Chapter 5: The Heckscher-Ohlin Model

  • Resource differentiation is the only source of trade
  • CA is influenced by the interaction between nation’s resources (the relative abundance of factors of production) and the technology of production
  • International trade is largely driven by the differences in resources and is one of the most influential theories in international econ
  • HO Theory (AKA factor-proportions theory) – emphasizes the interplay between the proportions in which different factors of production are available in different counties and the proportions in which they are used in producing different goods
  • By exploring this theory we will see that unlike the Ricardian model with a single factor of production, trade can affect the distribution of income across various facts even in the long run

5.1 – Model of a Two Factor Economy

  • 2 countries, 2 factors and 2 goods
  • both factors example capital and labour for both goods food and cloth are be moved within sectors
  • production function of cloth and food (The economy has a fixed supply of capital and labour)
  • QC = QC (KC, LC)
  • QF = QF (KF, LF)
  • Input requirements are the same as the Ricardian Model HOWEVER in this model we speak of the quantity of capital or labour used to produce a given amount of a good rather than the quantity required to produce a given amount
  • There is a resource constraint for capital/labour k
  • Below: factors cannot be substituted

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  • Important feature of this PPF is that the OC of producing an extra cloth in terms of food is not constant
  • When economy is producing mostly food, then there is spare labour capacity
  • When products can be substitute: the PPF is a round shape
  • The bowed shape means the OC in terms of food for producing one more cloth rises as the economy produces more cloth and less food
  • Value of economy’s production is
  • V= PC X PQ + PF X QF
  • Isovalue lines = tangent to PPF and the slope of that line is Price of Cloth/ Price of Food
  • The economy produces at the point that maximizes the value of production, this is the point of the highest isovalue line
  • The concept of trade-offs = a famer can produce one calorie of food with less capital is he uses more labour
  • To determine how much labour and capital, it depends on relative prices

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  • At any given wage-rental ratio, cloth production uses higher labour capital ratio so cloth production is labour intensive and food production is capital intensive
  • since CC is shifted ore outwards than FF it means that at any point use more labour relative to capital than will production of goof
  • when that is true we say cloth = labour intensive and food = capital intensive
  • definition if intensity depends on ratio of labour to capital used in production not ratio or labour/capital to output meaning you can’t have both labour and capital intensive at same time
  • CC and FF curves (above) are called relative factor demand curves
  • Downwards slope = substitution effect

Factors and Goods Prices

  • Say if labour rises than the cost of a product that uses a lot of labour that products price will rise also. But if that good doesn’t use too much labour then there won’t be much of an effect
  • A one-to-one relationship between the ratio of the wage rate to the rental rare (w/r) and the ratio of the price of cloth to that of food (Pc/Pf) shows as SS curve below:

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  • Cloth = labour intensive there is a one-to one relationship between the factor price ratio
  • The higher the relative cost of labour the higher must be the relative price of the labour intensive good

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  • Given the relative price of cloth (PC/PF)1 the ratio of wage rate to the capital rental rate just equal (w/r)1 this implies that the ratios of labour to capital employed in the production of cloth and food must be (LC/KC)1 and (LF/KF)1
  • If the relative price of cloth rises to #2 then the wage-rental ratio will rise to #2 however the labor-capital ratio will drop for both goods
  • As we go from PC/PF)1 to PC/PF)2 the income of workers will increase (higher wages)
  • General statement: such a change in relative prices will unambiguously raise the purchasing power of workers and lower the purchasing power of capital owners by raising real wages and lowering real rents in terms of both goods
  • In a competitive economy factors of production are paid their marginal product
  • When the ratio of labor-capital falls in producing either good, the MP of labor in terms of that good increases so workers find their real wage higher in terms of both goods

Resources and Output

  • Now we assume that the economy’s labor force grows and so the economy’s aggregate labor to capital ratio (L/K) increases
  • How does the economy employ additional hours? It’s the allocation of labor and capital across sectors
  • the labor capital ratio is higher in the cloth sector than food sector
  • so economy can increase the employment of labor to capital (holding labour-capital ratio fixed in each sector) by allocating more labor and capital to the production of cloth (which is labor intensive)
  • as labour and capital move from the food sector to the cloth, the economy produces more cloth and less food
  • the increase of the labour supply makes the PPF shift outwards, after the increase, the economy can produce more of both cloth and food
  • biased expansion or production possibilities = when the shift is larger in the direction of one good over the other
  • /Users/m_onelove8/Desktop/Screen Shot 2018-05-20 at 9.32.40 PM.png
  • increase in supply of labor expands the PPF disproportionately in the direction of cloth production
  • increase in supply of capital expands the PPF disproportionately in the direction of food production
  • THEREFORE, economy with high relative supply of labour to capital will be relatively between at producing cloth than economy with low relative supply of labor to capital
  • Generally, an economy will tend to be relatively effective at producing goods that are intensive in the factors with which the country is related well endowed

