RICARDIAN MODEL OF TRADE,

SPECIFIC FACTOR MODEL ,

HECKSCHER-OHLIN MODEL

INTERNATIONAL
ECONOMICS

PRESENTED BY –
ISHA BHARDWAJ
(F-2020-04-M)
 INTERNATIONAL TRADE
THEORIES
 Firsttheory of trade was given by Adam Smith. He gave
the Absolute Advantage Model.

 David Ricardio gave a refined version of this model

called Comparative Advantage Model. This model is also
known as Ricardian Model of Trade.

These two theories together are known as

Classical Theory of Trade.

 Modern Theory of International Trade was given by

Heckscher and Ohlin. This model is known as H-O Model
of Trade.
 ABSOLUTE ADVANTAGE MODEL
 According to Adam Smith, trade between two nations is
based on absolute advantage.
 When one nation is more efficient than (or has an absolute
advantage over) another in the production of one commodity
but is less efficient than (or has an absolute disadvantage
with respect to) the other nation in producing a second
commodity, then both nations can gain by each specializing
in the production of the commodity of its absolute advantage
and exchanging part of its output with the other nation for the
commodity of its absolute disadvantage.
 Bythis process, resources are utilized in the most efficient
way and the output of both commodities will rise.
 EXAMPLE -
 Consider
two countries Malaysia & India, producing
two goods Rubber and Textile.

Malaysia can produce 10 India can produce 5 Rubber

Rubber per hour or 5 per hour or 10 Textile per
Textile per hour, with the hour, with the given set of
given set of resources. resources.

 Thus, Malaysia is more efficient than, or has an absolute

advantage over, India for the production of Rubber.
Whereas India is more efficient than, or has an absolute
advantage over, Malaysia in the production of Textile.
With trade, Malaysia would specialize in the production
of rubber and vice versa.
 COMPARATIVE ADVANTAGE
MODEL
 According to the law of comparative advantage, even if
one nation is less efficient than (has an absolute
disadvantage with respect to) the other nation in the
production of both commodities, there is still a basis for
mutually beneficial trade.
 It is a one factor model where only one factor of
production is considered i.e., Labor.
 Comparative advantage – The ability of a country to
produce a product at a lower opportunity cost than other
countries.
 Opportunity Cost - The opportunity cost of a good A is

defined as the amount of another good, i.e. B, that has to

be given up in order to produce an additional unit of A.
ASSUMPTIONS -
 There are two countries in account, India and
Malaysia.
 There are two commodities in consideration, Cheese

and Wine.
 Labor is the only factor of production.

 Labor productivity in each country is constant.

 Supply of labor in each country is constant.

Note –
A country has comparative advantage in producing a
good if the opportunity cost of producing that good is
lower in the country than it is in the other country.
 EXAMPLE -
Country Labor cost of Opportunity cost of
production (in production
hours)
1 unit of 1 unit of 1 unit of 1 unit of
wine cheese wine cheese
India 80 100 80/100 = 0.8 100/80 = 1.25
Malaysia 50 90 50/90 = 0.55 90/50 = 1.8

It is clear from the table that Malaysia has an absolute

advantage over India for both the commodities.
Malaysia has the lower opportunity cost of the two countries in
producing wine (0.55 as compared to India’s 0.8)' while India
has the lower opportunity cost in producing cheese (1.25 as
compared to Malaysia’s 1.8).
CONT….
 Therefore,Malaysia has a comparative advantage in the
production of wine and India has a comparative
advantage in the production of cheese.
 In other terms it can be explained as –

Malaysia has more comparative advantage in the

production of wine as compared to India (50 units of labor
cost compared to 80 units of labor cost), whereas India
has less comparative disadvantage as compare to
Malaysia (100 units of labor cost as compared to 90 units
of labor cost, the difference is only of 10, whereas in the
above case the difference was of 30, that means more
comparative disadvantage).
 This theory suggests that a country should specialize in
production and export of those goods, in the production
of which the comparative advantage is more or
comparative disadvantage is less. Import of those
goods is done in which comparative advantage is less
or comparative disadvantage is more.
 In this case, India will specialize in production and

export of cheese as it has less comparative

disadvantage. It will import wine due to more
comparative disadvantage.
 Malaysia will specialize in the production and export of

