Chapter 2: The HeckscherOhlin model

Chapter 2: The HeckscherOhlin model

Learning objectives
On completion of this chapter and having done the relevant readings and activities, you should be able to: H[SODLQ WKH VKDSH RI WKH SURGXFWLRQ SRVVLELOLW\ IURQWLHU ZLWK WZR IDFWRUV of production H[SODLQ KRZ GLIIHUHQFHV LQ IDFWRU HQGRZPHQWV FDQ SURYLGH D EDVLV IRU international trade H[SODLQ ZK\ WUDGH FDQ KDYH SURIRXQG HIIHFWV RQ LQFRPH GLVWULEXWLRQ H[SODLQ WKH GLUHFWLRQ RI LQFRPH GLVWULEXWLRQ HIIHFWV QDPHO\ WKDW WUDGH benefits a countrys abundant factor and worsens the real income of the scarce factor H[SODLQ WKH HIIHFW RI FKDQJHG IDFWRU HQGRZPHQWV RQ VHFWRUDO RXWSXWV H[SODLQ WKH OLPLWDWLRQV RI WKH +2 PRGHO DV DQ HPSLULFDO K\SRWKHVLV about the commodity composition of trade.

Essential reading
Krugman, P and M. Obstfeld Chapter 4 Resources, Comparative Advantage, . and Income Distribution. Suranovic, S.M. International Trade: Theory and Policy. Chapter 60. http:// internationalecon.com/Trade/Tch60/Tch60.php

There is an interactive webpage through which you can practise building and manipulating the Lerner diagram:
www-personal.umich.edu/~alandear/glossary/figs/Lerner/ld.html

Further reading
Freeman, R.B. Are your wages set in Beijing?, Journal of Economic Perspectives 9(3) 1995, pp.1532. Jones, R.W. and J.P Neary The positive theory of international trade in Jones, . R.W. and P Kenen (eds) Handbook of International Economics Vol. 1: .B. International trade. (Amsterdam: Elsevier Science B.V 1998). .,

This offers an advanced level survey of trade theories.

Overview
The HeckscherOhlin (HO) model of international trade was originally developed by two Swedish economists Eli Heckscher and Bertil Ohlin in the early part of the twentieth century. Like the Ricardian model, it is a comparative advantage model of international trade where differences between countries are the basis for trade. Unlike the Ricardian model, where comparative advantage originates in differences in technology between countries, technology is assumed to be the same across countries in the HO model, with the emphasis instead placed on differences in factor endowments as the origin of comparative advantage. The model is explicitly general equilibrium in character and this feature is emphasised through the linkages between factor prices and choice

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of inputs, and factor prices and product prices. Accordingly, the model provides a particularly rich account of the mechanisms by which trade influences the economy. A notable insight of the model is that trade in goods can be regarded as a substitute for the international movement of factors (i.e. that trade in goods is indirectly trade in factors of production). This is seen most clearly in the factor price equalisation theorem.

Assumptions
A limitation of the Ricardian model is that it assumes a single factor of production, usually taken to be labour or a dose of labour combined with other factors in fixed proportions. This is firstly unrealistic and secondly, it does not permit the analysis of the impact of trade and trade policy on income distribution. In contrast, the HO model is what is known as a 2 u 2 u 2 model. That is, it is characterised by the assumptions of two goods, two factors of production and two countries. Let us also assume that there are: WZR JRRGV VD\ IRRG ) DQG PDQXIDFWXUHV 0 WZR IDFWRUV RI SURGXFWLRQ ODERXU / DQG FDSLWDO . WZR FRXQWULHV VD\ +RPH + DQG )RUHLJQ ) Further assume that technologies are identical across countries but different across sectors. In particular, let manufactures be the relative capital intensive sector and food the relative labour intensive sector. That is, for all possible relative factor prices, the ratio of capital to labour employed in the production of manufactures exceeds the ratio of capital to labour employed in the food sector (see Figure 2.1). While the sectors use factors of production with different intensities, it is assumed, in contrast to the Ricardian model, that both countries have access to the same technology (i.e. have the same production functions in both sectors). This is to concentrate attention on differences in resource endowments as the potential origin of comparative advantage.

