Trade and Resources: The Heckscher-Ohlin Model. Professor Ralph Ossa International Commercial Policy

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1 Trade and Resources: The Heckscher-Ohlin Model Professor Ralph Ossa International Commercial Policy

2 Introduction Remember that countries trade either because they are different from one another or because of increasing returns to scale. Countries may differ from one another in terms of technology, endowments, or preferences. The Ricardian model emphasized technological differences but abstracted from endowment differences. The Heckscher-Ohlin model instead emphasizes endowment differences but abstracts from technological differences. 2

3 Introduction (cont.) This is interesting because factor endowments certainly play a role in shaping the pattern of trade. For example, the U.S. exports orange juice to Canada not because its Orange farmers are inherently more productive but because it is endowed with good weather in Florida. It is also interesting because it introduces distributional issues without which it is hard to make sense of protectionism. While there will still be overall gains from trade, there will now be individual winners and losers from trade. 3

4 Overview of the lecture Develop the Heckscher-Ohlin model: (i) setup, (ii) autarky equilibrium, (iii) free trade equilibrium, (iv) gains from trade. Provide some empirical evidence on the Heckscher- Ohlin model. Along the way, consider some real-world applications of the Heckscher-Ohlin model. 4

5 Setup There are two countries: Home and Foreign, two goods: food and cloth, and two factors of production: labor and land. Countries differ in their factor endowments. Home is labor abundant relative to Foreign, in the sense that Home is endowed with relatively more labor: L/T > L*/ T*. Countries share the same technology. Cloth production is labor intensive relative to food production, in the sense that cloth production uses relatively more labor for all factor prices: 5 a LC /a TC > a LF /a TF

6 Setup: Application By assuming that technologies are the same across countries, we rule out factor intensity reversals across countries. If the production of one good is labor intensive relative to the production of another good in one country we also assume the same to be the case in the other country. However, this assumption does not always hold in practice. For example, shoe production is capital intensive relative to call center service production in the U.S. while the opposite is true in India. 6

7 Setup (cont.) Technology features constant returns to scale and diminishing marginal products. All markets are perfectly competitive. As one consequence, food and cloth producers take prices and wages as given. As another consequence workers are paid a competitive wage and land-owners are paid a competitive rent. 7

8 Autarky: PPF One can show that the opportunity cost of producing cloth in terms of food is not constant in this model. It is low when the economy produces a low amount of cloth and a high amount of food. It is high when the economy produces a high amount of cloth and a low amount of food. As a consequence, the PPF becomes curved. 8

9 Autarky: PPF (cont.) 9

10 Autarky: Production and prices The production possibility frontier describes what an economy can produce, but to determine what the economy does produce, we must consider the prices of goods. Perfect competition and profit maximization imply that the economy produces 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. 10

11 Autarky: 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 ). 11

12 Autarky: Production and prices (cont.) 12

13 Autarky: Production and prices (cont.) For given prices, production at point Q thus yields the highest feasible value of production. This is where the economy will produce. 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. 13

14 Autarky: Production and prices (cont.) Notice that an increase in the price of cloth relative to the price of food therefore leads to an increase in the production of cloth relative to the production of food. This relationship between relative prices and relative production can again be captured by a relative supply curve. Notice, however, that the relative supply curve is no longer kinked as it was in the Ricardian model since the PPF is no longer a straight line in the Heckscher-Ohlin model. 14

15 Autarky: Production and prices (cont.) Relative price of cloth, P C /P F RS Relative domestic 15 quantity of cloth, Q C Q F

16 Autarky: Preview comparative advantage Ultimately, we want to understand how cross-country differences in endowments influence the pattern of trade. Recall that countries export the good in which they have a comparative advantage. Recall also that having a comparative advantage means having lower opportunity costs or production. Recall finally that having lower opportunity costs of production comes along with having a lower autarky relative price. Hence, to understand how cross-country differences in endowments influence the pattern of trade we need to understand how such differences influence autarky relative prices. 16

17 Autarky: Preview comparative advantage (cont.) Since we assume that preferences are the same in both countries so that the relative demand curves are the same in both countries, cross-country differences in endowments only influence autarky relative prices if they are associated with differences in the countries relative supply curves. Hence, to understand how cross-country differences in endowments influence the pattern of trade, we need to understand how they are reflected in cross-country differences in the relative supply curves. To that end, we simply consider one country s relative supply curve and see how it shifts in response to changes in that country s endowment. 17