wine has it has more comparative advantage. It will

import cheese due to less comparative advantage.
 ONE FACTOR ECONOMY
Let there be a home country producing two commodities
cheese and wine.
Suppose,
 Qc: Quantity of cheese produced.
 Qw: Quantity of wine produced.
 L: Quantity of labor available.
Assume, per unit labor requirement for cheese production
and wine production are constant.
 aLc : Labor time required to produce 1 unit of cheese.
 aLw: Labor time required to produce 1 unit of wine.
 aLc.Qc – Labor time required to produce Qc units of
cheese.
 aLw.Qw – Labor time required to produce Qw units of
wine.
 aLc.Qc + aLw.Qw – Total labor time used for the
production.
 Since, available labor time is L, therefore,

aLc.Qc + aLw.Qw ≤ L

All the quantities of cheese and wine which satisfy this

inequality constitute the production possibility set.
It can be represented graphically, by Production Possibility
Frontier.
 Production possibility frontier represents different
combinations of cheese and wine, which an
economy can produce using all of its resources
efficiently.
 Mathematically, PPF can be represented as –

aLc.Qc + aLw.Qw = L
Qw

Slope = aLc/ aLw

L/aLw
PPF

L/aLc Qc
The production possibility frontier illustrates the different
mixes of goods the economy can produce. To determine
what the economy will actually produce, however, we need
to look at prices. Specifically, we need to know the relative
price of the economy's two goods, that is, the price of one
good in terms of the other.
Suppose,
 Pc – Price of one unit of cheese.

 Pw – Price of one unit of wine.

Therefore,
Per hour wages from production of cheese =
Per hour wages from production of wine =
In the absence of trade, if,
 > - Economy will produce only cheese and no wine.

This increases prices of wine and the process continues till they
become equal.
 < - Economy will produce only wine.

This increases prices of cheese and the process continues till

they become equal.
 = - Economy will produce both the goods.

⇒ =
Thus, we can say that in the absence of International Trade the
relative prices of goods are equal to their unit labor
requirement.
 TRADE IN ONE FACTOR ECONOMY
Suppose, apart from home country there is foreign country
as well which also produces cheese and wine using single
factor input(labor).
 Qc*: Quantity of cheese produced in foreign country.

 Qw*: Quantity of wine produced in foreign country.

 L*: Quantity of labor available in foreign country.
 a*Lc : Labor time required to produce 1 unit of cheese
in foreign country.
 a*Lw: Labor time required to produce 1 unit of wine in
foreign country.
Similarly as home country:
 Production possibility set – a* .Qc* + a* .Qw* ≤ L*
Lc Lw

 Production possibility frontier – a*Lc.Qc* + a*Lw.Qw* = L*

 Slope of PPF = a*Lc / a*Lw
Assume the Opportunity Cost of cheese in home country is
less than that in foreign country, this implies,

We know, is relative price of cheese in home country.

Similarly, is relative price of cheese in foreign country.

Therefore, before trade, relative price of cheese in home

country is less than that in foreign country.
 This makes export of cheese from home country
to foreign country more profitable. Hence, import
of wine from foreign country to home country
more profitable.
 Hence, home country will specialize in the
production of cheese and foreign country will
specialize in the production of wine.
 Therefore, both the countries will benefit from
the trade.
 SPECIFIC FACTOR MODEL
 The specific factors model was developed by Paul Samuelson and
Ronald Jones.
 It is a variant of the Ricardian Model.

 Like the simple Ricardian model, it assumes an economy that

produces two goods.

 Unlike the Ricardian model, however, the specific factors model

allows for the existence other of factors of production besides

labor.
 The models name refers to its distinguishing feature – That one

factor of production is assumed to be “specific” to a particular

industry.
 It is designed to evaluate the real-world phenomenon that some

factors of production are more mobile between industries than

others. It does that by assuming that some factors (capital & land)
can not move between industries (immobile), while the other
factor (labor) can freely move (mobile).
 ASSUMPTIONS
 Assume that we are dealing with one economy that can
produce two goods, manufactured goods (M) and food (F).
There are three factors of production; labor ( L ), capital ( K )
and land ( T for terrain).
 Manufactured goods are produced using capital and labor

(but not land).

 Food is produced using land and labor (but not capital).

 Labor is therefore a mobile factor that can be used in either

sector.
 Land and capital are both specific factors that can be used

only in the production of one good.

 Perfect Competition prevails in all markets.
 How much of each good does the economy produce?

- The economy’s output of manufactured goods depends

on how much capital and labor are used in that sector.

