The Heckscher-Ohlin Model

Udayan Roy
http://myweb.liu.edu/~uroy/eco41
October 2009
BASIC ASSUMPTIONS
The Heckscher-Ohlin Assumptions—
Basics
• There are
– two countries, Home and Foreign
– two goods, Cloth and Food, and
– two resources, Labor and Land
• these are used to produce Cloth and Food
The Heckscher-Ohlin Assumptions—
Preferences
• The preferences of all consumers in the world are
identical.
• The preferences of any individual are such that the
Marginal Rate of Substitution is independent of the scale
of consumption.
– The MRS of Wine for Cheese is the additional amount of Wine
that would keep the individual's level of happiness unchanged
even after the consumption of Cheese is reduced by one unit.
Under this assumption, if the amounts of Cheese and Wine being
consumed are, say, doubled, then the MRS remains unchanged. In
other words, the MRS does not change if the ratio of the amounts
of Cheese and Wine consumed, Cheese/ Wine, does not change.
 The Ricardian Assumptions—
Preferences
• The preferences of all consumers in the world are
identical.
• For any individual, the Marginal Rate of Substitution
is independent of the scale of consumption.
– An individual’s MRS of wine for cheese is the maximum
amount of wine that he/she would be willing to pay for
one unit of cheese.
– Under this assumption, if the amounts of Cheese and Wine
being consumed are, say, doubled, then the MRS remains
unchanged.
– In other words, the MRS does not change if the ratio of the
amounts of Cheese and Wine consumed, Cheese/ Wine,
does not change.
 Marginal Rate of Substitution
Cheese Wine Cheese- MRSWC
consumed consumed Wine Ratio
(C) (W) (C/W)
10 20 0.5 2
600 1200 0.5 2
10 5 2 1.6
The Heckscher-Ohlin Assumptions—
Markets
• All markets are perfectly competitive.
– That is, no buyer or seller of a commodity has the
power to affect the price of the commodity by himself.
– More specifically, the market for a commodity is said
to be perfectly competitive if:
• There are many sellers
• There are many buyers
• All sellers sell the exact same product
• Individuals make decisions so as to maximize
happiness, whereas
• Firms make decisions so as to maximize profits
The Heckscher-Ohlin Assumptions—
Governments
• Governments do not interfere with the
smooth functioning of markets
– There are no taxes, subsidies, tariffs, quotas,
etc.
• However, although there is free trade in
goods and services, there is no cross-border
movement of resources, such as labor
The Heckscher-Ohlin Assumptions—
Technology
• Technological knowledge is the same in both
countries
• Goods are produced (with land and labor)
using technologies that satisfy Constant
Returns to Scale.
– That is, if the producer of a commodity, say,
doubles the amounts used of all resources, then
the amount produced will have to double also.
The Heckscher-Ohlin Assumptions—
Factor Abundance
• Home has a higher ratio of labor to land than
Foreign does.
– That is, if TH, TF, LH, and LF denote the amounts of T
(land or territory) and L (labor) that Home and Foreign
are endowed with, then LH / TH > LF/ TF.
– L/T may be informally interpreted as the number of
workers per acre of land.
– Home is said to be the “labor-abundant” country and
Foreign is the “land-abundant” country.
The Heckscher-Ohlin Assumptions—
Factor Intensities
• The production of food is land-intensive
and the production of cloth is labor-
intensive
– That is, the number of workers per acre (L/T) is
always higher in cloth production than in food
production
 Prices of Goods
• Let PC and PF denote the nominal prices of
cloth and food.
• Then, PC/PF is the relative price of cloth (in
units of food) and
• PF/PC is the relative price of food (in units of
cloth)
– See earlier lecture
 Prices of Factors
• Let w be the nominal price (or, wage) of labor.
• Let r be the nominal price (or, rent) of land
• Then w/r is the relative price of labor (in units of
land) and
• r/w is the relative price of land (in units of labor)
– Example: If w = $10 per hour for one worker and r =
$100 per hour for one acre of land, then the relative
wage for one worker is 1/10 acres of land and the
relative rent on an acre of land is 10 hours of labor.
 Nominal Prices
• The nominal price of a commodity is simply
the number of dollars (or any other
relevant unit of account) that must be paid
to buy one unit of the commodity
• For example, the nominal price of labor—
also called the nominal wage—may be $8
per hour
 Real Prices
• The real price of commodity X, in units of
commodity Y, is the amount of Y that costs
the same as one unit of X
• For example, if the nominal price of labor is
$8 per hour and the nominal price of a cup
of coffee is $2, then the real price of labor
is 4 cups of coffee per hour
• Real prices are also called relative prices
 Real and Nominal Prices
• Real Price of X, in units of Y, is equal to
Nominal Price of X / Nominal Price of Y
• So, if w is the nominal wage and P is the
nominal price of a cup of coffee, then the
real wage is w / P.
• For example, if w is $8 per hour and P is $2,
then the real wage is w / P = 8/2 = 4 cups of
coffee per hour, as in the previous slide.
Figure 4-6: Factor Prices and Goods
Prices
As labor becomes more
Relative expensive relative to
price of
land, cloth, which is
cloth,
PC/PF
labor-intensive in
FPGP
production, finds itself
at a disadvantage and
becomes relatively
17
more expensive
compared to food