5.2 - Effects of International Trade Between Two-Factor Economies

  • Home has a higher ratio of labour to capital so home = labour abundant
  • Abundance is in terms of a ratio not in terms of absolute quantity
  • since cloth = labour intensive (and since home is labor abundant) home’s PPF relative to foreign is shifted out more in direction of cloth rather than food meaning home has higher ratio of cloth-food
  • since for any given ratio of cloth-food, home will be higher home has a larger relative supply of cloth so the supply curve is RIGHT of the foreign’s supply curve
  • in the chart below: point 1 is if there was no international trade = home equilibrium
  • point 3 = foreign equilibrium
  • in the absence of trade, relative price for cloth would be lower at home than in foreign
  • point 2 = in the middle, with trade existing … relative price of home rises and foreign declines
  • the economy exports the good whose relative price increases


  • Theorem: The country that is abundant in a factor, exports the good whose production is intensive in that factor (in which the country is abundantly endowed)

Distribution of Income

  • a resource in which a country has relatively large supply (labor in home and capital in foreign) is the abundant factor opposite is scarce factor
  • general conclusion: owners of a country’s abundant factors gain from trade, and scare loose
  • The specificity of factors to particular industries is often only a temporary problem
  • USA is abundantly endowed with high skilled labour while low-skilled labour is correspondingly scarce. Means trade has the potential to make low-skilled workers worse off forever

Skill based technological change and income inequality

  • The LL and HH show the skilled-unskilled employment ratio
  • High tech sector is more skill intensive than the low tech sector so the HH curve is shifted out more relative to the LL curve
  • A = increased trade leads to higher Skilled-unskilled ratio… producers decrease their relative employment of skilled workers
  • Increased trade = increase in wage inequity (it goes up from A to B) since price of skilled worker goes up… it makes producers want to decrease the employment of skilled workers
  • B = skill-biased technological change leads to higher skilled-unskilled wage ratio… producers increase relative employment of skilled workers
  • Tech change in both sectors = increase in wage inequality called skill-biased
  • LL and HH shifts out
  • Induces larger productivity gains in high-tech sectors
  • For any given relative price of high-tech goods, tech change is associated with higher skilled-unskilled wage ratio
  • USA sector example: when firms begin to export, they upgrade to more skill-intensive production technologies
  • So trade liberalization can then generate a widespread technological change including a large proportion of forms to make such technology-upgrade choices
  • A trend: labour income of workers declined and the return to capital owners increased
  • Capital-skill complementarity where capital is a much closer substitute for unskilled labour than for skilled labour
  • Technological changes take the form of new and better machines (capital) that displace unskilled workers but still require skilled workers

Factor Price Equalization

  • Absence of trade labour would earn less at home and capital would earn more since labour abundant home would have lower relative price of cloth and capital abundant foreign
  • The difference in relative prices of goods implies an even larger difference in the relative prices of factors
  • When home and foreign trade, the relative prices of goods converge, tendency equalization of factor prices
  • International trade leads to a complete equalization of factor prices, after trade the ratios become the same (the wage ratio and capital ratio)
  • How does equalization occur?
  • When trade occurs, they are trading not just goods but factors of production
  • Home lets foreign use its abundance of labour, not by selling labour directly but by trading goods produced with a low labor to capital ratio
  • Home exports goods that are embodied in its labor-intensive exports
  • In the real world, factor pries are not equalised
  • To understand why the model doesn’t give accurate predictions
  • Three assumptions curtail to the prediction of factor-price equalization are untrue:
  • Technologies are the same
  • If tech is different, proposition won’t hold
  • Costless trade equalizes the prices of goods in 2 countries
  • Can have natural barriers and barriers to trade like tariffs or quotas
  • Both countries produce both goods
  • Factor prices don’t need to be equalized between countries with radically different ratios of capital to labor or of skilled to unskilled labor

Empirical evidence on the HO Model

  • Trade is driven by differences in factor abundance across countries
  • Factor content of trade: the mix of factors of production used to produce a country’s exports

Trade in goods as a substitute for trade factors: factor content of trade

  • Tests on US Data

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