 Thisrelationship is summarized by a production function.

 The production function for good X gives the maximum

quantities of good X that a firm can produce with various

amounts of factor inputs.

- For instance, the production function for manufactured

goods tells us the quantity of manufactured goods that can
be produced given any input of labor and capital (land).
The production function for manufactured goods is
given by
Q M = QM ( K , L M )
where;
 Q is the economy’s output of manufactured goods
M
 K is the economy’s capital stock
 LM is the labor force employed in M sector
The production function for food is given by
Q F = QF ( T , L F )
Where;
 Q is the economy’s output of food
F
T is the economy’s supply of land
 L is the labor force employed in food
F
 The labor market equilibrium under full employment
implies that:

LM + L F = L

 We can use these relationships to construct the

production possibility frontier of the country.

To analyze the economy's production possibilities, the

question that arises is, how the economy's mix of
output changes as labor is shifted from one sector to
the other.
 This can be done graphically, first by representing the

production functions, then by putting them together to

derive the production possibility frontier.
 Output, QM

QM = QM (K , LM)

Labor Input, LM
Figure illustrates the relationship between labor input and
output of manufactures. The larger the input of labor, for a
given capital supply, the larger will be output. However, if
labor input increases without increasing capital as well, there
will normally be diminishing returns: because, adding a
worker means that each worker has less capital to work with,
each successive increment of labor will add less to production
than the last.
 Diminishing returns are reflected in the shape of the
production function: QM = QM (K , LM). It gets flatter as we
move to the right, indicating that the marginal product of
labor declines as more labor is used. The marginal product
of labor, is the addition to output generated by adding
one more unit of person-hour. The slope of QM = QM (K ,
LM) represents the marginal product of labor.

 The more the labor employed in the production of

manufactured goods, the larger the output. As a result of
diminishing returns, however, each successive person-hour
increases output by less than the previous one; this is
shown by the fact that the curve relating labor input to
output gets flatter at higher levels of employment.
Marginal Product of labor, MPLM

MPLM
Labor Input, LM
Figure shows the marginal product of labor, which is the
increase in output that corresponds to an extra unit of input,
decreases with increase in labor.

These were the graphical representation of production

function for manufactured goods. A similar pair of diagrams
can represent the production function for food.
 Thesediagrams can then be combined to derive the
production possibility frontier for the economy.

 Aswe saw Ricardian Model, the production

possibility frontier shows what the economy is
capable of producing; in this case it shows how
much food it can produce for any given output of
manufactured goods and vice versa.
TRADE IN SPECIFIC FACTORS MODEL
 With the opening of trade, the nation will specialize in the
production of and will export food (the labor-intensive
commodity) and import manufactured goods (capital-
intensive commodity).
 This will increase the relative price of Food(i.e., P /P ) and
F M
the demand & nominal wage rate of labor in the nation.
 Some labor will move from M to F, due to its mobile nature

and M will have to pay higher nominal wage rate for labor
even while facing decrease in relative price (i.e., PM/PF).
 The effect of this on the real wage rate of labor in the nation
is ambiguous. The reason is that the increase in PF/PM and
in the derived demand for labor will be greater than the
increase in the nominal wage rate and so the real wage rate
of labor falls in terms of commodity F.
 On the other hand for M, as the nominal wage rate increased
with a decrease in relative prices, the real rate of wage also
increases.
 Thus, the real wage rate in the nation falls in terms of F but

rises in terms of M. The effect on the real wage of labor is,

therefore, ambiguous.
 The real wage and income will fall for those workers who

consume mainly commodity F and will increase for those

workers who consume mainly commodity M.
 The result for specific capital is not ambiguous. Since capital

is specific to each industry, opening trade does not lead to

any transfer of capital from the production of commodity M
to the production of commodity F in the nation.
 With more labor used with the given specific capital in the
production of F (the nation’s export commodity), the real
return on capital in the production of F rises. On the
contrary, with less labor used with the same amount of
specific capital in the production of M (the nation’s
import-competing commodity), the real return on the
specific capital used in the production of M falls.
The conclusion reached by the specific-factors model is
that trade will have an ambiguous effect on the nation’s
mobile factors, benefit the immobile factors specific to the
nation’s export commodities or sectors, and harm the
immobile factors specific to the nation’s import-
competing commodities or sectors.
 HECKSCHER-OHLIN MODEL
 Developed by two Swedish economists, Eli Heckscher and
Bertil Ohlin the theory is often referred to as the Heckscher-
Ohlin theory.
 It is a model of a Two Factor Economy i.e., it has two factors

of production.
 According to this theory, the immediate cause of international

trade is the difference in the relative prices of commodities

between the countries and their differences in the commodity
price arise on account of the difference in the factor supplies
in two countries.
 It shows that comparative advantage is influenced by:

