ECON7530

Lecture 4
Resources and Trade:
The Heckscher-Ohlin Model (Part 1)
Nhan Phan
UQ School of Economics
Week 4: Get ready for assessment!
Student Services guide to a successful semester

Prepare for your upcoming assessment and mid semester exams

• Learn effective study skills and preparation tools Learning Advisers

• Improve your memory retention skills

• And build your confidence doing assessment and exams

To do: Investigate how Learning Advisers and their resources can help with
your assessment.

Census date is an important date for students to be aware of:

• Census date is the last date to drop courses or cancel enrolment without
financial liability. For most students Census Date is 31 August.

To do: Make sure you are happy with your current courses, and if you are unsure
about them connect with your faculty to discuss changing or dropping courses.

2
Last Week – Summary
• Countries export goods in which they have a comparative advantage –
high productivity or low wages give countries a cost advantage.
• With trade, the relative price settles in between what the relative prices were
in each country before trade.
• Trade benefits all countries due to the relative price of the exported
good rising.
• Empirical evidence supports trade based on comparative advantage
• Although transportation costs and other factors prevent complete
specialization in production.
• In addition, in reality, there are multiple factors of production – PPF is not
linear
Learning Objectives
• Explain how differences in resources generate a specific pattern of
trade.
• Discuss why the gains from trade will not be equally spread even in
the long run and identify the likely winners and losers.
Introduction
• In the Ricardian Model, mutually beneficial trade occurs due to
differences in labour productivity between countries.
• The Heckscher-Ohlin theory argues that trade occurs due to
differences in labour, labour skills, physical capital, capital, or other
factors of production across countries.
The Comparative Advantage arises from the interaction of
• Different relative abundance of factors of production between
countries.
• Production processes use factors of production with different relative
intensity.
UQ Extend – The Heckscher-Ohlin (HO) Model
Also called a 2x2x2 model
1. Two countries
2. Two goods
3. Two factors of production: (most commonly) labour and capital.
4. The mix of labour and capital used varies across goods.
5. The supply of labour and capital in each country is constant and
varies across countries.
6. In the long run, both labour and capital can move across sectors,
equalizing their returns (wage and rental rate) across sectors.
Production Possibilities
Due to having more than one factor of production:
• The opportunity cost in production is no longer constant
• The PPF is no longer a straight line.
• Concave to the origin: increasing marginal opportunity cost
UQ Extend – Example
• Two countries: Home and Foreign.
• Two goods: Cloth and Food.
• Two factors of production: Labour and Capital.
Suppose using a fixed mix of capital and labour in each sector:
• 𝑎𝐾𝐶 = 2: capital used to produce one meter of cloth
• 𝑎𝐿𝐶 = 2: labour used to produce one meter of cloth
• 𝑎𝐾𝐹 = 3: capital used to produce one kg of food
• 𝑎𝐿𝐹 = 1: labour used to produce one kg of food
• No factor substitution.
UQ Extend – Example
Production possibilities describe different amounts of cloth and food
that can be produced, given factor endowments and technology.
Notations:
• 𝐾 = 3000: total amount of capital available for production in Home
• 𝐿 = 2000: total amount of labour available for production in Home
• 𝑄𝐶 : total cloth production (in meters)
• 𝑄𝐹 : total food production (in kgs)
UQ Extend – Constraints
Production possibilities are influenced by both capital and labour
• Capital used to produce cloth and food cannot exceed the supply of
capital available.
𝑎𝐾𝐶 𝑄𝐶 + 𝑎𝐾𝐹 𝑄𝐹 ≤ 𝐾
• In our example: 2𝑄𝐶 + 3𝑄𝐹 ≤ 3000
• Likewise, the labour used to produce cloth and food cannot exceed
the supply of labour available.
𝑎𝐿𝐶 𝑄𝐶 + 𝑎𝐿𝐹 𝑄𝐹 ≤ 𝐿
• In our example: 2𝑄𝐶 + 𝑄𝐹 ≤ 2000
UQ Extend –Production Possibilities
• The economy must produce
subject to both constraints.
• Without factor substitution, the
production possibilities frontier is
the interior of the two factor
constraints.
• The production possibility
frontier is defined by the red line
in this figure.
UQ Extend – Production Possibilities
• The opportunity cost of producing one more meter of cloth, in terms
of food, is not constant. When the economy produces
2
• low amount of cloth & high amount of food: 𝑂𝐶𝐶 =
3
• high amount of cloth & low amount of food: 𝑂𝐶𝐶 = 2
• When the economy devotes more resources towards production of
one good, the marginal productivity of those resources tends to be
low so that the opportunity cost is high.
Extension
• No factor substitution: The PPF before
does not allow substitution of capital
for labour in production.
• Unit factor requirements are constant
along each line segment of the PPF.
• If producers can substitute one input
for another in the production process,
the PPF is concave to the origin.
• Still, opportunity cost of cloth increases
as producers make more cloth.
Mixing of Inputs – Relative Factors
• Producers may choose different amounts of factors of production
used to make cloth or food.
• We allow for factor substitution here
• To produce 1 cloth, you don’t exactly need 2 labour & 2 capital
• You can produce with 3 labour & 1 capital, or 1 labour & 4 capital
• The choice depends on:
• The wage, 𝑤, paid to labour.
• The rental rate, 𝑟, paid when renting capital.
 Factor Substitution – Does It Make Sense?