18 Autarky: Preview comparative advantage (cont.) To understand how a country s relative supply curve shifts in response to changes in that country s endowment, we proceed in a number of steps. First, we show that relative goods prices determine relative factor prices. Second, we show that relative factor prices determine factor intensities. Finally we show how, for given factor intensities, endowment changes affect relative production. 18

19 Autarky: Goods prices and factor prices In competitive markets, the price of a good should be reduced to the cost of production. In our model, the cost of production depends on the wage rate w, and the land renting rate r. The effect of changes in the wage rate depend on the intensity of labor services in production. The effect of changes in the land renting rate depend on the intensity of land usage in production. An increase in the wage rate should affect the price of cloth more than the price of food since cloth is the labor intensive industry. Changes in w/r are therefore directly related to changes in P C /P F. 19

20 Autarky: Goods prices and factor prices (cont.) 20

21 Autarky: Factor prices and factor intensities Producers may choose different amounts of factors of production to make cloth or food. Their choice depends on the wage rate and the land renting rate. As the wage rate increases relative to the land renting rate, producers use less labor services and more land in the production of food and cloth. However, since food production is land intensive and cloth production is labor intensive, producers are using relatively more land for food production for all wage rental ratios. 21

22 Autarky: Factor prices and factor intensities (cont.) 22

23 Autarky: Relative endowments and relative production International Commercial Policy Since the economy produces at the point that maximizes the value of production, all resources are employed in equilibrium. The allocation of resources to sectors can be represented in the following diagram: 23

24 Autarky: Relative endowments and relative production (cont.) International Commercial Policy 24

25 Autarky: Relative endowments and relative production (cont.) International Commercial Policy For given output prices, how do outputs change if endowments change? Recall that holding output prices constant, means holding factor prices constant, which in turn means holding factor intensities constant. 25

26 Autarky: Relative endowments and relative production (cont.) International Commercial Policy 26

27 Autarky: Relative endowments and relative production (cont.) International Commercial Policy 27

28 Autarky: Relative endowments and relative production (cont.) International Commercial Policy Rybczynski theorem: For given relative goods prices, an increase in the endowment of a factor will increase output in the sector that uses this factor intensively, and will decrease output in the other sector. Together with constant returns to scale, this implies that, for given relative goods prices, a higher labor-land ratio comes along with a higher relative cloth production. 28

29 Autarky: Putting the pieces together International Commercial Policy Recall that Home is labor abundant and Foreign is land abundant, in the sense that Home is endowed with relatively more labor than Foreign: L/T > L*/ T*. Hence, Home s relative cloth supply will be larger than Foreign s relative cloth supply for any relative cloth price. As a consequence, Home s autarky relative cloth price will be below Foreign s relative cloth price so that Home will have a comparative advantage in cloth production. 29

30 Autarky: Putting the pieces together (cont.) 30

31 Autarky: Putting the pieces together (cont.) Heckscher-Ohlin theorem (first variant): A country has a comparative advantage in the good that uses its abundant factor intensively. 31

32 Trade: Pattern of trade Again, prices must be equalized with trade to rule out arbitrage opportunities. Hence, the relative price of cloth rises in the labor abundant country (Home) and falls in the labor scarce country (Foreign) if trade is liberalized. In Home, the rise in the relative price of cloth leads to a rise in the relative supply of cloth and a fall in relative demand of cloth; Home becomes an exporter of cloth and an importer of food. The decline in the relative price of cloth in Foreign leads it to become an importer of cloth and an exporter of food. 32

33 Trade: Pattern of trade (cont.) Heckscher-Ohlin theorem (second variant): A country exports the good that uses its abundant factor intensively. 33

34 Trade: Goods prices and factor prices International Commercial Policy The close relationship between goods prices and factor prices discussed earlier, has two important additional implications. The first is summarized by the Stolper-Samuelson theorem. The second is summarized by the factor price equalization theorem. 34

35 Trade: Stolper-Samuelson theorem Stolper-Samuelson theorem: An increase in the relative price of a good will increase the real return to the factor used intensively in the production of that good, and will decrease the real return to the other factor, in terms of both goods. Notice that, together with the Heckscher-Ohlin theorem, this implies that the owners of the abundant factor gain but the owners of the scarce factor lose if trade is liberalized. Hence, trade can have important distributional consequences. 35

