Economics 340: International Economics Andrew T. Hill Heckscher-Ohlin Theory

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1 Economics 340: International Economics Andrew T. Hill Heckscher-Ohlin Theory Textbook Readings: Pugel & Lindert, International Economics, 11th Edition, pp , th Edition, pp , In the previous sections, we have looked at comparative advantage as it was explained by Ricardo and further developed by the neo-classical economists. Ricardo s explanation for comparative advantage centered on differences in labor productivity (technology) coupled with the idea of opportunity cost. But, he didn t explain why there were differences in productivity in different countries. Weaknesses in Ricardo s model: In 1919, Eli Heckscher ( ) wrote a short article entitled The Effects of Foreign Trade on the Distribution of Income. (Economisk Tidskrift 21 [1919] pp ). In that article, he argued that international trade alters factor prices and that those changes in factor prices lead to the redistribution of income within a country. It was Heckscher s landmark article that laid the groundwork for factor endowment theory which is more often referred to by international economists as Heckscher-Ohlin Theory. Eli Heckscher ( ): Born in Stockholm in 1879, Eli Heckscher studied history and economics at Uppsala University. In 1909 he became professor of economics and statistics at Stockholm University College of Commerce. He held that post until 1929 when he was made research professor and director of the Institute of Economic History. He retired from academia in He was considered a leader in a diverse array of economic topics from economic history to international trade theory. His most significant contribution to economic theory was the factor proportions theory of international trade first outlined in his 1919 article The Effects of Foreign Trade on the Distribution of Income and developed further by Ohlin in Heckscher s student Bertil Ohlin ( ) developed further Heckscher s work. Ohlin argued in his work Interregional and International Trade (1924) that countries were endowed disproportionately with different factors of production which make them better at producing goods which use the more abundant factor more intensively. 24

2 Bertil Ohlin ( ): Bertil Ohlin was born on 23 April 1899 in Klippan, Sweden. He received a degree in mathematics, statistics, and economics at the University of Lund in He continued his studies with Eli Heckscher at the Stockholm School of Business Administration where he was awarded a degree in economics in He received an AM at Harvard in 1923 and completed his Ph.D. at the University of Stockholm in Ohlin taught at the University of Copenhagen from 1925 to 1930 before taking the position vacated by Eli Heckscher at the Stockholm School of Business Administration in He remained in his post at Stockholm until He was visiting professor at the University of California at Berkeley in 1937 and at Columbia and Oxford in Ohlin was one of the few economists who have been successfully able to contribute widely to economic theory and also hold political office. He served as a member of the Swedish Riksdag (parliament) from 1935 to 1970, was Swedish Trade Minister from 1944 to 1945, and leader of the Swedish Liberial Party from 1944 to He was awarded the Nobel Prize in Economics jointly with James Meade in 1977 for his work on international trade theory. He died on 3 August 1979 in Stockholm. The factor endowment theory (a.k.a. Heckscher-Ohlin Theory) relies on several simplifying assumptions: According to the factor-endowment theory, relative price levels differ among nations because: Heckscher-Ohlin Theory (Factor Endowment Theory)states that given these circumstances listed immediately above, a nation will export that commodity for which a large amount of the relatively abundant (cheap) input is used in production. The country will import that commodity for which a large amount of the relatively scarce (expensive) input is used in production. Example of Resource Abundance and Input Intensity: A country is relatively labor-abundant if it has a higher ratio of labor to other factors of production than does the rest of the world. 25

3 A product is labor-intensive if labor costs are a greater share of its value than they are of the value of other products. To determine whether the United States is a land-abundant country, we could use a formula like this one: To determine whether a certain good X is land-intensive, we could use a formula like this one: Example: Simple Case using Heckscher-Ohlin Theory: Assume that auto production is capital-intensive, requiring much capital and little land; wheat production is assumed to be land-intensive, requiring much land and little labor. Suppose that capital is relatively abundant in Germany and that land is relatively abundant in France. What country will have the comparative advantage in autos? What country will have the comparative advantage in wheat? Factor-Price Equalization Theory says that a nation that is trading will find output expanding in its comparative-advantage industry, which uses a lot of the cheap, abundant factor. As a result of the rise in demand for the abundant factor, its price increases. At the same time, the expensive, relatively scarce factor is being released from the comparative-disadvantage industry. As a result of the decrease in demand for the scarce factor, its price decreases. This process occurs simultaneously in both countries in the two-good, two-country model. Therefore, each country experiences a rise in the price of the abundant factor and a fall in the price of the scarce factor. So, trade will lead to an equalization in the price of each factor in the two countries. THINK-PAIR-SHARE: If we have two countries, Mexico and the United States, and two goods, textiles and corn, and we know that textiles are relatively labor-intensive in production and corn is relatively land-intensive in production, does the factor-price equalization theory say that the price of labor and the price of land in Mexico will equalize while the price of labor and the price of land in the United States will equalize? Or, does it say that the price of labor in Mexico and the United States will equalize while the price of land in Mexico and the United States will equalize as a result of trade? 26

