloth and an exporter
of food.
Trade in the Heckscher-Ohlin Model (cont.)
An economy is predicted to be relatively efficient
at (have a comparative advantage in) producing
goods that are intensive in its abundant factors of
production.
An economy is predicted to export goods that are
intensive in its abundant factors of production and
import goods that are intensive in its scarce
factors of production.
This proposition is called the Heckscher-Ohlin theorem.
Trade in the Heckscher-Ohlin Model (cont.)
Over time, the value of goods consumed is constrained to
equal the value of goods produced for each country.
P
C
D
C
+ P
F
D
F
= P
C
Q
C
+ P
F
Q
F

where D
C
represents domestic consumption demand of cloth and
D
F
represents domestic consumption demand of food
(D
F
Q
F
) = (P
C
/P
F
)(Q
C
D
C
)
Quantity
of exports
Price of exports
relative to imports
Quantity
of imports
Trade in the Heckscher-Ohlin Model (cont.)
(D
F
Q
F
) = (P
C
/P
F
)(Q
C
D
C
)
This equation is the budget constraint for an
economy, and it has a slope of (P
C
/P
F
)
(D
F
Q
F
) (P
C
/P
F
)(Q
C
D
C
) = 0
The Budget Constraint
for a Trading Economy
Trade in the Heckscher-Ohlin Model (cont.)
Note that the budget constraint touches the PPF: a
country can always afford to consume what it
produces.
However, a country need not consume
only the goods and services that it produces
with trade.
Exports and imports can be greater than zero.
Furthermore, a country can afford to consume more
of both goods with trade.
Trading Equilibrium
Trade Expands the Economys
Consumption Possibilities
Trade in the Heckscher-Ohlin Model (cont.)
Because an economy can afford to consume more with
trade, the country as a whole is made better off.
But some do not gain from trade, unless the model
accounts for a redistribution of income.
Trade changes relative prices of goods, which have effects
on the relative earnings of workers and land owners.
A rise in the price of cloth raises the purchasing power of domestic
workers, but lowers the purchasing power of domestic land
owners.
The model predicts that owners of abundant factors gain
with trade, but owners of scarce factors lose.
Factor Price Equalization
Unlike the Ricardian model, the Heckscher-Ohlin model
predicts that input (factor) prices will be equalized among
countries that trade.
Because relative output prices are equalized and because of
the direct relationship between output prices and factor
prices, factor prices are also equalized.
Trade increases the demand of goods produced by abundant
factors, indirectly increasing the demand of the abundant
factors themselves, raising the prices of the abundant factors
across countries.
Factor Price Equalization (cont.)
But factor prices are not really equal across countries.
The model assumes that trading countries produce the same
goods, so that prices for those goods will equalize, but
countries may produce different goods.
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.
Factor Price Equalization (cont.)
The model also ignores trade barriers and transportation
costs, which may prevent output prices and factor prices from
equalizing.
The model predicts outcomes for the long run, but after an
economy liberalizes trade, factors of production may not
quickly move to the industries that intensively use abundant
factors.
In the short run, the productivity of factors will be determined by their
use in their current industry, so that their wage/rate may vary across
countries.
Does Trade Increase Income Inequality?
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.
Did the former trend cause the latter trend?
Does Trade Increase
Income Inequality? (cont.)
The Heckscher-Ohlin model predicts that owners of
abundant factors will gain from trade and owners of scarce
factors will lose from trade.
But little evidence supporting this prediction exists.
1. According to the model, a change in the distribution of
income occurs through changes in output prices, but there is
no evidence of a change in the prices of skill-intensive goods
relative to prices of unskilled-intensive goods.
Does Trade Increase
Income Inequality? (cont.)
2. According to the model, wages of unskilled workers should
increase in unskilled labor abundant countries relative to
wages of skilled labor, but in some cases the reverse has
occurred:
Wages of skilled labor have increased more rapidly in Mexico than
wages of unskilled labor.
But compared to the U.S. and Canada, Mexico is supposed to be
abundant in unskilled workers.
3. Even if the model were exactly correct, trade is a small
fraction of the U.S. economy, so its effects on U.S. prices and
wages prices should be small.
Trade and Income Distribution
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.
Trade and Income Distribution (cont.)
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.
Empirical Evidence of the
Heckscher-Ohlin Model
Tests on US data
Leontief found that U.S. exports were less capital-intensive than U.S.
imports, even though the U.S. is the most capital-abundant country in
the world: Leontief paradox.
Tests on global data
Bowen, Leamer, and Sveikauskas tested the Heckscher-Ohlin model on
data from 27 countries and confirmed the Leontief paradox on an
international level.
Tests on manufacturing data between low/middle income
countries and high income countries.
This data lends more support to the theory.