36 Trade: Stolper-Samuelson theorem (cont.) International Commercial Policy For example, an increase in the relative price of cloth will increase the real return to labor and decrease the real return to land, in terms of both cloth and food. Intuitively, this is because the increase in the relative price of cloth leads to an increase in the wage-rental ratio, which leads to an increase in the land-labor ratio employed in cloth and food production. This then increases (decreases) the real return to labor (land) since real factor returns are given by marginal products and the marginal product of labor (land) is increasing (decreasing) in the land-labor ratio. 36

37 Trade: Stolper-Samuelson theorem (cont.) International Commercial Policy 37

38 Trade: Factor price equalization theorem Moreover, the Heckscher-Ohlin model predicts that factor prices will be equalized among trading countries. This result is known as the factor price equalization theorem. Because output prices are equalized and because of the direct relationship between output prices and factor prices, factor prices are also equalized. Intuitively, 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. 38

39 Trade: Factor price equalization theorem (cont.) Of course, factor prices are not really equal across countries. Three counterfactual assumptions are driving this counterfactual prediction. First, the model assumes that both countries have the same technology. Second, the model assumes that both countries produce both goods. Third, the model assumes that there are no trade costs. 39

40 Gains from trade We have already established that the owners of the abundant factor gain but the owners of the scarce factor lose if trade is liberalized. However, the owners of the abundant factor gain more than the owners of the scarce factor lose in the sense that the owners of the abundant factor could compensate the owners of the scarce factor for their losses and still be better off. Hence, while some people gain and some people lose from trade, the economy as a whole still gains from trade in the Heckscher-Ohlin model. 40

41 Gains from trade (cont.) The economy as a whole still gains from trade since trade expands the economy s consumption possibilities. Under autarky, domestic consumption has to equal domestic production. Under trade, however, domestic consumption can differ from domestic production, since domestically produced goods can be exchanged for foreign produced goods at world market prices. 41

42 Gains from trade (cont.) Consumption of food, D F Output of food, Q F Consumption possibilities under trade exceed consumption possibilities under autarky. The consumption point no longer coincides with the production point since the economy can exchange goods at world prices. Production and consumption under autarky Production under trade Slope = -(P C /P F ) AUTARKY Slope = -(P C /P F ) TRADE Consumption of cloth, D C Output of cloth, Q C 42 Copyright 2009 Pearson Addison-Wesley. All rights reserved.

43 Evidence At first sight, the evidence on the Heckscher-Ohlin model is confusing. Some studies seem to find that the Heckscher-Ohlin model does poorly, while others seem to find that the Heckscher-Ohlin model does well. On closer inspection, the following message emerges: The factor price equalization version of the Heckscher- Ohlin model does poorly. However, once the assumptions underlying the factor price equalization theorem are relaxed, the Heckscher Ohlin model does well. 43

44 Evidence: Leontief (1953) International Commercial Policy Leontief (1953) was the first to confront the Heckscher- Ohlin model with the data. He considered the simple factor price equalization version. At the time of his study, the U.S. was the most capital abundant country in the world. Hence, he expected U.S. exports to be capital intensive and U.S. imports to be labor intensive. However, he found exactly the opposite. This result became known as the Leontief paradox. 44

45 Evidence: Bowen et al. (1987) International Commercial Policy While Leontief (1953), tested the basic two-factor, twogood version of the Heckscher-Ohlin model, Bowen, Leamer, and Sveikauskas (1987) repeated his analysis using a multi-factor, multi-good version of the Heckscher-Ohlin model. However, the multi-factor, multi-good version they considered also featured factor price equalization. As a consequence, the empirical performance of the model was again poor. 45

46 Evidence: Trefler (1995) International Commercial Policy Trefler (1995) was the first to consider a non-factor price equalization version of the Heckscher-Ohlin model. Remember that the factor price equalization theorem rests on three main assumptions: (i) all countries have the same technology, (ii) all countries produce all goods, (iii) there are no trade costs. Trefler (1995) allowed for cross-country differences in technology and found that the model performed much better. 46

47 Evidence: Davis and Weinstein (2001) Davis and Weinstein (2001) relaxed the second assumption of the factor price equalization theorem and allowed for complete specialization. Again, the model performed much better. 47

48 Evidence: Romalis (2004) International Commercial Policy Former Chicago Booth professor John Romalis, relaxed the third assumption of the factor price equalization theorem and allowed for costly international trade. Again, the model performed much better. His results suggest that countries indeed export disproportionate amounts in industries that use their abundant factor intensively. 48

49 Evidence: Romalis (2004) (cont.) 49

50 Evidence: Romalis (2004) (cont.) 50

51 Evidence: Romalis (2004) (cont.) 51

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