w/

Food

Manufactures

0
Figure 2.1: No factor intensity reversals

(K/L)i

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Chapter 2: The HeckscherOhlin model

Figure 2.1 illustrates the relationship between relative price of labour to capital (w/r, where w is the wage rate and r is the rental price of capital) and the capital labour ratio employed in each sector. As labour becomes more expensive relative to capital, Figure 2.1 shows the production process of both sectors becomes more capital intensive, but the capitallabour ratio in manufacturing is always higher than that in food production. In other words, we assume there are no factor intensity reversals. The phenomenon in which relative factor-intensities change at different factor prices is known as factor-intensity reversal. In theory, there can be many factor-intensity reversals. Sometimes it is convenient to assume that factor-intensity reversals do not happen (whether they are important empirically is debatable). This assumption (i.e. no factor-intensity reversal) is sometimes known as the strong factor intensity condition. It is also assumed that perfect competition prevails in both goods and factor markets and that production functions satisfy constant returns to scale. The assumption of constant returns to scale is crucial in deriving a number of results. The two countries are assumed to differ in their endowments of factors. In particular, assume Home is relatively more capital abundant than Foreign. Hence, (K/L)H > (K/L)F. Finally, consumers of the two countries are assumed to have identical preferences. The assumptions of the HO model imply that countries are effectively identical in every respect except their endowment of factors of production. It is the interaction of different factor abundances across countries and different factor intensities across sectors that gives rise to a pattern of comparative advantage and thus a basis for international trade.

Tools and results for a closed economy

The procedure for understanding the workings of the model is similar to that employed in the Ricardian model. Firstly, we describe the characteristics of an economy that does not trade and then we consider what happens when two such economies trade with each other. From goods prices to input choices The key analytic concepts of the HO model concern the way in which resources (i.e. labour and capital), are allocated between the two sectors, food and manufactures, as well as the backward linkage to factor prices and the forward linkage to product prices. The most important single tool of the HO model is the diagram expressing these linkages. In KO it is Figure 4-7 From Goods Prices to Input Choices. A version of this diagram is reproduced as Figure 2.5 below. Figure 2.5 is based on two assumptions of the model. These are: FRVW PLQLPLVDWLRQ SULFH HTXDOV DYHUDJH FRVW Thus in each sector producers are assumed to minimise costs. This means that at each factor price ratio (w/r) they choose the factor input ratios (Ki/ Li) which minimises costs. The assumption of constant returns to scale means that the cost-minimising input ratio is independent of the scale of production.1
The choice of technique is discussed by KO (pp.5557) and also in the Appendix to Chapter 4.
1

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1/

PM

1/

PF

0
Figure 2.2: Unit value isoquants

To understand the mechanisms behind Figure 2.5 we examine the cost minimisation decision more carefully. Figure 2.2 illustrates unit-value isoquants for food and manufactures. These are isoquants, one for each sector, along which the value of output (revenue) is equal to 1. That is, PMQM = 1 holds along the M isoquant, which implies the quantity of manufactures associated with this isoquant is QM = 1/PM, the inverse of the price of manufactures. Similarly, PFQF = 1 holds along the F isoquant, which implies the quantity of food associated with this isoquant is QF = 1/PF, the inverse of the price of food. Notice the M isoquant is positioned towards the K-axis as it is relatively capital intensive, while F is positioned towards the L-axis as it is relatively labour intensive. Firms will choose the factor input ratios (Ki/ Li)M and (Ki/ Li)F that minimises the cost of producing a given value of output. The assumption of perfect competition implies there are zero profits in equilibrium, so cost is equal to revenue in the production of each sector. Hence, PMQM = 1 = wLM + rKM implies zero profit in the M sector and PFQF = 1 = wLF + rKF implies zero profit in the F sector.
K (KM/LM)
Cone of Diversification

M
1/

(KF/LF)
PM

F - w/r
1/ PF

0
Figure 2.3: Cost minimisation

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Chapter 2: The HeckscherOhlin model