The first test of the Heckscher-Ohlin theorem was performed by
economist Wassily Leontief in 1953.
Leontief supposed correctly that in 1947 the United States was
abundant in capital relative to the rest of the world.
Thus, from the Heckscher-Ohlin theorem, Leontief expected
that the United States would export capital-intensive goods and
import labor-intensive goods.
What Leontief actually found, however, was just the opposite:
the capitallabor ratio for U.S. imports was higher than the
capitallabor ratio found for U.S. exports!
This finding contradicted the Heckscher-Ohlin theorem and
came to be called Leontiefs paradox.
Empirical Evidence of the
Heckscher-Ohlin Model
TABLE 4-1
Leontief used the numbers in this table to test the Heckscher-Ohlin theorem. Each
column shows the amount of capital or labor needed to produce $1 million worth
of exports from, or imports into, the United States in 1947. As shown in the last
row, the capitallabor ratio for exports was less than the capitallabor ratio for
imports, which is a paradoxical finding.
Leontiefs Paradox
Leontiefs Paradox
Explanations
U.S. and foreign technologies are not the same, in contrast to
what the HO theorem and Leontief assumed.
By focusing only on labor and capital, Leontief ignored land
abundance in the United States.
Leontief should have distinguished between skilled and
unskilled labor (because it would not be surprising to find
that U.S. exports are intensive in skilled labor).
The data for 1947 may be unusual because World War II had
ended just two years earlier.
The United States was not engaged in completely free trade,
as the Heckscher-Ohlin theorem assumes.
Factor Content of U.S. Exports and
Imports for 1962
Testing the Heckscher-Ohlin Model
Estimated Technological Efficiency, 1983 (United
States = 1)
Empirical Evidence of the
Heckscher-Ohlin Model (cont.)
Because the Heckscher-Ohlin model
predicts that factor prices will be equalized across
trading countries, it also predicts that factors of
production will produce and export
a certain quantity goods until factor prices
are equalized.
In other words, a predicted value of services from factors
of production will be embodied in a predicted volume of
trade between countries.
Empirical Evidence of the
Heckscher-Ohlin Model (cont.)
But because factor prices are not equalized across countries,
the predicted volume of trade is much larger than actually
occurs.
A result of missing trade discovered by Daniel Trefler.
The reason for this missing trade appears to be the
assumption of identical technology among countries.
Technology affects the productivity of workers and therefore the value
of labor services.
A country with high technology and a high value of labor services
would not necessarily import a lot from a country with low technology
and a low value of labor services.
Summary
1. Substitution of factors used in the production process is
represented by a curved PPF.
When an economy produces a low quantity of a good, the
opportunity cost of producing that good is low and the marginal
productivity of resources used to produce that good is high.
When an economy produces a high quantity of a good, the
opportunity cost of producing that good is high and the marginal
productivity of resources used to produce that good is low.
2. When an economy produces the most it can from its
resources, the opportunity cost of producing a good equals
the relative price of that good in markets.
Summary (cont.)
3. If the relative price of a good increases, then the real wage
or real lending/renting rate of the factor used intensively in
the production of that good is predicted to increase,
while the real wage and real lending/renting rates of other factors of
production are predicted to decrease.
4. If output prices remain constant as the amount of a factor of
production increases, then the supply of the good that uses
this factor intensively is predicted to increase, and the
supply of other goods is predicted to decrease.
Summary (cont.)
5. An economy is predicted to export goods that are intensive
in its abundant factors of production and import goods that
are intensive in its scarce factors of production.
6. The Heckscher-Ohlin model predicts that relative output
prices and factor prices will equalize, neither of which occurs
in the real world.
7. The model predicts that owners of abundant factors gain,
but owners of scarce factors lose with trade.
Summary (cont.)
8. A country as a whole is predicted to be better off
with trade, even though owners of scarce factors
are predicted to be worse off without
compensation.
9. Empirical support of the Heckscher-Ohlin model is
weak except for cases involving trade between high
income countries and low/middle income
countries.
Assigned Problems from the Textbook
Questions 1, 2, 3, 4 & 6 ( page 105).
Additional Chapter Art
Input Possibilities in Food Production
Comparative International Wage Rates (United
States = 100)
Skill Intensity and the Pattern of U.S. Imports
from Two Countries
Source: John Romalis, Factor Proportions and the Structure of Commodity Trade, American Economic Review, March
2004.
Changing Patterns of Comparative Advantage
Changing Patterns of Comparative Advantage
(continued)
Estimated Technological Efficiency, 1983 (United
States = 1)
Choosing the Optimal
Land-Labor Ratio
Changing the Wage-Rental Ratio
Determining the Wage-Rental Ratio
A Rise in the Price of Cloth