 Relative factor abundance

 Relative factor intensity

 Assumptions of the model –

1. There are two nations , two commodities, and two factors

of production (labor and capital).
2. Both nations use the same technology in production.
3. One Commodity is labor intensive, and other is capital
intensive in both nations.
4. There is perfect competition in both commodities and
factor markets in both nations.
5. There is perfect factor mobility within each nation but no
international factor mobility.
6. All resources are fully employed in both nations.
 THREE POSTULATES OF H-O MODEL
 There are two factors of production – Labor (L) and Capital
(K).
 There are two countries & they differ in factor abundance –
one is Labor abundant & Capital scarce and other is Capital
abundant & Labor scarce.
 There are two commodities – One is labor intensive and other
is capital intensive in both the countries. Both the
commodities involve the use of both factors.

NOTE – On the basis of these postulates, the H-O Theorem

predicted that the capital surplus country specializes in the
production and export of capital-intensive goods and the labor
surplus country specializes in the production and export of
labor-intensive goods.
 FACTOR ABUNDANCE
There are two theories of factor abundance –
 Price Criterion
 Physical Criterion

Suppose, there are two commodities X & Y.

 Let Capital & Labor of X be denoted as K & L.
 Let Capital & Labor of Y be denoted as K* & L*.
 Let & be nominal price of Capital & Labor of
country X.
 Let be nominal price of Capital & Labor of
country Y.
 Price Criterion – Factor abundance can be defined in terms of
factor prices as a country in which capital is relatively cheap and
labor is relatively more expensive, is regarded as capital
abundant country, regardless of physical quantities. It is a
demand & supply criterion, and it takes into account effects of
both conditions.

 Physical Criterion – A country which is endowed with a higher

proportion of capital to labor than the other country is called
capital abundant country and vice-versa for labor abundant
country. It is a pure supply criterion, and ignores the effects of
demand conditions.
 FACTOR INTENSITY
In a world of two commodities and two factors (labor and
capital), we say that commodity Y is capital intensive if the
capital–labor ratio (K*/L*) used in the production of Y is
greater than K/L used in the production of X.

For example, if two units of capital (2K*) and two units of

labor (2L*) are required to produce one unit of commodity Y,
the capital–labor ratio is one. That is, 2/ 2 in the production of
Y. If at the same time 1K and 4L are required to produce one
unit of X, K/L = 1/ 4 for commodity X. Since K*/L* = 1 for Y
and K/L = 1/ 4 for X, we say that Y is K intensive and X is L
intensive.
K/L > K*/L* - Capital Intensive
L/K > L*/K* - Labor Intensive
Shape of the Production Frontier
Capital

Labor
 ILLUSTRATION OF THE H-O
THEOREM
 A nation will export the commodity whose production
requires the intensive use of the nation’s relatively
abundant and cheap factor and import the commodity
whose production requires the intensive use of the
nation’s relatively scarce and expensive factor.
 This means Nation 1 will export X because X is Labor

intensive and L is relatively abundant in Nation 1 and

vice versa.
 It postulates that the difference in relative factor

abundance and prices is the cause of pre-trade

differences in relative commodity prices between the
two nations.
 Since the two nations have equal tastes, they face the same
indifference map.
 There is no trade in left hand diagram.

 Indifference curve I is the highest IC that Nation 1 and

Nation 2 can reach in isolation, and points A and A/

represent their equilibrium points of production and
consumption in the absence of trade.
 The tangency of IC I at points A and A/, prices of PA in

Nation 1 and PA/ in Nation 2.

 Since PA < PA/ , Nation 1 has a commodity-advance in X

and Nation 2 has a commodity-advance in Y.