Figure 2.3 depicts the Lerner diagram,2 which illustrates cost minimisation in both sectors. There is a unique isocost line (wL + rK = 1) that is tangent to both isoquants. This determines the (unique) equilibrium factor price ratio (w/r), which reflects the slope of the isocost line, at which both goods are produced with zero profits. The prices of the two goods determine the position of the isoquants and cost minimisation pins down the equilibrium factor price ratio and factor input ratios in the two sectors. The rays through the origin through points M and F in Figure 2.3 describe the equilibrium techniques of production for the two sectors. The area enclosed by these two rays is called the cone of diversification. If the endowment point of the economy lies within this cone, then there is incomplete specialisation (both goods are produced in positive amounts). The StolperSamuelson (SS) theorem We can use the Lerner diagram to examine the implications of price changes on factor prices. This gives a diagrammatic demonstration of the StolperSamuelson (SS) theorem, one of the most important results of the HO model. The StolperSamuelson theorem states that if both goods continue to be produced (incomplete specialisation), an increase in the relative price of a good will increase the real return of the factor used intensively in the production of that good and a decrease in the real return to the other factor of production. To demonstrate the SS theorem of the HO model consider the implications of an increase in the price of manufactures from PM to PM', as illustrated in Figure 2.4. When the price of manufactures rises, the quantity of output needed to generate one unit of revenue falls, shifting in the M-sector unitvalue isoquant inwards. Cost minimisation implies a lower equilibrium factor price ratio i.e. w/r falls, lowering the relative cost of labour to capital so both food and manufactures are produced using a less capital intensive technique of production than before the prices change (this corresponds with the shape of the curves in Figure 2.1). To find the effect of the price change on w and r independently, consider the intercepts of the isocost line on the L-axis and K-axis respectively. Recall that the equation for the isocost schedule is wL + rK = 1. Along the K-axis L = 0, so r = 1/K. The change in the intercept from y to x in Figure 2.4
K

There is an interactive webpage through which you can practise building and manipulating the Lerner diagram: www-personal.umich. edu/~alandear/glossary/ IU.GTPGTNFJVON

(KM/LM) (KM/LM)'

x (KF/LF)
1/ 1/ PM' PM

z v

(KF/LF)'

- w/r 0

1/

PF

Figure 2.4: The StolperSamuelson theorem

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therefore corresponds to a fall in K-intercept and hence a rise in r. Similarly, examination of the intercept along the L-axis yields a fall in w. Hence a rise in the price of manufactures has been shown to raise the nominal price of capital, the factor used intensively in manufacturing, and lowers the nominal price of labour, the factor used intensively in the food sector. To establish that the real wage falls and the real rental rate rises, thereby completing the proof of the SS theorem, we need to consider prices. Since the price of food is unchanged, the real wage and real rental rate have obviously fallen and risen, respectively, in terms of food. Additionally, the price of manufactures has risen, so the real wage in terms of manufactures has unambiguously fallen. The conflict arises in the case of rental rates in terms of manufactures since r has risen but so has the price of manufactures. To resolve this we appeal to the magnification effect, which is that the change in r is more than proportional to the change in PM. This can be seen in Figure 2.4 since xy/0y > vz/0z, where the former reflects the proportional change in r and the latter the proportional change in PM. Goods prices, factor prices and factor intensity linkages We can combine the analysis of Figures 2.12.4 to construct Figure 2.5, which shows the way in which resources (i.e. labour and capital), are allocated between the two sectors, food and manufactures, as well as the backward linkage to factor prices and the forward linkage to product prices.3
w/

3 These concepts are developed in KO (pp.6164 Resources and Output).

Food Manufactures (w/r)0

PF/ PM

(PF/PM)0

(KF/LF)0

(KM/LM)0

K/

Figure 2.5: Goods prices, factor prices and factor intensity linkages

The factor intensity curves in the right-hand half of Figure 2.5 reflect the choice of cost-minimising technique. In both sectors as wages rise relative to rental rates, producers substitute capital for labour (i.e. (Ki / Li) rise), but the capitallabour ratio of food is always lower than that of manufactures, reflecting the fact that food is the relatively labourintensive sector. In the left-hand half of Figure 2.5 the SS curve, which shows the relationship between goods prices and factor prices reflects the Stolper Samuelson theorem. Here, it is shown that the relative wage/land rent ratio rises when the relative food price (in terms of manufacturing) rises.