As both Home and

Foreign use the same
technologies, the same
5 Wage-rent FPGP curve is applicable
ratio, w/r in both countries
Figure 4-6: Factor Prices and Goods
Prices
Under free trade, the
Relative relative price of cloth
price of
will be the same in both
cloth,
PC/PF
countries
FPGP
Therefore, the wage-
rent ratio will also be
17 the same in the two
countries

5 Wage-rent
ratio, w/r
 Figure 4-5: Factor Prices and Input
Choices
As labor becomes
Cloth relatively more
Wage-rent production expensive, relatively
ratio, w/r Food more land is used in
production
production…

… of both food and

cloth

But the number of acres

5
of land per worker is
always higher in food
production, reflecting
the assumption that
4 Acres of food production is land
12
Land per intensive
worker, T/L
 Figure 4-5: Factor Prices and Input
Choices
As both Home and
Foreign use the same
Cloth
Wage-rent technologies, these two
production
ratio, w/r Food curves must be true in
production both countries.

As free trade equalizes the

wage-rent ratio worldwide,
acres of land per worker in
cloth production must be the
5
same worldwide.
Same must be true for food
production.
Therefore, Foreign, which has
4 12 Acres of
Land per more land per worker than
worker, T/L Home, must produce relatively
more food …
 Figure 4-11: Relative Supplies
In Figure 4-5, we saw that
at w/r = 5, Foreign must
RSFOREIGN produce relatively more
Relative
price of food and Home must
RSHOME
cloth, produce relatively more
PC/PF cloth.
In Figure 4-6 we saw that
w/r =5 corresponds to PC/PF
17
= 17.
Therefore, Home must
produce relatively more
cloth at PC/PF = 17, or
indeed at any other relative
price.
Yards of cloth produced
As cloth becomes more expensive relative to per calorie of food
food, the output of cloth will increase relative produced, QC/QF
to food, Therefore, the relative supply curves
slope upward.
 Figure 4-11: Relative Demand
The H-O assumptions
about preferences imply
Relative that that consumer
price of
behavior can be
cloth,
PC/PF summarized by this
Relative Demand curve
and that the same curve is
17 true in both Home and
Foreign