 The right panel shows that with trade Nation 1 specializes
in X and Nation 2 in Y.
 Specialization continues until Nation 1 reaches point B
and Nation 2 B/, where the transformation curves are
tangent to the common relative price line PB.
 Nation 1 exports X in exchange for Y and consume at
point E on IC II. Nation 2 exports Y for X and consume at
point E/ (which coincides with point E).
 Note that Nation 1’s exports of X equal Nation 2’s imports
of X (i.e. BC=C / E /).
 Similarly,Nation 2’s exports of Y equal Nation 1’s
imports of Y (i.e. B / C / =C E).
 At PX/PY > PB, Nation 1 want to export more of X than
Nation 2 wants to import at this high relative price, and
PX/PY falls towards PB.
 At PX/PY < PB, Nation 1 want to export less of X than
Nation 2 wants to import at this low relative price, and
PX/PY rises towards PB.
 Point E involves more of Y but less of X than point A.
 However, Nation 1 gains from trade because E is on
higher IC II.
 Similarly,at E/ which involves more X but less Y than A/,
Nation 2 is better of because E/ is on higher IC II.
 FACTOR-PRICE EQUALIZATION
THEOREM
 According to the factor-price equalization theorem
when the prices of goods are equalized between
countries due to international trade, the prices of the
factors (i.e. capital and labor) also get equalized
between countries.
 What this means is that international trade will cause

the wages of homogeneous labor (i.e., labor with the

same level of training, skills, and productivity) to be
the same in all trading nations. Similarly, international
trade will cause the return to homogeneous capital
(i.e., capital of the same productivity and risk) to be
the same in all trading nations.
 We know that in the absence of trade the relative price of
commodity X is lower in Nation 1 than in Nation 2
because the relative price of labor, or the wage rate, is
lower in Nation 1.
 As Nation 1 specializes in the production of commodity

X (the L-intensive commodity) and reduces its production

of commodity Y (the K-intensive commodity), the
relative demand for labor rises, causing wages (w) to rise,
while the relative demand for capital falls, causing the
interest rate (r) to fall.
 The exact opposite occurs in Nation 2. That is, as Nation

2 specializes in the production of Y and reduces its

production of X with trade, its demand for L falls, causing
w to fall, while its demand for K rises, causing r to rise.
Shape of the Production Frontier
Capital

Labor
 To summarize, international trade causes w to rise in
Nation 1 (the low-wage nation) and to fall in Nation 2
(the high-wage nation), Thus, international trade reduces
the pre-trade difference in w between the two nations.
 Similarly,international trade causes r to fall in Nation 1
(the K-expensive nation) and to rise in Nation 2 (the K-
cheap nation), thus reducing the pre-trade difference in r
between the two nations.

 This proves that international trade tends to reduce the

pre-trade difference in w and r between the two nations.
 THE RYBCZYNSKI THEOREM
 The Rybczynski theorem demonstrates the relationship
between changes in national factor endowments and
changes in the outputs of the final goods within the
context of the H-O model.
 It states that at constant relative goods prices, a rise in the

endowment of one factor will lead to an expansion of the

output in the sector which uses that factor intensively, and
an absolute decline in the output of the other good.
 The theorem is useful in analyzing the effects of capital

investment, immigration and emigration within the

context of a Heckscher-Ohlin model.
Capital

Labor
 THE STOLPER-SAMUELSON
THEOREM
 The Stolper-Samuelson theorem describes the
relationship between changes in prices of goods and
changes in factor prices such as wages (for labor)
and rents (for capital) within the context of the H-O
model.
 The theorem states that if the price of the capital-

intensive good rises then the price of capital (rents)

will also rise, while the wages paid to labor will fall.
Thus, if the price of Y were to rise, and if Y were
capital intensive, then the rental rate on capital
would rise while the wage rate would fall.
 EMPIRICAL TESTING OF THE
HECKSCHER-OHLIN THEOREMS

 THE LEONTIEF PARADOX

Leontief in his 1953 study found that despite the fact that the
USA was a capital-abundant country it was exporting labor-
intensive products, which is an outcome contrary to the
predictions of the H-O theorem. This came out in the
observation that the exports of USA were found to be less
capital-intensive than USA's imports even when USA ranks
high among the countries with high capital-labor ratios.

THIS FINDING CONTRADICTED THE H-O THEOREM,

AND CAME TO BE CALLED “LEONTIEF’S PARADOX“
 However, it was argued that the Leontief Paradox was
not actually a paradox and the profile of trade of the
USA was consistent with the propositions of the H-O
theorem.
 'This was argued on the grounds that though USA's

exports are less capital intensive than imports, but USA

exported products that are more skilled labor-intensive
and technological intensive than the products imported.
This is consistent with the observation that USA is a
high-skilled country with a comparative advantage in
capital-intensive products.