28

Chapter 2: The HeckscherOhlin model

Note The SS curve is drawn as a straight line in Figure 2.5. This need not be the case, and in general it will be non-linear, as in KO Figures 4-6 Factor Prices and Goods Prices and 4.7 From Goods Prices to Input Choices. As it stands, Figure 2.5 says nothing about the direction of causality between its components. The relationships illustrated are simply necessary consequences of the twin assumptions of cost minimisation and price equals average cost. However, if one of the elements is fixed, say the goods price ratio, then the mechanism of the SS curve and the sectoral factor-intensity curves determine the wagerental ratio and the choice of technique in the two sectors. If, instead, we held fixed the relative factor price ratio, then the SS curve determines the relative goods price ratio consistent with the assumptions of the model. The intuition for this follows from the fact that food is always more labour-intensive than manufacture, and hence, as the cost of labour rises relative to the cost of capital the unit cost of the labourintensive good (food) must rise relative to the land-intensive good (food). Activity In KO (p.58) it is said that a good cannot be both land- and labour-intensive. This should be qualified by the word simultaneously or at the same factor price ratio (w/r). At different factor price ratios it is possible for factor intensity to be reversed. As an exercise in the use of Figure 2.1, assume that at low (w/r), food is relatively labour-intensive but that at high (w/r) this is reversed, and food is relatively capital-intensive. Redraw Figure 2.1 to reflect this and consider the implications for Figure 2.5. In particular, what does the SS curve look like? What happens to the above-mentioned linkage between goods prices and factor prices? Factor endowments and production possibilities A second important tool of the HO model is the Edgeworth Box diagram (or box-diagram) see KO Figure 4-8 The Allocation of Resources (pp.6263). The box-diagram shows how a given endowment of resources, labour and capital, is allocated between sectors when the wagerental ratio (and implicitly also the goodsprice ratio) is given. An interesting and famous result employing the box-diagram concerns what happens to resource allocation and sectoral outputs when the factor endowment changes. KO Figure 4-9 An Increase in the Supply of Land illustrates the case where the supply of land (Note: KO use land and labour in their example, instead of labour and capital) is taken to increase. If goods prices (and hence factor prices also) are taken to be fixed, then KO Figure 4-9 An Increase in the Supply of Land shows that an increase in the endowment of land will lead to an increase in the output of the landintensive good and a decrease in the output of the capital intensive good. More generally, it can be shown that if the endowment of a factor increases (or decreases) then at unchanged goods prices, the output of good which uses that factor intensively will increase (or decrease) and the output of the other good will decrease (or increase). This result is known as the Rybczynski Theorem (RT). The Lerner diagram can be used to construct the Edgeworth box. Consider Figure 2.6, where E denotes the endowment point of this country (within the cone of diversification). Employment of labour and capital in the two sectors must sum to the total endowment in the economy if there is to be full employment. The factor input ratios determined by cost minimisation (through points M and F) facilitate the construction of the

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16 International economics

(KM/LM) E

A M
1/

(KF/LF)
PM

B F - w/r 0
Figure 2.6: The Lerner diagram
1/ PF

employment vectors in the two sectors by completing the parallelogram to E. Vector OA (employment in the manufacturing sector) plus vector AE (employment in the food sector) must equal OE, that is, must exhaust resource endowments in the economy.
E (KF/LF) A

(KM/LM)

Figure 2.7: From Lerner diagram to Edgeworth box

The employment vectors (from factor input ratios) can be transferred to the Edgeworth box, whose dimensions reflect the endowment of labour and capital in the economy, as illustrated in Figure 2.7. The Edgeworth box can be used to demonstrate the Rybczynski Theorem. Holding relative goods prices constant implies that relative factor prices and the factor input ratios are also fixed (from Figure 2.5). An increase in the endowment of, say, labour, expands the width of the box, as illustrated in Figure 2.8. With constant factor input ratios, it is straightforward to find the new allocation of labour and capital between the two sectors by extending employment vectors from the origin and the new endowment point E'. Comparing A with A' shows that there is more employment of both factors in the food sector, causing an expansion of the food sector, and less employment of both factors in the manufacturing sector, which causes the manufacturing sector to shrink. This demonstrates the Rybczynski Theorem.