3 Yards of cloth consumed

In this figure, when the price of a yard of cloth is 17 times per calorie of food
the price of a calorie of food, the number of yards of consumed, QC/QF
cloth consumed is 3 times the number of calories of food
consumed, for every individual worldwide. Why isn’t the
latter ratio different for different people?
 Relative Demands
• Let’s say that Alex consumes 3 times as
many yards of cloth as calories of food
(relative demand is QC/QF = 3) when a yard
of cloth is 17 times as expensive as a calorie
of food (relative price PC/PF = 17)
• If Alex’s income changes, his relative
demand should not change because MRS is
independent of the scale of consumption
 Relative Demands
• Since identical preferences have been assumed, if
the relative price of cloth is PC/PF = 17, then
Betty’s relative demand must also be QC/QF = 3
irrespective of Betty’s income
• Therefore, the same relative demand curve
represents everybody
• Therefore, the same relative demand curve
represents both Home and Foreign
 Figure 4-11: Relative Supplies and
Demands
• The relative supplies
and demands can be
combined to find the
RSFOREIGN autarky relative prices
Relative in Home and Foreign
price of RSHOME
cloth, • Clearly, they are
PC/PF different
• Therefore, trade will
occur if it is allowed
• Since Home and
Foreign Foreign differ only in
their relative factor
endowments, that
Home RD difference must be the
reason why trade
occurs
Yards of cloth
produced per calorie
of food produced,
QC/QF
 Who will export what?
• In autarky, the labor- PC/PF
intensive good is relatively
cheaper in the labor-
abundant country Foreign
autarky
• Therefore, under free
Free
trade, the labor-intensive Trade
good is exported by the Home
labor-abundant country…
• … and the land-intensive
Foreign : land abundant, labor scarce
good is exported by the Home: land scarce, labor abundant
land-abundant country Cloth: labor intensive production
Food: land intensive production
 The Heckscher-Ohlin Theorem
• To repeat, when trade occurs, the labor-abundant
country (Home) exports the labor-intensive good
(cloth) and
• The land-abundant country (Foreign) exports the
land-intensive good (food)
• In general, each country exports the good that
makes intensive use of the resource that is
abundant in that country
• This is called the Heckscher-Ohlin Theorem
– See the section “Relative Prices and the Pattern of
Trade” in chapter 4 of the textbook
 Goods Prices: from autarky to free
trade
• In autarky, the labor- PC/PF
intensive good is relatively
cheaper in the labor-
abundant country Foreign
• Free trade makes relative autarky

prices equal everywhere Free

• Therefore, the labor- Trade
Home
intensive good becomes
more expensive in the
labor-abundant country,
Foreign : land abundant, labor scarce
and less expensive in the Home: land scarce, labor abundant
labor-scarce country. Cloth: labor intensive production
Food: land intensive production
 Figure 4-6: Factor Prices and Goods
Prices
Fig. 4-11 showed that, in
Relative autarky, the relative
price of
price of cloth is higher in
cloth,
PC/PF
Foreign
FPGP
Therefore, in autarky,
the wage-rent ratio
Foreign must also be higher in
Foreign
Free Trade
Free trade makes the
Home wage-rent ratio the
same in the two
countries

Home Foreign Wage-rent

ratio, w/r
Free Trade
 Factor Prices: from autarky to free
trade
PC/PF w/r
• In autarky, the wage-rent
ratio is higher in the labor-
scarce country and lower in Foreign
autarky
the labor-abundant country
• When autarky ends and free Free
trade begins, the wage-rent Trade
Home
ratio falls in the labor-scarce
country and rises in the
labor abundant country Foreign : land abundant, labor scarce
Home: land scarce, labor abundant
Cloth: labor intensive production
Food: land intensive production
WHO GAINS AND WHO LOSES
FROM GLOBALIZATION?
 Real Wage and Real Rent