4 Trade and the Distribution of Income: The factor endowment theory states that the export of commodities embodying large amounts of the relatively cheap, abundant factors make those factors less abundant in the domestic market. The increased demand for the abundant factorleads to an increasein its return. At the same time, returns to the factor used intensively in the import-competing product (the scarce factor) decrease as its demand falls. The increase in the returns to each country s abundant factor thus comes at the expense of the scarce factor s returns. Using the example from the THINK-PAIR-SHARE immediately above, Group Problem: Assume tastes and technology are identical in Hong Kong and Japan. Assume Hong Kong is labor abundant and Japan is capital abundant. Assume production of textiles is labor intensive and production of tractors is capital intensive. a. Sketch the production possibilities frontiers for Hong Kong and Japan in the space below. Be prepared to explain why you drew them the way that you did. b. In autarky, which country has a comparative advantage in the production of which good? Show how you know, or why you don t know. 27

5 c. What does the Heckscher-Ohlin theory predict would happen if trade were opened between Hong Kong and Japan? d. What do you predict will happen to the price of capital in Japan, the price of capital in Hong Kong, the price of labor in Hong Kong, and the price of labor in Japan as a result of trade following the Heckscher-Ohlin model? e. What do you predict will happen to the incomes of capital owners and workers in both Japan and Hong Kong? Leontief s Paradox There have been many attempts to test whether the factor endowment theory that Heckscher and Ohlin developed actually holds empirically. The first such attempt came from Wassily Leontief in 1953 in his paper Domestic Production and Foreign Trade: The American Capital Position Reexamined in Proceedings of the American Philosophical Society 97 (1953). If you realize that the United States is a highly developed country with lots of capital used in production, it follows from the factor endowment theory that the United States is capital-abundant and should export capital-intensive goods while importing laborintensive goods. It is this prediction of the Heckscher-Ohlin theory that Leontief set out to test. He examined data from 1947 for 200 export industries and import-competing industries. Import-competing industries are those U.S. industries that compete heavily against imports from foreign countries. He found the following data: Table 11: Factor Content of U.S. Trade: Capital and Labor Requirements per Million Dollars of U.S. Exports and Import Substitutes* Empirical Study Import Substitutes Exports Import/Export Ratio LEONTIEF (1947 data) Capital $3,091,339 $2,550,780 Labor(person years) Capital/person years $18,184 $14, LEONTIEF (1951 data) Capital $2,303,400 $2,256,800 Labor(person years) Capital/person years $13,726 $12, * SOURCE: Carbaugh, International Economics, 7th Edition, 2000, p

6 When Leontief looked at the 1947 data he found that the capital/labor ratio for our exports were less than the capital/labor ratio in the import-competing industries. The conclusion he drew was that the U.S. was exporting labor-intensive goods while importing capital-intensive goods. This result is completely backwards from what Heckscher-Ohlin theory would predict! Leontief was criticized for his work. Most international economists at the time had some sort of argument as to why his findings weren t correct. The most widely accepted idea was that the 1947 data were not truly reflective of normal trade patterns since the world was still recovering from World War II. Leontief did the same study again using data from While he found that the import/export ratio of the capital/labor ratio wasn t nearly as big as when he used the 1947 data, he still found that the United States was exporting labor-intensive goods while importing capital-intensive goods a result that was completely contrary to the results one would obtain from the factor endowment theory. Hence Leontief s Paradox! It has come to be generally accepted that the reason Leontief found his paradox is that factors of production need to be much more narrowly defined when testing the factor endowment theory. For example, there are many different kinds of land (urban, arable, unusable for any production, etc.). Likewise, there are many forms of capital most notably physical versus human capital. When one more narrowly defines the factors of production into finer categories, one finds that the Heckscher-Ohlin theory holds much better than when only considering land, labor, capital, and entrepreneurial ability. Predicated Essays 1. Korean workers earn only $2.50 an hour; if we allow Korea to export as much as it likes to the United States, our workers will be forced down to the same level. You can t import a $5.00 shirt without importing the $2.50 wage that goes with it. Discuss. 2. What does the factor-price equalization theorem postulate? What does it mean for wages and the rental rate of land in Mexico and the United States if the United States is relatively landabundant and Mexico is relatively labor-abundant? 3. How does the Leontief paradox challenge the overall applicability of the factor-endowment model? 4. The factor-price equalization theorem indicates that with free trade, the real wage earned by labor becomes equal to the real rental rate earned by landowners. Is this correct or not? Why? 5. You read in a newspaper that the owners of capital in a particular country are urging their government to restrict trade through import quotas. What might you infer about the relative factor abundance in that country? Why? 29