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Chapter 2: The HeckscherOhlin model

E (KF/LF) A A' (KM/LM)

E'

0 L
Figure 2.8: The Rybczynski Theorem

Note: The Rybczynski Theorem is useful for evaluating the effects of an endowment change in a small, open economy, for which it is plausible to assume the country faces constant relative world prices. By contrast, endowment changes in large, open economies endogenously impact on relative world prices, so the RT cannot be applied to these. The box-diagram can also be used to derive a countrys production possibility curve. It is then possible to see that if the endowment of a factor grows, its production possibility curve will be shifted outward in a manner that is biased towards the good which uses the growing factor intensively.4 This is of interest in its own right but can also be used to compare production possibilities of different countries with different factor endowments. Thus a country which is overall relatively well-endowed with labour as compared with another country will possess a production possibility curve which is biased towards food, the labour-intensive good. This is illustrated in Figure 2.9 below, where two production possibility curves are depicted. As Home is capital-abundant relative to Foreign,
Food

See Note KO (pp.6364) and Figure 4-10 Resources and Production Possibilities.

Foreign PPF

Home PPF

0
Figure 2.9: Biased production possibilities

Manufactures

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16 International economics

its PPF is biased towards manufactures, while the Foreign PPF is biased towards cloth. Activity Using Figure 2.9 show that at the same relative goods prices the labour-abundant country will produce a larger quantity of food relative to manufactures. Hence show that the labour-abundant countrys relative supply curve of food lies below the relative supply curve of the capital-abundant country (Hint: see the example in KO with food and cloth and examine KO Figures 4-10 Resources and Production Possibilities and 4-11 Trade Leads to a Convergence of Relative Prices.)

Trade, income distribution and factor price equalisation

The pattern of trade The impact of trade in the HO model may be analysed by first considering what prices would be in the two countries in the absence of trade (i.e. pre-trade or autarky prices). For this we need to make some assumptions about demand conditions in the two countries. Usually it is assumed that demand conditions are similar in the two countries but for easy exposition it is convenient to assume that they are identical. This may be represented in the KO framework as identical relative demand curves and the same pattern of indifference curves in the PPF diagram. It is then easy to see from Figure 2.10 below that the autarky relative price of manufactures will be low in the capital-abundant Home country while the relative price of food will be low in the labour-abundant Foreign country. Accordingly, the labour-abundant country will find it profitable to export food, while the capital-abundant country will find it advantageous to export manufactures. Trade will tend to equalise goods prices in the two countries, thereby raising the price of food in the labour abundant country and raising the relative price of manufactures in the capital-abundant country. As a consequence, in the trading equilibrium, Home will be more specialised in manufactures than in autarky (production moves from A to B with trade); and similarly, Foreign will be more specialised in food than in autarky (production moves from A' to B' with trade). These arguments can be summarised thus: a country will tend to specialise and export those goods that intensively use the factor with which it
Food Home (PM/PF)W (PM/PF)H C A IFT IA B (PM/ 0 Manufactures 0
F PF)

Food Foreign

B' A'

C' IFT IA (PM/PF)W Manufactures

Figure 2.10: Autarky and free trade equilibrium

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Chapter 2: The HeckscherOhlin model

is abundantly endowed. This proposition is sometimes known as the HeckscherOhlin theorem and represents a core insight of the HO model, namely that when technology is internationally identical it is differences in relative resource endowments that are the origin of differences in relative costs and hence of comparative advantage. Income distribution and factor price equalisation Figure 2.11 below reproduces the SS curve from the left-hand segment of Figure 2.5. If Home and Foreign have access to the same technology then they will have the same SS-curve, but capital-abundant Home has a higher autarky relative wage and a higher relative price of food than Foreign.
PM/ PF