w Nominal wage: currency earned per hour of a worker’s labor

w/PC Real wage: yards of cloth purchasable with the nominal wage
w/PF Real wage: calories of food purchasable with the nominal wage
r Nominal rent: currency earned per hour per acre of land
r/PC Real rent: yards of cloth purchasable with the nominal rent
r/PF Real rent: calories of food purchasable with the nominal rent
 Marginal Product of a Resource
• The Marginal Product (MP) of labor in cloth
production is the additional amount of
cloth that would be produced if an
additional unit of labor is employed
– We can similarly define
• Marginal Product of labor in food production,
• Marginal Product of land in cloth production, and
• Marginal Product of land in food production
 Marginal Product of a Resource
• See page Figure 7-2 of the textbook for
more on the Marginal Product.
 Example: Level of Resource Use
• Suppose an additional worker produces an
additional 5 yards of cloth in one hour’s work.
Then MP = 5.
– See page Figure 7-2 of the textbook for more on
the Marginal Product.
• Therefore, to make one additional yard of
cloth, you need only 1/5 of a worker.
• In general, the labor needed to make one unit
of cloth can be calculated as 1/MP
• Marginal Cost is the additional cost of an
additional unit of output
• Therefore, MC = w × (1/MP) = w/MP
 Price = Marginal Cost
• If P > MC at the current level of production,
additional production would increase profit
• If P < MC at the current level of production,
reduced production would increase profit
• Therefore, profit is maximized only if P = MC
• Therefore, if a good is being produced, P = MC
must be true
 Real Wage and Real Rent
• Therefore, P = MC = w / MP w
• Therefore, w/P = MP  MPLC
• This implies that the real wage in
units of, say, cloth is the Marginal
PC
Product of labor in the
production of cloth
r
• Similarly, the real rent in units of
 MPTF
food is the Marginal Product of
land in food production PF
 Real Factor Rewards and
Productivity
• In general, the real payment to a resource
is equal to its productivity (or, marginal
product)
– This is the main conclusion of the Marginal
Productivity Theory of Income Distribution
 Factor Use and Factor Productivity—
Labor-Abundant Country
Cloth
Wage-rent production
ratio, w/r Food
• We saw earlier that when production
autarky ends and free trade
begins w/r rises in the labor- Foreign
abundant country (Home).
Therefore, Free trade
• More land is used per worker
– in cloth production and in
food production Home
• This makes labor more
productive…
• …and land less productive
• Therefore,
• w/PC and w/PF both increase, and Acres of
• r/PC and r/PF both decrease. Land per
• Abundant resource Foreign : land abundant, labor scarce worker, T/L
benefits from globalization Home: land scarce, labor abundant
• Scarce resource loses Cloth: labor intensive production
Food: land intensive production
 Factor Use and Factor Productivity—
Land-Abundant Country
Cloth
Wage-rent production
ratio, w/r Food
• When autarky ends and free production
trade begins w/r falls in the
land-abundant country Foreign
(Foreign). Therefore,
• Less land is used per worker Free trade
– in cloth production and in
food production
• This makes labor less Home

productive…
• …and land more productive
• Therefore,
• w/PC and w/PF both decrease, and
• r/PC and r/PF both increase. Acres of
• Abundant resource Land per
benefits from Foreign : land abundant, labor scarce worker, T/L
globalization Home: land scarce, labor abundant
• Scarce resource loses Cloth: labor intensive production
Food: land intensive production
 Trade: Who Gains and Who Loses?
• In short, each country’s abundant resource
benefits from trade and
• Each country’s scarce resource loses from
trade
 Factor Price Equalization
Cloth
• Free trade equalizes Wage-rent production
the wage-rent ratio ratio, w/r Food
• Therefore, the land- production
per-worker ratio in
cloth production is Foreign, autarky
also equalized
• This equalizes the Free trade
productivity of labor
in cloth production Home, autarky
in the two countries
• This equalizes w/PC
in the two countries
• In a similar way,
w/PF, r/PC, and r/PF Acres of
each become Land per
equalized worldwide Foreign : land abundant, labor scarce worker, T/L
Home: land scarce, labor abundant
Cloth: labor intensive production
Food: land intensive production
 Factor Price Equalization Theorem
• The Factor Price Equalization Theorem:
When there is free trade in goods, the real
reward for any resource (in units of either
good) becomes the same in both
countries!
– An implication of this result is that if there is
free trade in goods, resources will have no
incentive to move from one country to another
 Factor Price Equalization Theorem
• Heckscher-Ohlin theory implies FPE.
• But does FPE imply that free trade will
make everybody equally rich?
• Certainly not!
– Not every individual is endowed with the same
amount of resources
How accurate is the Heckscher-Ohlin
theory?
• Sadly, it’s not very accurate by itself
– It explains North-South trade quite well…
– But not trade within the North
• But, if modified to take cross-country
differences in technology into account, it
fits the data well
• So, a theory that combines the insights of
Ricardo and Heckscher-Ohlin might be best
The contribution of Heckscher-Ohlin
theory
• The theory’s main contribution is to point
out that cross-country differences in
relative resource availability can explain
trade
• It does not claim that differences in relative
resource availability are the only reason
why trade occurs
 We’re Done!
• Any questions or comments?