Source: Wikimedia
Input Possibilities in Food Production
• As the wage 𝑤 increases relative
to the rental rate 𝑟, producers
use less labour and more capital
in the production of both food
and cloth.
Production Possibilities
• The economy produces at the point that maximizes the value of
production, 𝑉.
• An isovalue line is represents a constant value of production, 𝑉:
𝑉 = 𝑃𝐶 𝑄𝐶 + 𝑃𝐹 𝑄𝐹
• 𝑃𝐶 : price of cloth
• 𝑃𝐹 : price of food
𝑃𝐶
• The slope of the isovalue line is −
𝑃𝐹
Production Possibilities
• Given the relative price of cloth,
the economy produces at the point
that touches the highest possible
isovalue line.
• The isovalue line is tangent to the PPF
𝑃𝐶
• At that point: 𝑂𝐶𝐶 =
𝑃𝐹

• The trade-off in production equals

the trade-off according to market
prices.
UQ Extend
Mixing of Inputs – Relative Factors
• Assume that at any given factor prices,
cloth production uses more labour relative
to capital than food production uses:
𝑎𝐿𝐶 𝑎𝐿𝐹 𝐿𝐶 𝐿𝐹
> 𝑜𝑟 >
𝑎𝐾𝐶 𝑎𝐾𝐹 𝐾𝐶 𝐾𝐹
• We say production of cloth is relatively
labour intensive.
• Production of food is relatively capital
intensive.
• Relative factor demand curve for cloth 𝐶𝐶
lies outside that for food 𝐹𝐹.
UQ Extend – Factor Prices and Goods Prices
• In competitive markets, the price of a
good should equal its cost of production,
which depends on the factor prices.
• How changes in the wage and rent affect
the cost of producing a good depends on
the mix of factors used.
𝑤 𝑃𝐶
• Changes in are tied to changes in .
𝑟 𝑃𝑊
• An increase in the rental rate of capital
should affect the price of food more than
the price of cloth since food is the capital
intensive industry.
 The Two Graphs

Tying these two graphs together, and we have the Stolper-Samuelson theorem
UQ Extend – Stolper-Samuelson Theorem
If the relative price of a good increases, then:
• the real wage or rental rate of the factor used intensively in the
production of that good increases,
• the real wage or rental rate of the other factor decreases.
Any change in the relative price of goods alters the distribution of
income.
UQ Extend – Stolper-Samuelson Theorem:
From Goods Prices to Input Choices
UQ Extend – Stolper-Samuelson Theorem
What does the theorem imply?
𝑃𝐶
An increase in the relative price of cloth is predicted to:
𝑃𝐹
𝑤
• Increase income of workers relative to that of capital owners
𝑟
𝐾
• Increase the ratio of capital to labour services used in both
𝐿
industries.
• Increase the real income (purchasing power) of workers
• Lower the real income of capital owners
Stolper-Samuelson Theorem
& Purchasing Power
𝑃𝐶 𝐾
• Suppose increases, from the theorem, this implies increases
𝑃𝐹 𝐿
• Factors of production are paid their marginal products.
• When the ratio of labour to capital falls in one good, the marginal product of
labour in terms of that good increases.
This applies to both goods
• Workers find their real wages higher in terms of both goods.
• In contrast, capital owners find their real wages lower in terms of
both goods.
UQ Extend – Resources and Output
• Before, we learn what happens when relative price changes.
• Another question: How do levels of output change when the
economy’s resources change?
• Rybczynski theorem: If you 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.
UQ Extend – Rybczynski theorem
• Assume an economy’s labour force
grows, implying its ratio of labour to
capital 𝐿Τ𝐾 increases.
• Expansion of production possibilities is
biased toward cloth.
• Note the relative price of cloth does
not change
• The ratio of labour to capital used in both
sectors remains constant.
• Food production declines
Resources and Output
• Implication of the Rybczynski theorem: everything else held constant,
an economy with a high ratio of labour to capital produces a high
output of cloth relative to food.
• Now, suppose Home is relatively abundant in labour and Foreign in
capital:
𝐿 𝐿∗
> ∗
𝐾 𝐾
• Likewise, Home is relatively scarce in capital and Foreign in labour.
• Home will be relatively efficient at producing cloth because cloth is
relatively labour intensive.
Resources and Output
• Following the intuition from the Ricardian model, we can easily
imagine what happens when countries start trading
• Namely, Home is more efficient in producing cloth, so it should export
cloth
• Similarly, Foreign should export food
• But for a more detailed analysis, and practical application, we leave
that to next week!
Summary
• Substitution of factors used in the production process generates a
curved PPF.
• When an economy produces a low quantity of a good, the opportunity cost of
producing that good is low.
• When an economy produces a high quantity of a good, the opportunity cost
of producing that good is high.
• When an economy produces the most value it can from its resources,
the opportunity cost of producing a good equals the relative price of
that good in markets.
Summary
• An increase in the relative price of a good causes
• the real wage or real rental rate of the factor used intensively in the
production of that good to increase,
• while the real wage and real rental rates of other factors of production
decrease.
• 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 increases, and the supply of the other good
decreases.