S (PF/PM)H (PF/PM)W (PF/PM)F

S 0
w/ r

(w/r)F

(w/r)W

(w/r)H

Figure 2.11: Goods and factor price equalisation

Activity Explain why identical technology for both goods in both countries implies that the SScurve is the same in both countries. Free trade in goods will equalise goods prices in the two countries at, say, (PF/PM)W, which from Figure 2.11 we see must also equalise factor prices at (w/r)W. This is a remarkable result and is known as the Factor Price Equalisation theorem. It shows that trade in goods can act as a complete substitute for the international mobility of factors; that trade in goods represents an implicit trade in factors of production. Activity In the real world factor prices are clearly not internationally equalised.5 What are the empirical and the theoretical reasons why factor price equalisation might fail? (Hint: when considering theoretical reasons investigate what happens to the SS curve when the strong factor-intensity condition fails to hold.) From Figure 2.11 you can also see that in the labour-abundant country, trade has the effect of raising the wagerental rate ratio, and in the capital-abundant country trade has the effect of lowering the wagerental rate ratio. This links back to the StolperSamuelson theorem discussed earlier in the chapter.6
5

See the discussion in KO (pp.6872 Factor Price Equalization and Trade and Income Distribution in the Short Run).

6 See KO (pp.8687 Goods, Prices and Factor Prices).

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Empirical evidence
The hypothesis of the HeckscherOhlin theorem that countries tend to export goods that use their abundant factors intensively, has been one of the most tested hypotheses in the whole of economics. The most famous test of the HeckscherOhlin theorem was undertaken by Leontief and was published in 1953. Leontief found that US exports appeared to be more labour-intensive than US imports. This result appeared to contradict the intuition that the US was a capital-abundant country relative to the rest of the world and quickly became known as the Leontief paradox. Subsequently, the Leontief tests and other variants have been widely repeated for a number of countries with, at best, mixed results.7 On the basis of such results, one must conclude that despite the analytical attraction of the HO model, relative factor endowments represent a weak or partial explanation of the observed commodity composition of international trade. Activity For your own country or region, identify the main import and export commodities. How far does the HO model provide an explanation for this trade?
7 For a discussion see KO (pp.7581 Empirical Evidence on the Heckscher-Ohlin Model).

A reminder of your learning outcomes

On completion of this chapter and having done the relevant readings and activities, you should be able to: H[SODLQ WKH VKDSH RI WKH SURGXFWLRQ SRVVLELOLW\ IURQWLHU ZLWK WZR IDFWRUV of production H[SODLQ KRZ GLIIHUHQFHV LQ IDFWRU HQGRZPHQWV FDQ SURYLGH D EDVLV IRU international trade H[SODLQ ZK\ WUDGH FDQ KDYH SURIRXQG HIIHFWV RQ LQFRPH GLVWULEXWLRQ H[SODLQ WKH GLUHFWLRQ RI LQFRPH GLVWULEXWLRQ HIIHFWV QDPHO\ WKDW WUDGH benefits a countrys abundant factor and worsens the real income of the scarce factor H[SODLQ WKH HIIHFW RI FKDQJHG IDFWRU HQGRZPHQWV RQ VHFWRUDO RXWSXWV H[SODLQ WKH OLPLWDWLRQV RI WKH +2 PRGHO DV DQ HPSLULFDO K\SRWKHVLV about the commodity composition of trade.

Sample examination questions

1. Suppose a country is labour-abundant (there are two factors of production labour and capital) and its trade ministry imposes an import tariff. This will hurt its domestic capitalists and benefit its workers. (You must answer true, false or uncertain and justify your answer in a few lines. An unsupported answer would receive no marks.) 2. Is the Leontief paradox paradoxical?

Guidance on answering sample examination question 1

This is a straightforward application of the StolperSamuelson theorem which shows that opening up trade will benefit the abundant factor and hurt the scarce factor. Imposing a tariff reduces trade and hence will work in the opposite direction (i.e. the scarce factor will benefit and the abundant factor will be hurt.) Thus the statement of the question is clearly false.

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