Chapter 4 Factor Endowments and Hecksher-Ohlin

Yanan University

Finance and Economics Dep.

Aihong Qin

Comparative advantage based on factor endowments

Factor prices how they are influenced by trade

Trade causing income disparities between skilled and

unskilled wages

Introduction

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

 NB: classicals explained using labour as a factor only -Productivity of labor

Assumptions

1.Two Nations(1&2), 2commodities(X&Y),two fators(L&K)- for illustration and comparison

Same technology used-access &same pdn techniques-if factor prices were same in both nations producers will use the same amount of K&L but prices differ, resulting in the use of a cheap factor

X-L-intentive,Y-Capital intensive Constant returns to scale- ↑K or L in either nation by a

certain proportion then output ↑ by same.

Assu

Incomplete specialization- even with free trade both counties will continue to produce- No small country assumption

Equal taste in both nations-Demand preferences are identical. Consumption of X&Y will be uniform if relative commodity prices

Perfect competition- Neither producer can influence the prices in these nations

Assumptions

In the L-R, commodity prices equal their cost of production-no economic profit after cost

Internal factor mobility- Mvt within ONLY-from areas and industries of lower earnings to areas of higher until earnings are uniform

No transport cost, tariffs, all other barriers to trade

All resources are fully employed –no unutilized factors of pdn

Balanced international trade btwn 2 nations- Exports=Imports.

Factor Intensity

Implies that relatively more of one of the factors is used.

With X&Y as commodities of pdn , Y is capital intensive if Capital-Labour(K/L) ratio used in the production used in the pdn of Y is greater than K/L used in the pdn of X.

It is not the absolute amount of capital and labour used in pdn of X &Y- but amount of capital per unit of labour.

Factor Intensity

Nation 1&2

Capital-Labour Ratio=1 for Y and ¼ for X. , therefore Y is capital intensive.

Nation2: K/L =4 for Y and and 1 for X thus Y is capital intensive.

NB Its at all possible relative factor prices.

Factor AbundanceDef: 2 WAYS1. Interms of physical units- total amount of labour

capital and labour available in each nation.2.interms of Relative factor prices- rental price of

capital and price of labour in each nationPhysical units we say there factor abundance if ratio

of total amount of capital to the total amount of labour is greater than another nation TK/TL>TL/TK.

Not absolute ????Factor prices a nation is capital abundance if the ratio

of the rental price of capital to the price of labour is lower in Nation 2 than 1.

Factor Abundance& Production Frontier

FA cont

Nation 2 which is capital abundant will produce good Y which is capital intensive.vise versa.

Hecksher –Ohlin Theory

Originated from “ The Effect of foreign trade on the Distribution of Income”.1991 by Eli Hecksher

The idea was popularised and further built, clarified by Bertil Ohlin in 1933 in a famous bk “Interregional and International Trade.”

Divided into two theorems1. H-O theorem- deals with and predicts the

pattern of trade2.Factor – price equalization- which deals with

effect of international trade on factor prices.

H-O TheoremBased on assumptions highlighted aboveIt states that 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 pdn requires the intensive use of the nation’s relatively scarce and expensive factor.

Theorem emphasizes that relative factor endowments and factor abundance is the primary cause of differences in comparative advantage

A.k.a Factor- proportions or factor endowments theorem.

General Equilibrium

General Equilibrium

      Differences in distribution of ownership of factors of production(income) and taste leads to differences in demand of final commodity prices

Leads to dd of factors of pdn-derived ddDd of factors and Supply of factors give rise to

factor pricesFactor prices and technology will lead to

commodity prices

H-O

ExplanationAutarky –Nation 1 produces @A and more of

X-Labour intensive good

-Nation 2-produces at A’ and more of Y capital intensive good

- IC 1 passes thru A&A’- PA less than PA’- With trade- Nation1 specialises in X and moves from A to B - Nation2 specailises in Y and moves from A’ to

B’

HO

- Therefore Nation 1 will export BC of X and Inport C’B’ of Y

- New IC both nations will benefit.- If ratio of Px/Py greater than Pb then Nation 1

wants to export more of commodity X than what Nation2 wants at a higher relative priceof X and then Px/Py falls toward Pb

Factor-Price EqualizationInternational trade will bring about

equalization in the relative and absolute returns to homogeneous factors across countries

International trade will cause the wages/return of homogeneous labour/capital- relative and absolute wages and return will be equal.

A labour intensive nation will produce more of X and therefore DD for labour increases raising wages and decreasing interest.

F-PET

F-EShows that w/r1 and w/r2 will move

towards w/r* as more labour is demanded in Nation 1 and as more capital is demanded in Nation 2

Effects of Trade on the Distribution of Income

Real income of labour rises in Nation1 which is labour abundant, as wages rise and real income of capital rise in Nation 2 as interest rise

Empirical TestingNo- in real world homogeneous factors

do not receive the same returns. e;.g Engineers in America and SA

Why- some assuptions are not real e.g same technology , no tansportation cost, no trade barriers, existence of imperfect competition, non constant returns to scale

Empirical Testing-Leontief ParadoxUsing US data for 1947, Wassily Leontief in 1951

tried to test the Heckscher –Ohlin Theory.US as the most K-abundant nation in the world ,

Leontief expected that the US expoerted K-Intensive commodities and imported L-intensive commodities.

Using Input-Output table – estimated K/L for US import substitutes rather than imports- as the data on imports was not available

Results showed that US import substitutes were about 30% K intensive than US exports. US exported more L-intensive goods and imported capital intensive goods.

Leontief

Leontief explained the results arguing that since US labour was 3 times productive than foreign labour , therefore US was labour intensive- ,an explanation rejected by even Leontief himself later

Another explanation was based on taste- US taste was biased towards K-intensive goods= but taste are similar across nations.

Explanations of the Leontief and H-O

1947 not a good year since it was after WW2

Use of a two factor model, L&K only leaving natural resources

Tariffs-a tax on imports which stimulate production in the domestic economy.

Use of only physical capital leaving human capital

Factor -Intensity ReversalRefers to a situation where a given commodity is

the L-intensive commodity in the L- abundant nation and K-intensive commodity in the K-abundant nation.e.g if X is L-intensive commodity in N1(Low wage), and at the same timeit is K-intensive in N2(high wage nation)

We use the concept of elasticity of substitution which measures the degree or ease with which one factor can be substituted for another in the pdn as relative price of the factor declines.

If elasticity of L for K is much greater in pdn of X than Y- it means that its much easier to substitute L for K in the pdn of X than Y

Factor-Intensity reversal is more likely to occur the greater the difference in the elasticity of substitution for L &K in the pdn of two commodities

Factor –Intensity Reversal results in the invalidity of H-O and factor-price equalization.

H-O fails to hold as a L-abundant nation cant export a capital –intensity commodity.